May 2024

“The national debt, if it is not excessive, will be to us a national blessing.”  Alexander Hamilton

The level of sovereign indebtedness has been rising steadily since the Global Financial Crisis, almost regardless of political affiliation of the party in charge or economic conditions.  To be sure, the lockdown-induced recession saw a significant jump in debt levels, but in the grand scheme it has been a minor contributor to the total increase.  At present Germany is alone among G7 countries (per the IMF) to have less than a 100% debt/GDP ratio while in 2008 only Japan and Italy had crossed that threshold.  We have seen the deleterious effect that rising cost of debt service has had on national budgets, and if the upcoming rate cut cycle is modest this problem will only continue to fester.  In the meantime, with economies at or near full employment annual deficits remain high.  In the US in particular every event is seen as an opportunity to spend more money, with no consideration for longer term economic health and with no prospect for change for the foreseeable future.  It wasn’t long ago that debt sustainability for several southern European countries was a major issue for markets but for the moment complacency reigns.  Should this matter?  Well, a quick trot through the economic history of the world shows out-of-control government finances as a major contributor to the collapse of economic systems, and the longer it takes before a salve is administered the more painful the cure.  So while we rest easy today we should remember that beyond simple economic cycles we also have unfavourable demographics (Europe) and massive unfunded pension liabilities (US) that will slowly, inexorably squeeze our economies in the future.  The challenge of course is to know when debt levels will matter but we should never forget that at some point they will matter.

For the moment markets remain focused on shorter term issues, primarily monetary policy with the ECB likely to cut rates in June.  We retain our view that given sticky inflation levels there is limited scope in major economies for anything other than a couple of cuts at most.  And so, government bond markets reversed some of the previous months’ correction (USD 10Y fell 20 bp) and equities recovered lost ground, which confirms that markets have largely settled into a range pending significant news to push them one way or the other.  In the UK, the Prime Minister called an election for July 4, an ironic choice perhaps meant as metaphor for the future ex-PM’s independence to leave this country to take up residence in Silicon Valley as many expect.  Given the similarity in policies there is likely to be no immediate market impact and in terms of financial services it is a dead certainty that the Labour party dislikes the banks as much as the Tories.

Elsewhere in Europe it was a busier month for banks as BBVA’s attempted takeover of Banco Sabadell continued to progress despite the target’s resistance.  As currently constructed the transaction is a better deal for Sabadell’s shareholders than BBVA’s, so one would assume there’s a good chance this will happen.  Readers will know that domestic consolidation is one of our favourite subjects, but at this stage the commentariat is running ahead of the actual deal flow.  In our opinion this consolidation is key to unlocking the next phase of improved structural profitability and resilience of the financial sector.  In other news, there were growing signs that commercial real estate (CRE) exposures continue to fade as a major systemic risk while remaining problematic for banks with large concentrations.  For the month the funds A share rose +1.44% with credit contributing +173bps in gross performance and equities -5bps.  We have not significantly altered the risk of the book, choosing to maintain the same strategy pending greater clarity.  That being said there continue to be a number of interesting name-specific opportunities, primarily around the themes of capital repatriation, expected refinancings and developments on CRE exposures.   We retain an optimistic outlook for return generation.