Active Thinking

At GAM Investments’ latest Active Thinking forum, David Dowsett reviews asset performance during the second quarter and shares seven observations to hold in mind as we enter Q3. Gregoire Mivelaz explains why he believes the subordinated debt of European financials is set to outperform.

05 July 2023

David Dowsett, Global Head of Investments

Market performance review

During the second quarter of 2023, we saw very strong performance from the Nikkei 225 and the Nasdaq. Nasdaq and S&P 500 performance reflects either the artificial intelligence belief or hype, depending on your opinion. It is notable that long duration assets, driven by tech stocks, have done well while bonds have not. Gilts were the worst performer in Q2 as the bonds most affected by the Bank of England’s attempts to catch up having underestimated the inflation threat.

Other sectors that suffered during the second quarter included commodities, the Hang Seng, to some degree Shanghai’s SSE Composite Index and indeed the overall China story. In Q2, we saw higher inflation but, at the same time, weaker performance from the manufacturing sector and better performance of tech stocks rather than real world growth assets. This is likely the exact opposite to what was expected for the second quarter and to some degree for the first half of the year.

2023 year-to-date has so far been a strong year for financial assets. The story we told at the beginning of the year, that 2023 would be a recovery year after the horrendous performance of 2022, is holding true, although the surprise has been the relative underperformance of fixed income as a whole given the continued tightening from central banks. A further surprise has been the outperformance of the developed world relative to emerging markets and, in particular, China. 2023 was supposed to be the year that China would re-join the global economy and exit Covid. This is not particularly visible in asset prices at this point.

This is important context. Markets buffet around from week to week. We have seen a lot of event risk, particularly in the banking sector, but nonetheless, returns for the year are making progress and repairing the damage that was done in 2022.

Seven observations to hold in mind as we enter Q3

1. US unemployment is the lowest since 1969, running at around 3.5%.


2. Chinese youth employment is at an all-time high.


3. The US Federal budget in 2024 will be the equivalent to the third largest economy in the world. Apart from China and the US, the largest actor in the global economy is the US Federal government. This is because of the expansion we are seeing in its fiscal policy at present.


4. In the last 12 months, the Bank of Japan has purchased USD 1.1 trillion Japanese government bonds. That is the equivalent of 24% of Japanese GDP.


5. Without the 28 top performers in the S&P 500, the index would be negative year-to-date, demonstrating that there is a high concentration of returns rather than a breadth of returns in that market.


6. The market gain of the seven largest big tech names in the US this year is larger than German GDP. This shows the extent of wealth creation in those seven stocks year to date – Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla – all of which are widely held by US equity investors.


7. If you want to take that one step further, the market cap of Apple, Microsoft and Google is now larger than that of the entire emerging market (EM) equity universe. The EM equity universe contains companies that theoretically service 6.5 billion people but the market cap of just three companies is larger than that.

The week ahead

In the shorter term, this week we will see confirmation of the PMIs. They are already showing manufacturing weakness, with the service sector continuing to maintain equilibrium. Very importantly, on Friday, the latest payrolls data will be released. We expect that to show that the US economy is healthy, with no impending signs of recession. I think this release is particularly worth paying attention to because the last two weeks’ jobless claims in the US have been slightly higher. If we were to see a downturn in the payrolls number, markets might quite quickly extrapolate that. I do not think that is the most likely scenario but one to highlight and to watch out for.

Gregoire Mivelaz, Subordinated debt

This year has been extraordinary. Three months ago, the US regional banks caught us by surprise, as did the speed at which events unfolded with Credit Suisse. Investors were questioning whether subordinated debt and Additional Tier 1 (AT1) contingent convertibles (CoCos) were the place to be. Two weeks ago, BBVA came back to the AT1 CoCo market, with more demand than supply. We have also had earnings seasons from US, UK and Swiss banks and they are on track.

However, the negative headlines had an impact. The equity price of European banks is up more than 10% year-to-date. On the equity side for European banks, the market is saying rising rates are positive for profitability and net interest margins. This is no surprise, but what we think is surprising is that European subordinated debt is only up 1% year-to-date. When the equity prices of European banks are strong, normally spreads should tighten and prices should go up. European high yield is up 4.8%, meaning subordinated debt has massively underperformed high yield year-to-date. We find this surprising considering the risk of recession. In our view, the underperformance of subordinated debt versus European high yield is due the headlines during the first quarter. Now there is more clarity on those headlines, we believe the future looks bright for the financial sector.

US regional banks and European banks are two different stories and the equity market is pricing them as such. An important message is that the US banking sector is not weak, but a part of the sector had some issues, while the bigger banks remain strong. The collapse of Silicon Valley Bank was due to regulatory and risk management failures. Since 2019, a bank with a balance sheet of under USD 250 billion is not subject to the same regulatory framework, stress testing and liquidity requirements as those with a balance sheet of more than USD 250 billion. As a result, we saw the failure in those banks considered ‘small’ from a regulatory standpoint.

This is not the case in Europe, where banks with a balance sheet of over EUR 30 billion are subject to regulatory requirements. Furthermore, if liquidity is properly managed, deposit outflows have less of an impact. European banks have a liquidity coverage ratio (LCR) of 160% and more than 100% of that is sitting at the European Central Bank (ECB) in cash.

Despite this, spreads have widened for the bonds we own. However, we do not believe there is an issue and so we believe we will see a pull to par. We have conviction that the fundamentals of European banks are strong, the valuations are attractive and the technicals are good.

For example, rates are much higher. The market was expecting a US recession this year. However, this has not yet been shown in the data and core inflation is very sticky. The situation is challenging for central banks that have already hiked substantially but will need to do more. However, financials benefit from rate hikes. For example, HSBC’s pre provision profits are rising from 20 billion to 30 billion per annum due to rising rates. In contrast, for high yield, Moody’s predicts default rates to be 3.9% in the best case scenario or 15.1% in the worse case. The default cycle has already started, with defaults up more than 1% year-on-year. The issue is the pricing; the crossover for European high yield is inside 400 bps which means the market is pricing a default of 2.7%. However, the market is pricing all the worst outcomes for subordinated debt which we do not think will materialise. We believe defaults could prove more challenging for high yield than for investment grade single A rated issuers that benefit from rising rates.

What happened three months ago was one of the biggest crises in financials since 2008/2009. Three months later, banks having come back with AT1 CoCos with more demand than supply highlights that the market has absorbed a lot of those headlines. We had three positive catalysts; the positive earnings season, banks calling their callable perpetuals and banks coming back to the market.