July 2022

“Opera is when a guy gets stabbed in the back and, instead of bleeding, he sings.”  Robert Benchley

July is peak season for European opera festivals but this year it was politicians across the continent that provided all the dramma giocoso.  UK Prime Minister Falstaff got things rolling by finally succumbing to pressure to resign, kicking off a leadership race that is unlikely to augur significant policy change but will likely reduce No 10’s consumption of cheap wine (available by the suitcase load!).   Meanwhile Italy, the home of opera buffa conjured a political crisis out of thin air as support for Mario Draghi was withdrawn in a bizarre act of political attention-seeking-by-suicide by coalition member 5S, resulting in early elections scheduled in September.   And Germany, which has long been on a Parsifalian quest for the Holy Grail of Net-Zero more closely resembled Gotterdamerung as anxiety over Russian gas supplies added pressure to a rapidly slowing economy.  For good measure the Spanish government hastily announced a revenue tax on domestic banks profiting from higher interest rates (which haven’t happened yet and may not happen).   Bravissimo!

Elsewhere, as expected, central banks raised rates, with the Federal Reserve leading the way with another .75% hike.  The ECB finally joined the game with a hike of .50% while the BOE is widely expected to move again in early August. In the meantime, underlying data continued to tell a mixed story.  Inflation remains elevated and increasingly appears to be morphing into a full-blown spiral that will persist even as some acute pressure points (fuel, supply chain) are being alleviated.  On the other hand growth has decidedly fallen off, particularly in Europe where some data shows recessionary conditions already exist.  Ahead lies a conflict that will test how serious policy makers really are to snuff inflation at the cost of a hard landing.  As mentioned before, the betting here is that the will to raise rates – particularly in Europe – will fade rapidly if growth continues to slow and EU policy makers will be very happy to declare victory on any moderation in the inflation rate.  Which means that we will inevitably be facing another war on inflation at some point in the future and a continued recurrence of volatility spikes.

The markets reacted to the conflicting signals in a manner indicating that technical rather than fundamental factors were the key drivers.  The SPX rallied 9% in a rebound of sentiment, although we believe it’s too early to call the correction over.  European government bonds had a violent start to the month before turning sharply to end with considerably lower yields.  Notably, Italian debt was shaken by political developments but recovered strongly as it seems that extreme election outcomes are unlikely.  The ECB’s rollout (short on detail, long on rhetoric) of new anti-fragmentation tools also assuaged traders who’ve learned over the years to not fight the central bank bazooka.  As mentioned previously, rates markets are now decidedly pricing in a short tightening cycle.

Financials had a rocky month, buffeted both by events (Spanish tax, Italian election) and persistent selling in credit markets, which saw spreads widen to well beyond fundamental value.  As the month wore on some equilibrium returned but investors remain leery of stepping into what are illiquid markets.  On a positive note quarterly earnings reports told a constructive story – healthy balance sheets and interest margin expansion already coming through – which reaffirms our conviction that the market’s reaction has gone too far.  For the month the funds A shares were down -2.73%, with credit underperformance contributing the bulk of the loss at -223bps gross, versus -45bps for equities.

While it has been painful thus far, we are confident that the outlook is more constructive from here.  Liquid credit has already started recovering and a broader recovery is very likely.  We used the sell-off to tweak the portfolio by incrementally switching into names that will be more responsive in the near term.  To be clear we still feel conviction for our core positions and would increase if we see more transparency around sources of volatility.