February 2022

“For they have sown the wind and they shall reap the whirlwind.”

February was certainly a whirlwind month as interest rates, earnings and geopolitics all combined to create a highly volatile environment for all asset classes which bounced from “risk-on to risk-off” throughout the month.   A surprise statement that the ECB could bring forward rate hikes to 2022 hit European markets – but not financial stocks – at the beginning of the month while Russia’s revanchist irridentism towards the Ukraine sparked a massive flight to quality and broad selloff in everything except commodities.  Notwithstanding our relative defensive posture, the fund’s A shares lost 5.2% as credit securities responded badly to the ECB news while equities were buffeted by the war worries, as the SX7E shrugged off a 10% mid-month gain to end the month down 12%. Credit accounted for -486bps in gross performance, while equities contributed -38bps after we trimmed our exposure in the post-ECB rally.

The net result of all the activity in February can be interpreted to have the following effects.  Firstly, any prolonged military action in Ukraine will have a dampening effect on European growth as sustained, elevated commodity prices and further disruptions to supply will hamper both productive capacity and consumer demand.  Therefore, it is our view that prospects for hikes in ECB rates will be delayed.  Similarly, the Fed will proceed with a March hike but is likely to base further hikes on future data.  The BOE raised rates in February but is also likely to pause.  Secondly, the damage inflicted on corporate and financial balance sheets from market volatility and economic sanctions will be significant but not systemic.  Volatility in February undoubtedly was increased by liquidity driven selling, particularly in credit markets.  Finally, the duration of this uncertainty is clearly driven by the length of time to find a resolution to the conflict, but also by the need to understand the longer-term implications of policy changes made in response.

From the fund’s perspective this represents a significant opportunity.  The rate induced sell-off compounded by the Ukraine news has resulted in AT1s/RT1s and credit securities pricing recessionary conditions and in our view, we think there is potential for significant recovery in the coming months as the reality of a more deliberate ECB gets factored in.  Similarly, equity prices have now lost more than the “rate-hike” premium and are now heavily discounting this year’s projected earnings, which seems excessive except in the most bearish scenarios, and we have noted a lack of market discrimination between names potentially impacted by the conflict and those with a limited exposure to only second-round effects.  We also believe that the technical position of the market has also somewhat reset given the amount of liquidation seen last month.  So, our intent will be to use weakness to close AT1 shorts and selectively add securities as conditions allow.  Similarly, we will look to patiently add to equity positions with strong capital positions and focused, resilient business models.  We expect to see continued volatility in the near term, but we will be driven by longer term considerations, very mindful of how potential risks might evolve.