January 2022

 “If I had my way, I’d remove January from the calendar altogether and have an extra July instead.”  Roald Dahl

The best thing about getting to the end of January is knowing you won’t see it again for another 11 months.  This year’s version came complete with market drama, geopolitics, political scandal and economic uncertainty, while December’s twin themes of Omicron and inflation rumbled in the background.  Of all these it was interest rates that dominated, with prospects of the Fed’s tightening cycle leading to a 35 bp back up in 10-year UST’s while also flattening the yield curve by 15 bp.  This in turn snuffed an early rally in stocks and led to a significant correction (11% SPX, 15%+ NASDAQ) that was also driven by growing tensions on the eastern Ukraine border.  On the COVID front there were signs that the Omicron wave was starting to recede, with England leading the way out of restrictions.  Decisions to end restrictions may have been influenced by revelations of widespread rule breaking by the PM and staffers during previous lockdowns, which in turn has triggered speculation about the PM’s future.  The PM’s defence, that he was “ambushed by a cake”, may not have the same ring as “we’ll fight them on the beaches” or “the lady’s not for turning”, and is hardly the stuff of prime ministerial peroration, but it somehow seems appropriate for the present incumbent.

Returning to the markets, the impact of future rates hikes on risk assets remains the paramount question.  Historically, higher rates have led to corrections (2018 most recently), but the question has always been how high and how rapidly before the impact is felt.  In the aftermath of the Dot-Com bubble Fed slowly raised rates over a two-year period before markets cracked, while in previous cycles effects were felt within six months.  As mentioned previously, this time round the Fed’s job is complicated by the excess liquidity in the system, which has pushed valuations in some markets to extreme levels, and the scale of indebtedness, which would suggest that higher rates could start to bite sooner.  History also teaches us that mountains of investor “dry powder” are a relatively common feature late in market cycles and ultimately don’t have a significant impact on the scale of corrections.

What does this all mean for European financials?  For a start both the fundamentals and the technical remain very supportive.  Equity valuations remain very attractive and most institutional investors are quite underweight the sector.  But one should be cautious of generalizing across the market.  Large banks with a significant investment banking presence are likely to experience headwinds as capital markets activity dries up at the same time that they have abandoned cost discipline (not the first time this has happened late in a market cycle!).  On the other hand, higher rates should alleviate some of the structural pressure on NIMs for more traditional lenders, especially if some non-bank competitors suffer from a withdrawal of liquidity.  We would also expect that credit markets should underperform as an asset class, but medium-sized, well-capitalized institutions will be cushioned given their attractive valuations.

Near term we expect that current volatility may well continue into the March announcement, with guidance provided then to set the tone beyond that.  On that basis we will continue to remain tactical with our portfolio while keeping our preference for our deep value equity positions.  We will continue to scale back our overall credit exposure while keeping the focus on securities that fit the criteria mentioned above.  The rest of the year is certain to present a number of attractive opportunities and our objective at this stage is to retain the flexibility to react to these.  For the month of January, the fund’s A shares gained +0.37%, which validates our strategy in this market environment with our net long equity exposure contributing +94bps in gross performance, against a -47bps contribution from credit.