September 2023

“Markets will fluctuate.  Sometimes they fluc down, and sometimes they fluc up.”  Louis Rukeyser

September markets were dominated by interest rates and the sudden realization that central banks pausing their hiking cycle does not mean imminent cuts.  Long term bond yields accelerated their rise during the month (US +50 bp) and the impact was felt in every corner of the market from mortgage and corporate to equity markets.  Across universities a collective sigh of relief could be heard from finance professors who have been lecturing on the importance of “discount rates” and “risk/return” trade-offs against a decade-long backdrop of zero rates as suddenly, “Interest rates matter again!”.  They most certainly do.  As we have alluded on multiple occasions in the past year the risk that overheated rate cut expectations in Q1 (remember 3.3% 10-year yields?) would unwind in the face of resilient data was always there.  Thus far the move has been well-behaved, but the consensus has shifted to the point where talk of 5%+ yields is fairly common, which will ultimately weigh on both risk markets and the economy.  Corporate equities seem most exposed given the level of current valuations and potential for margin compression.  Data releases in early October will set the tone and given that the consensus has shifted so quickly any data not confirming the trend will yield an interesting market reaction.  And with elevated term borrowing costs fiscal pressures will grow for states with large budget deficits.  It could be a bumpy month ahead.  It is also likely to be the final act of the two-year transition to a new equilibrium for interest rates, resembling a pre-2007 world.

Away from the bond market the focus in Europe was on the ECB meeting, which saw rates raised a further 25 bp.  This was not an obvious move, and in our opinion unnecessary.  It will be the last of this cycle.  Data continues to point to tepid economic activity with the periphery outperforming the core.  Of note, Greece’s credit rating was upgraded to the cusp of investment grade, a remarkable turnaround since the Sovereign Debt Crisis, reflecting the work that has been done to improve the country’s (and the banks’) balance sheet.  Greece is almost unique in Europe at the moment for having a strong, stable government, something perhaps not seen since Pericles was dipping his toga in the Aegean.  Elsewhere, the Italians modified their bank tax two more times to settle on the final, more modest version while the Netherlands announced they will be increasing their bank levy while also introducing a tax on share buybacks for all listed companies, which will impact banks as they have surplus capital.  It is safe to say windfall taxation of Europe’s banks has gone fully mainstream.

Against the backdrop of edgy markets, the fund’s A shares rose +74bps net, with fixed income contributing +67bps in gross performance and equities +21bps.  Looking beyond the macro factors October will also bring Q3 results, which are likely to confirm trends in place from the previous two quarters – namely strong performance from traditional banks with mixed results from investment banks.  We will undoubtedly hear about how the outlook for deal making is improving and professions of optimism that “things have turned the corner” but colour us sceptical.  In general, smaller institutions should also do better, with continued capital accretion and clean balance sheets.  We will also be looking for signs of how commercial real estate exposures (CRE) are performing, as that situation will certainly be aggravated by higher borrowing costs.  In terms of the portfolio, we have consciously focused on shorter term credit and AT1 securities to minimize duration exposure, which while not immunizing against a complete risk off environment allows us to maintain flexibility to add risk in dislocated markets.