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Active Thinking

At GAM Investments’ latest Active Thinking forum, David Dowsett reviews the market reaction to the recent monetary policy decisions and US payrolls report, while Romain Miginiac outlines the dual benefit of green bonds, namely their ability to generate a positive environmental impact while also providing exposure to the financial sector which he believes offers an attractive risk/return opportunity in the current environment.

09 February 2023

David Dowsett, Global Head of Investments

Last week was fairly tumultuous for markets. Beginning with the central banks, the Federal Reserve (Fed) raised rates by 25 basis points (bps) as expected. Notably, during the press conference, Chairman Jerome Powell mentioned disinflation 11 times and seemed quite relaxed about the recent easing in monetary conditions. The market took that very positively and rallied strongly. Following this, the Bank of England (BoE) and the European Central Bank (ECB) each raised rates by 50 bps on Thursday. The BoE essentially called time on the rate hiking cycle while the ECB committed to 50 bps in March, and most likely another 25 bps in May, but signalled that that it probably would not raise rates further after that. This led to a huge rally in markets. Thursday was also notable in that it was a capitulation trade for those who had had winning trades in 2022. For example, the Bank of America runs a long-short momentum basket which dropped 7% on Thursday alone. So as markets were going up, trades that had momentum over the previous 12 months suffered significantly. Securities such as Italian government bonds rallied by 40 bps for no clear reason on Thursday and we also saw very strong moves in some of the non-profitable US technology names; Carvana, which dropped 89% during the course of 2022, was one of the strongest performers. The rallying market thus proved a very painful environment for the shorter-term trading community.

The payrolls report, released on Friday, showed an exceptionally strong number. Against market expectations of the US economy adding around 200,000 jobs, it added 517,000 jobs. The unemployment rate fell to the lowest rate since 1969, average hourly earnings increased, and the work week also increased. This led to a short period of correction in bonds on Friday and, to some degree, in equities because market participants are now considering whether the Fed might need to hike rates by another 50 bps if the payrolls number next month is similar to this one. The reality is that unless there are job losses and we are seeing refinancing, there will not be a recession – and at present, we are seeing neither.

Further, the US high yield spread has fallen to the lowest level since May. The yield from US BBB corporate bonds is now at the same level as the 90-day T-bill yield meaning investors get the same yield from risk-free cash as from buying just investment grade corporate bonds. That is a conundrum, which it is difficult to make sense of. Further, the projected forward price-to-earnings ratio in the US is now in the 87th percentile since 1976 at over 18x. Once again, this is not indicative of a slowdown or a recession coming. With that said, the yield curve is still very inverted and central banks are minded for recession. We should therefore be cautious about reading too much into one payrolls number. I think we need to see more data and, in the meantime, there is a lot of confusion in markets. That could mean that the trading conditions from here are directionless and volatile rather than going up and down in a straight line as they have done for periods of the past year. There is less data in the week to come, but Powell’s speech will be important following last week’s payrolls number and it will also be important to see if he pushes back on the dovish impression that he gave at last week’s press conference.

In Japan, there were rumours that dovish candidate Masayoshi Amamiya will be named the new central bank governor and we may get some more clear signalling on that this week. The recent situation with the Chinese balloon in US airspace is disappointing, particularly following US Secretary of State Anthony Blinken’s meeting with China President Xi, which marked a key re-establishment of dialogue between those two countries after a long period. Progress in US-China relations is unlikely to happen in the short term now and there is likely to be greater sensitivity on this topic. Putting all of that together, I still think it is right to be somewhat sceptical of market moves that we have seen over the past 10 days or so, in particular.

Romain Miginiac, Portfolio Manager and Head of Research at Atlanti

Green bonds have the dual benefit of generating a positive environmental impact with visibility on how the money is being used, while also providing exposure to the financial sector which we believe offers an attractive risk-return opportunity in the current environment. The other side of the story is we are positioned in high quality highly rated bonds (BBB+ average rating), which means investors can get a decent pickup to the euro investment grade market without sacrificing quality or without taking more duration.

Why green bonds?

A key component of why we like green bonds is because the impact is clear and can be measured quantitatively, for example through tonnes of C02 avoided by investments in renewable energy. However, we also think that green bonds are a very efficient tool to support climate financing. Data from the Climate Policy Initiative shows climate financing flows have accelerated to around USD 850 billion in 2021. That is still far below the amounts needed to meet the Paris Agreement targets of at least USD 4.3 trillion per annum by 2030. Green bonds can be a useful tool to bridge the climate financing gap.

