February 2023

“The report of my death was an exaggeration.” Mark Twain

All it took was one outsized increase in Non-Farm Payroll data the first Friday in February to completely unwind the prevailing narrative that the economy was on its last legs and that rate cuts were just around the corner.  This data was accompanied by a surprise increase in PMIs and stubborn inflation numbers, and soon bond markets were in full retreat, backing up .5% from the low point reached in 10 year USTs with similar moves in Europe.  Faithful readers of this commentary will note that last month we cautioned that the premature death of tightening cycles is quite common and this one has proved no different.  As expected, key central banks all hiked rates by amounts that were widely anticipated.  Notably the Fed’s pivot to smaller hikes was overshadowed by the jobs data and the cacophony of officials calling for ever higher yields with the zeal of converts to their newfound Monetarist cause.  As previously noted, we firmly remain data dependent and one should ignore the noise.

In addition to macro events February brought earnings season into full swing and for European financials it was a proper first glimpse at the impact of higher rates.  By and large the news was good and a number of banks across the Eurozone had very successful results and instigated share buybacks a clear signal that the sector has finally achieved an equilibrium level of capitalization.  To be sure, there are still a handful of problem institutions that must be dealt with and this whole exercise has taken at least five years too long.  The challenge now for the survivors is to improve their profitability towards mid-teens ROE which means going beyond share buybacks and continuing the focus on cost management.  We have finally seen NIM expansion, but managements shouldn’t get lulled into a false sense of security that it will always remain thus.

Outcomes for financials were driven by the subjects of the previous two paragraphs – the banks equity index rose 6.5% driven by earnings while sectors of the bond market were down as much as 5 points largely driven by rate moves as subordinated spreads were largely unchanged.  For the month, the fund’s A shares were up 2.47% as our focused strategy performed well in more challenging markets.  This performance was driven by strong contributions from credit and equity generating respectively +185bps and +66bps in gross performance. The equity contribution was driven by our largest core equity holding in a Greek bank which contributed +60bps. In credit, our positions in off-the-run Tier 2 bonds strongly outperformed broader credit markets. These were driven by the inaugural issuance of an AT1 by Alpha Bank at the beginning of the month which initially led to a sharp tightening of the Tier 2s of the same name, and shortly after the Tier 2s of our names with comparable profiles and spread levels. Our top 3 positions contributed +191bps in performance as a result, and we continue to see large dislocations in this corner of the market.

We took the opportunity to trim long exposures closest to fair value into strength, consistent with our view that uncertainty will linger in markets and therefore dry powder should be maintained.  In the months ahead we will certainly see further rate hikes and data could present conflicting views on future direction.  We still believe the best opportunities lie ahead.