The Gilt trip

For all the talk of recession and bond moves of late, you’d think we are in a backdrop of what is complete capitulation. Yet on our recent London/ Europe trip we witnessed two-hour lines for designer brands (and three hours for an equivalent leather goods store for pets) – yes, admittedly seasonality is a factor and yes, cash balances are at their peaks, however conservatism in terms of spending is still absent.

Insightful market colour is hard to come by, so as borders opened we decided to take our usual meetings with management teams on the ground as opposed to Zoom. Being contrarian investors, we often like to poke holes at consensus thoughts. We think the following takeaways are relevant in navigating the heightened volatility in today's markets and remain considerations for any fixed income investor.

1. Disconnect between financial markets and real economy is gapping wider - we expect this to converge in the long term but note investors are asymmetrically positioned and could miss the pivot

What we mean by this is the forward-looking nature of markets is almost paradoxical compared to main street observations. What is evident is that fighting the central bank is different this time - hiking into a recession is a given. Inflation is a greater evil than a recession and central banks are willing to over hike to force higher unemployment and lower inflation. As markets are forward looking, investors are naturally looking towards the pivot where central banks take their foot off the gas. We don’t think this will eventuate until we see demand hobbling (not just diminishing) and inflation clearly abating.

Markets will hold investors accountable which has been evidenced by the farcical start to the new Tory governments tenure resulting in a complete meltdown in the gilt market ultimately causing systemic like issues for UK pension funds. So while instability can often be triaged with specific measures, the market is unlikely to drive a change in direction or narrative if inflation is still hot. Needless to say given the lags in monetary policy implementation, the pivot might come quicker than expected and timing the “buy the dip moment” could be missed.

There are risks to this view of course as credit markets are already pricing in a recessionary environment and spreads could take another leg wider from here. In literal and economic terms in Europe, winter is coming but if it’s anything like the sweltering summer the UK has just had, we could see markets reposition and correct as quickly as the weather did.

What we see in the chart below is Eurozone unemployment vs Eurozone Consumer Confidence. There is an inverse correlation between confidence and unemployment since 2012 yet we are at a juncture where forward leading and backward-looking prints have converged.

Speedometer still going hard despite weak data prints

Demand for large purchases like vehicles is holding up strong, autos manufacturers are pointing towards a resilient consumer, in fact volumes are up 5% yoy with notable delivery increases in Italy Spain and France. What’s interesting is we’re again seeing the demand for luxury products like Mercedes, Audi, Porsche, and Tesla outperform.

The rhetoric has now flipped from a supply chain induced inflation story to a demand driven inflation story as more manufacturers are reporting backlog in orders out till 2024 even as semiconductor shortages subside. The chart below depicts the trend between consumer confidence and vehicle sales diverging – this potentially suggests the consumer is more resilient than what the market prices. 

2. Asset quality – issues aren’t flowing through yet but strap in for a weaker FY23

In European IG, financials account for ~50% of total debt outstanding of which banks are an overwhelming majority. Through our conversations, we sensed management teams were guiding to relatively low levels of loan provisioning levels in the medium term. Although we have our doubts as to whether cost of risk is the 20-40bp guided to is downplaying a scenario of higher energy prices, higher unemployment and weaker GDP growth, there is enough evidence to suggest banks will weather the overall downturn well. Having said this, dispersions across each region will persist.

For example, banks must concern themselves with debt holidays in Poland and Slovakia, energy price stress in the Czech Republic. Politics continue to be central to our view with right wing nationalism in Hungary and uncertainty over the fiscal approach the newly formed Italian government will bring.

That being said European banking buffers could be characterised as strong even after allowing for an expectation that Non-Performing Loans (NPLs) are likely to rise. Looking at the chart below, banks are still incredibly well capitalised from a common equity perspective, NPLs remain low and loan coverage ratios are high which is important in the context of justifying investments lower in the capital stack.

Truss-worthy fiscal policy? We are of the view UK underperforms relative to peers as we think the consumer is far more sensitive shocks compared to European peers as a large proportion of fixed rate mortgages roll off in the next two years (similar to Australia) as new fixed rates have doubled. Australian corporate bonds issued in Sterling have been dragged materially wider as part of the gilt and sterling credit sell off as these bonds do not form part of the domestic credit benchmark. Hence, we point to pockets of opportunity in this segment.

3. Energy transition is here

The transition to battery electric vehicles is already here as manufacturers are establishing JV’s with battery makers and have been pushing aggressive electrification agendas through to 2035. Mercedes Benz have been a front-runner in this space by effectively repurposed their manufacturing plants to facilitate only two offerings – AMG and EQ-series. This means consumers will no longer be able to buy an entry level A/ B Class after 2025. Rather, the alternative is an electric vehicle or a performance sports car.

Manufacturers are finding ways to reduce input costs already noting a 10% reduction in gas consumption while maintain full operations with scope to further increase this to 30% - 50% in Germany. Yes, perhaps the catalyst for this had already been underway but the geopolitical tensions with Russia has definitely accelerated this and reaffirmed the view that investment in electrification is needed.

With this comes CAPEX and grid transformations that need to be sufficient enough to accommodate the pivot of governments and auto makers. We question whether this transition is priced into spreads particularly given their resilience vs other sectors. Manufacturers like VW have already guided to increase supply in green bond issuance to the tune of EUR7bn (10% increase to net supply) which would put upward pressure on spreads.

Conclusion

We think bearishness is warranted given the conundrums that are yet to be solved but being outright risk off in credit markets especially when positioning is so asymmetric is a crowded trade at the moment – particularly if a large part of the downside risks are already priced in.

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