Examples of areas where green bonds have an impact are in renewable energies, sustainable transport, forestry projects or sustainable agriculture. Green bonds offer access to a very wide range of projects with positive impacts, financed across the world.

Why green bonds through financials?

Although capital markets have developed substantially, the majority of financing to corporates is done through bank lending. Banks have a pivotal role to play, financing all sectors, whether it is individuals, SMEs or large corporates. In terms of impact potential, banks have the ability to act as a catalyst to support the transition by offering, for example, products that incentivise individuals to renovate their houses, or incentivise companies to deliver on their transition plans. They also have a role playing ‘the bad guys’ by setting stricter requirements for some, otherwise they will cut financing or exit business relationships. The situation is similar in the insurance sector, and for example in 2021, AXA announced that it would drop RWE, a German utility company, as a client for its insurance activities because its coal capacity was too high. RWE is a multi-billion euro company (close to EUR 30 billion of market capitalisation) and this showed that financials are serious about taking action if customers do not meet their expectations in terms of climate transition plans. Financials will likely become increasingly stringent in the way that they deal with situations like these.

From an impact perspective, the green bonds issued by European financials offer the broadest opportunity. For example, 25% of the proceeds of Credit Agricole’s green bonds go towards SMEs. Green bonds allow investors to access the impact from private markets in liquid public markets and without taking the extra credit risk of specific projects. Investors buying a green bond from a large corporate would be supporting a company that most likely has a dedicated sustainability department and the financial resources to hire consultants to help shape their climate strategy. On the other hand, an SME typically does not have the budget to hire dedicated resources for that. This is where banks can play a very important role, offering advisory services to help SMEs understand their carbon footprint and potential levers they can pull to align their business with the Paris Agreement targets. We think the sector can play a very important role and act as a catalyst to support the whole economic transition, beyond large corporates. As well as SMEs, green bonds from financials also support private individuals with loans with lower rates to make their houses more energy efficient for example. We think this is an area where the breadth of the impact that the financial sector offers is unique within the green bond market. Green bonds of financials allow investors to benefit from the impact across a broad range of sectors and geographies while benefitting from the strong credit quality of issuers and liquidity.

An attractive risk-return opportunity

In addition to their positive impact, green bonds from financials offer an attractive opportunity from a risk return perspective. In the current environment, financials benefit strongly from higher rates, while default rates on corporate issuers are expected to increase materially. Banks’ earnings are rising to levels that we have not seen for a long time and insurance companies’ solvency ratios are going up directly as rates rise. However, for corporates, the situation is becoming more challenging with higher rates leading to higher financing costs, as well as rising input costs with inflation and a potential decrease in revenues in the case of a recession. In our view, financials are one of the most resilient sectors, even in a downturn.

We are also going through a period where the European Central Bank is actively reducing the size of its balance sheet. However, the central bank has never been able to buy bank debt or subordinated debt so, unlike the investment grade market, our bonds will not be affected.

In 2022, financials underperformed versus non financials in the credit market. We see financials as the sweet spot in the current environment. For corporate high yield bonds, Moody’s forecasts rising default rates in their baseline scenario, and up to 10% to15% in their pessimistic scenarios, reflecting the view that risks are skewed to the downside. On the other hand, financials are benefitting from higher rates, with for example, HSBC expected to make USD 15 billion more in pre-provision profits in 2023/2024 than they did over the past three years (2019-2021). To put that into perspective, it is almost twice the provisions that they took during Covid in 2020, meaning it would take a scenario twice as bad as Covid to wipe out just the excess earnings.

Investors remain concerned that financials are still a cyclical sector, with many biased by the global financial crisis (GFC), the eurozone crisis and especially stories such as Lehman Brothers or other big bailouts. However, regulation has completely transformed the sector and banks have close to tripled the amount of capital since before the GFC. In our view, banks are probably one of the most defensive sectors and earnings alone could be sufficient to absorb the impact of a negative scenario that may arise.

The yields on investment grade rated subordinated bonds from banks and insurance companies in euros, called Tier 2s, are at around 5% today which we think is very attractive for BBB rated paper. The last time we saw these kinds of yields was during the eurozone crisis and the financial crisis so they are paying levels similar to those of very distressed scenarios and at times when the banking and insurance sectors were very different. Now we are being paid similar levels of yields but we believe that the sector is one of the safest and most resilient.

We believe the current environment presents a strong opportunity for investors looking for an attractive opportunity in the investment grade market.

Important legal information
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is not a reliable indicator of future results or current or future trends. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice. There is no guarantee that forecasts will be realised.

Romain Miginiac

Fund Manager & Head of Research at Atlanticomnium SA
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