Anthony Bailly
Head of European Equity
Market trends on the month
March 2023 was marked by an unexpected financial crisis, which culminated in the downfall of several banks on both sides of the Atlantic (Silvergate Bank, Silicon Valley Bank and Crédit Suisse). The equity markets nonetheless held up remarkably well, with, for the first time in 20 years, gains by the MSCI World (+2.8% in dollars(1)), even though financial stocks fell by more than 8%(2). The EuroStoxx with dividends reinvested stayed in positive territory on the month, gaining 0.4%, while US markets outperformed, thanks mainly to their heavy weightings of tech stocks (S&P 500 +3.7%, and the Nasdaq +6.8% in dollars with dividends reinvested)(1)
In the United States, the Fed raised its key rate target range by another 25 basis points (bp), to 4.75-5.00%(3). However, in stating that the financial crisis was contributing to “tighter credit conditions for households and businesses”, the Fed left the door ajar to the end of the tightening cycle. At least, that’s how the markets interpreted it. After one last rate hike at the next meeting, they are now pricing in several cuts by yearend(3). On the inflation front, while the Consumer Price Index (CPI) fell from 6.4% to 6.0% in data released in March(3), core inflation (i.e., ex food and energy) was more stubborn, merely slipping from 5.6% to 5.5%(3). The labour market remained robust, with 311,000 job creations(3), but the 0.2-point increase in the unemployment rate was a first glimpse of easing on the job market. The PMI(4) surprised on the upside in both its manufacturing (up by 1.9 points to 49.2) and services (up by 3.2 points to 53.3)3 components. These indicators suggest that the economy is still running on all cylinders.
In the euro zone, the ECB raised its key rate by 50 bp, as it had previously flagged, in spite of stress in the financial system(3). The latest inflation figures didn’t leave it much choice, with a continued upward trajectory that took core inflation to 5.7% from 5.6% the previous month(3). Leading indicators, meanwhile, provided a mixed picture, with the PMI manufacturing slipping from 48.5 to 47.3, while the service component rose sharply, from 52.7 to 55.6(3).
And, in China, the rebound driven by domestic demand appears to be still on track, with the non-manufacturing PMI at 58.2, a high since 2011, whereas the non-manufacturing index’s pullback from 52.5 to 51.9(3) might have been interpreted as a slackening in global demand.
Against this backdrop, bond yields fell on the month of March, the US 10-year yield by 45 bp to 3.47% on 31 March (-40 bp in real rates) and the Bund by 36 bp to 2.29% by month-end (-21 bp in real rates).(1)
The P/E(4) of the European market came to 12.7x at the end of March (vs. 12.9x at the end of February)(5). Growth’s(6) valuation premium over Value(7) widened from 128% to 143%. The premium is now very close to its all-time high and doesn’t seem to make sense, given the change in paradigm that has occurred in inflation, monetary policies and interest rates since the Covid crisis.
Fund performance & positioning
Buoyed by lower interest rates, the EuroStoxx (with dividends reinvested) thus rose by 0.4% on the month of March, driven by long-duration sectors, which outperformed by far, including Consumer Goods (+7.6%) and Technology (+6.5%). In contrast, stress in the banking system dragged down cyclicals and financial sectors, including Commodities (-7.7%), Banks (-13.9%) and Real estate (-18.3%). This environment was especially favourable to Growth, which outperformed the EuroStoxx by far, with a 5.0% gain, while Value fell by 3.9%. This brought Growth’s year-to-date outperformance vs. Value to 9.7%, due almost exclusively to this rotation on the month(8).
R-co Conviction Equity Value Euro(9) gave up 3.0% on the month, underperforming its benchmark by 3.4%, and is now up by 11.0% on the year to date (0.8% below its benchmark, but 3.9% above he Value index)(8). The fund’s March underperformance (by about 80%) was due mainly to allocation, as it was penalised by its overweighting of banks and its underweighting of Growth (consumer goods and technology), which got a boost from a flight to quality(10).
We made several major changes in March, some before the events in the banking sector, others afterward.
First of all, in accordance with our process, and as the convexity of cyclical and financial sectors had worsened with their strong gains in the first two months of 2023, we began to sell down our positions in those sectors. By way of illustration, we had substantially reduced our banking exposure prior to the latest financial crisis. The fund’s overweighting of this sector fell from 11% at the end of January to 9.5% at end-February. This continued in March, bringing the overweighting to 8.5% on 8 March. In parallel, and for the same reasons, we had also reduced our exposure to certain cyclical stocks that had fared especially well on the year to date, in particular Arcelor, Faurecia, Airbus and Saint-Gobain and sold off some positions entirely, such as IAG and Atos.
In the aftermath of the sale of Crédit Suisse, we revised the convexity of the banking sector in reaction to several factors: We felt that: (i) to cope with the banking sector’s difficulties on both sides of the Atlantic, the regulator could end up adopting new constraints on liquidity or bank participation in deposit-guarantee funds. This would, in effect, limit the dividend payouts or share buybacks that had driven the sector. For the moment, this is only a potential scenario, but it would be surprising if the market did not price it in by raising the sector’s risk premium, at least until confidence has been sufficiently restored in the financial system; (ii) banks (European and US) will be more conservative in their lending practices, showing greater selectiveness to avoid defaults, something that could weigh on lending volumes. Such a tightening in credit conditions would, in turn, undermine growth and make a recession more likely, particularly in the US; and (iii) despite an inflationary environment (which is good news for value stocks), central banks may be less hawkish in their monetary policy. This could limit the impact of higher rates in their extent but also over time and would impact the increase in interest margin in the coming years.
With all this being said, we see several reasons to continue overweighting the sector: (i) it is attractively priced; we are back down to 0.7x in P/B(11) and we are approaching 6.0x in P/E. This is just 20% above the lowest valuation hit during the Covid crisis; (ii) the sector will achieve high EPS(12) growth in 2023, at a projected 13% this year(13), and we see no reason to doubt that; and (iii) recent shifts in interest rates have limited the inversion of the yield curve.
After the changes we had made before 8 March, and based on this analysis, we have reduced our overweighting of the banking sector evenly. It now amounts to 5.2% of fund investments. Meanwhile, to factor in the increased likelihood of a recession, we have also once again lowered our exposure to the portfolio’s most heavily indebted companies, i.e., Alstom and Faurecia.
For the moment, we have not reinvested the cash freed up by these transactions, which accounted for 8.1% of the portfolio at the end of March. This position is unusual and results from changes made over the past few weeks to exploit, first, the rebound in cyclicals and, second, our revaluation of banking sector convexity.
The macroeconomic environment changed appreciably in March 2023 with the financial crisis. Meanwhile, OPEC’s surprising announcement of a cut in output has exacerbated concerns over growth, for two reasons: higher oil prices will drag down global activity, and they are inflationary, in reaction to which central banks will stick to their hawkish stance, also with negative repercussions on economic activity. Against this backdrop, we reiterate our stance, which is resolutely more conservative than at the start of the year. The portfolio’s defensive/cash pillar now makes up 34% of the fund’s NAV, up from 28% at the end of February. This reflects a macroeconomic environment that is more uncertain than one month ago.
Completed writing on 5 April 2023
