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We have been asked for our top down view on the month of July’s performances and valuations.

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  • We have been asked for our top down view on the month of July’s performances and valuations.

Context:

During the month of July, markets were strong due to:

  • – An agreement on the EUR 750 billion European recovery fund that removes a big tail risk, and allows significant firepower to jumpstart the European economy
  • – Anticipation of strong results; for example, we have seen UBS performing extremely well, and Barclays pre-announced strong results (excess capital increasing to GBP 9 billion

 

Impact for the fund: Positive sentiment in the market resulted in positive price momentum across the board

 

European Recovery Fund

  • – EUR 750 billion to address the consequences of Covid-19, of which EUR 360 billion is in loans and EUR 390 billion is in grants
  • – EUR 750 billion to be funded by EU borrowings (European Commissions will borrow funds on behalf of the EU on the capital markets)
  • – EUR 750 billion will be distributed based on countries that need it the most – with the goal of boosting economies of countries facing the most difficulties (mainly Italy, Greece, etc)
  • – Overall, this is very positive given (1) large scale coordinated action by the EU (2) it will boost the EU economy and help recover from the Covid-19 induced macro headwinds and (3) it removes tail risk

 

European Banks Results

  • – Still early stage, but from what we have seen so far, very strong results – excess capital positions are very supportive for bondholders and earnings are sufficient to absorb higher loan loss provisions
  • – UBS reported a very strong set of results. While profitability was impacted by higher credit losses, very strong operating performance (especially CIB) led to a very strong 13.2% return on capital. The group’s capital metrics improved quarter on quarter to 13.3% (from 12.8% in Q1 20) and excess capital increased to USD 10 billion, which is very positive from a bondholders’ perspective
  • – Barclays pre-released part of its Q2 20 results, with the group’s capital ratios increasing significantly to 14% (CET1 ratio) and excess capital set to rise by GBP 3 billion to GBP 9 billion
  • – Positive-read across from US banks: As expected, loan losses provisions continue to be elevated as banks brace for sharp recession, and revenues from retail and commercial banking activities continue to be under pressure from low interest rates and lower activity from lockdowns. The bright spot of earnings was extremely strong capital markets revenues, which has more than offset additional reserve build-up. For example, JP Morgan reported its highest quarterly revenue ever. Furthermore, the bank increased its CET1 capital ratio by 90 bps over the quarter, which is obviously very supportive to subordinated debt holders. We expect to see similar trends for European banks, on top of which capital positions are likely to surprise to the upside
  • – Overall – European banks’ earnings should be a positive driver for the market, as we expect capital positions to remain rock solid and high loan loss provisions to be absorbed by earningsValuations
  • – Market sentiment has been positive in July, given positive news around the European Recovery Fund as well as bank earnings that reflect very resilient fundamentals
  • – Spreads have tightened – for example AT1 CoCos in USD, where spreads were around 50 bps to 450 bps tighter. As markets remained mostly priced to maturity (63% priced to maturity), there remains significant upside on a re-pricing to call (spreads to call above 600 bps)
  • – Legacy bonds continue to perform on a case-by-case basis. For example, RBS’s old USD perpetual FRNs paying the Libor +232 bps went up from 92% to 95% on the month. They are still attractive, in our view, with a yield to call of 6% to a call in January 22. Others have continued to lag, and we continue to see this as one of the most attractive areas in our markets
  • – Overall, we see subordinated financials debt as well-positioned to perform strongly given (1) strong fundamentals (2) attractive valuations with upside on a re-pricing to call (3) significant upside in legacy bonds with a very strong investment case
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