July 2021

“Meet the new boss, same as the old boss.”
Pete Townshend

On July 19 the month came alive with the long-expected lifting of remaining COVID restrictions in the UK, so called Freedom Day.  Unsurprisingly the “lifting of all restrictions” actually saw the introduction of a number of new restrictions, thereby dampening the expected bounce of a reopening.  Most bizarre was the decision to keep in place the track-and-trace system for a further month, which created a pingdemic of self-isolation leading to staff shortages which led to business closures and empty supermarket shelves, something not seen since the run on loo rolls in March 2020.  Elsewhere both the Fed and ECB held pivotal meetings to outline longer term policy outlook and, in both cases, not much is forecast to change.  In the Fed’s case, the ghost of the 2018 tightening still looms over Chairman Powell and like his forebears in the 1970s there is now little doubt that the tolerance for an overheating economy will dominate Fed policy in the medium term.  For the ECB the momentous news centred on the revolutionary shift from an inflation target of “below but close to 2%” to simply 2%.  Phew, gripping stuff!

Markets meanwhile had a volatile month, with government bonds as the tail wagging the dog.  In what turned out to be an anti-taper tantrum, 10y Treasuries squeezed 20bp tighter on continued unwinding of steepening trades and lingering concern that the recovery will be more tepid than expected on Delta variant concerns.  In response the SPX shook off a mid-month wobble to end +2.5% while broad European indexes were mildly higher.  Overall an interesting dynamic is shaping up in the macro environment.  Will lower rates continue to spawn – as they have for the past ten-plus years – a return to a risk-on melt up across credit and equities, or is the recent move more than a massive hedge fund short-squeeze and actually an indicator of declining economic performance?  The view here is that the former scenario is likely, and that upcoming data will bear this out, leading yields to resume their upward grind.

Meanwhile in the financial sector there was a great deal of activity, as early Q2 results showed a fairly consistent story of consensus beating numbers driven by provision write-backs and higher capital levels. However, equity prices faced headwinds from net interest income (NII) compression, reflecting margin pressure among lenders.  The banks must not lull themselves into thinking that this is purely driven by lower bond yields.  Long-term franchise erosion is also at play as the cumulative effect of digital entrants and other banking service disaggregators continue to gain ground vs sleepy traditional players.  Anyone who has tried to open a bank account recently will know this.  Of course, a great deal of the stasis enveloping bank back offices relates to years of remedial regulatory infrastructure and bureaucracy, which the newbies have missed thus far.  This advantage should not be underestimated.   Perhaps traditional lenders are waiting for the inevitable slip ups that will lead to bulkier processes at digital players?  In the UK the FCA recently notified FinTech Monzo that it has commenced a money laundering investigation, the result of which should be worth noting.

The European IBs also benefited from the very buoyant deal environment to post strong quarters.  Worryingly there were many comments from managements heralding a new era and rolling out aggressive hiring plans and geographic expansion plans amidst fierce competition for junior talent.  Faithful readers will no doubt be aware of our long-standing scepticism of the long-term profit sustainability for the Europeans.  It is more likely that we will look back at the 10% ROE that some players recently achieved as the apex rather than a milestone on the road to mid-teens, and that newly opened offices – often in jurisdictions that were abandoned in the last ten years – will have to be abandoned again.  Somewhere music can be heard and Chuck Prince is still dancin’.

July also saw the release of the long-awaited Credit Suisse Archegos report.  A weighty tome, a quick perusal of contents brings no surprises and in fact reads like a generic report that might have been written after any previous market calamity ranging from the 2008 Global Financial Crisis all the way back to Merrill Lynch’s 1987 mortgage debacle.  Among the recommendations were the usual salves of raising the profile of the risk function and redefining culture and, on cue, a high-profile risk czar was appointed.  What nobody appears to be asking is why CS should still be in a business that lost more than the IB has made cumulatively in the past 5 years or so.  Factor in reduced risk appetite with a higher cost structure and any rational individual would question the decision to restructure rather than exit the business.

Against this backdrop, bank and insurance equities struggled with rate volatility, but received a late boost when the ECB formally and unequivocally lifted the dividend ban while positive stress test result were broadly supportive across the capital structure. The Fund’s A shares returned +0.6% with the lion’s share coming from our credit portfolio. AT1s represented the largest part of the gross performance, contributing +62bps, with a single second-tier peripheral bank accounting for most of the performance. Equities had a -25bps negative contribution following an extended move lower on bank stocks on the back of rates tightening. We increased the Fund’s exposure to equities in order to take advantage of the move.  Looking forward we expect the first half of August to be active, with remaining results and important data releases.  Our securities are well positioned for what we believe will be a constructive environment and we intend to use that as an opportunity to reduce risk consistent with our overall desire to maintain flexibility for the balance of the year.