Active Thinking

At GAM Investments’ latest Active Thinking forum, Gregoire Mivelaz discussed the current macroeconomic environment and his views on the benefits of investing in the subordinated debt of financials in this inflationary period.

04 April 2022

Notwithstanding the tragic events in Ukraine and the volatility we have seen in markets, we see some bright spots in the macroeconomic picture. The Omicron variant is starting to feel more endemic, particularly in the US and Europe, with Asia transitioning more slowly. Focus has moved away from the pandemic and towards inflation. Inflation is much more permanent than central banks assumed six months ago. We believe this is the main reason why markets have been so soft since September 2021.

The unexpected invasion of Ukraine inevitably brings geopolitical risks and led to the risk-off sentiment we have seen in recent weeks. It is important to note that European banks’ exposure to Russia is small and manageable, at less than 1.5% of total assets. Indeed, since 2014, banks globally have reduced exposure to Russia by 50%. Even completely writing down this 1.5% exposure, EU banks would still have ample excess regulatory capital. Therefore, as bondholders, we do not have to be concerned from a solvency standpoint. The facts tell us the invasion is a non-credit event that can be absorbed.

We are seeing markets, to some extent, returning to normal. Investment concerns have shifted away from the war in Ukraine and investors are firmly focused on inflation. Two weeks ago, Christine Lagarde, President of the European Central Bank (ECB), told us that despite geopolitical uncertainty, the ECB is not concerned about GDP growth, but rather about inflation.

Due to the world being more inflationary, finding fixed income securities with low sensitivity to rising interest rates is even more important. We also think quality income matters more than simply the search for yield. In our view, subordinated debt offers a solution as it encompasses both of these. We believe that European credit will outperform US credit, with the ECB likely to hike rates fewer times than the Fed. We also expect financials to outperform corporates, given the former benefits from an inflationary environment. Finally, we believe subordinated debt will outperform senior unsecured debt.

One might question why one would own bonds in an inflationary environment. Crucially, not all sectors and bonds are equal. For the corporate sector, rising rates increase funding costs. In contrast, financials benefit from higher rates as it boosts their profitability. In terms of types of bonds, fixed-to-floaters are less impacted, and floaters also benefit from higher rates. In our view then, subordinated debt offers a sweet spot as it is predominantly issued by the financial sector and most bonds are issued as fixed-to-floaters. Indeed, we believe we are at the best entry point for the asset class for the next two to three years.

This year we expect the Fed to hike seven times. Normally, when the Fed starts to hike, the yield curve is somewhat steep and the Fed flattens the curve. Today, for the first time, we are in a situation where the curve is flat and is inverting. When a curve inverts, it normally takes around 12-18 months for a recession to occur. Further, when the curve inverts, equities tend to increase more than 10% on average over the next 12 months. Today, we are in a different situation because of quantitative easing. The central banks have flattened the curve and this creates some uncertainty. What we do know is that the very short part of the curve – the cost of money - is too low so the Fed will increase this, but the rest of the curve is very flat so we think there is going to be a parallel shift and we do not think the Fed will allow the curve to remain inverted for too long. Normally, when it inverts, it begins to steepen as fast as it flattened. The profitability of European banks is less impacted by the shape of the curve than the deposit rate, which is currently at -0.5%. There is a lot of complexity at the moment, but despite that, it is a very good environment for the financial sector. European banks have reduced costs through digitisation, asset quality is very strong, volume is strong and banks have pricing power which is offsetting the impact of the flat curve somewhat.