You’ll know by now that financial markets find themselves in the midst of yet another violent
patch that both regulators and mainstream investors failed to foresee.
Those of you who have followed our latest research will know that the fabric of our modern
economies and markets is woven from many semi-stable equilibria. You will also know that
the switch from one semi-stable equilibrium to another tends to be violent, unpredicted, and
dangerous.
One symptom of this was Credit Suisse’s default this weekend, when it wiped-out the entire
value of its $17 billion AT1 (Coco) bond. Lawsuits abound and the cries of fixed income fund
managers are chilling.
Time to remind ourselves that markets and regulators are in a capricious mood right now.
Investors must objectively deal with this reality as opposed to complaining that they don’t like
the new rule book.
What this means for your Eriswell portfolio:
1) Eriswell has no direct exposure to bank AT1s, or Cocos as they are sometimes called.
2) I am also happy to report that we have almost no direct exposure to European and
international banking stocks, other than the implicit exposures of portfolios with stock
index ETFs. The only exception is clients who target higher levels of risk as part of tactical and
trading strategies and even these are tiny.
I’d like to spend a moment on the distinction between trading and investment……
Here’s what we wrote about Contingent Convertible Bonds (Cocos, or AT1s) on 4 March 2016:
Was our 2016 ‘toxic Coco’ forecast accurate? Yes, absolutely, for longer-term investors—a
100% loss on a bond such as Credit Suisse’s is never great—but the trading perspective is
more nuanced. This is because there were many tactical opportunities along the way for
higher-risk players including hedge funds. Whose trading positions were backstopped by a
hard knowledge of who the fool was at the table—the managers of retail bond funds!
Retail investors today should be wary about holding on to funds where the manager may not
get the play, may be slow to react, or may be unfamiliar with the specialised risk management
techniques required for trading portfolios.
Banks are in my opinion trading assets pure and simple—both from market observations and
the theoretical valuation analyses we perform using in-house option-based distressed asset
valuation models. The banking sector outperformed strongly in 2022 as investors concluded
that rising interest rates would increase their profits given the banks’ ability to drag passing
on rate increases to depositors while accelerating the interest charged on loans to creditors.
(Fig 1, banks in red).
Then over the past few weeks, these gains evaporated as investors discovered that the rosy
picture painted by the banks was an illusion.
Zoom out to a 10Yr view and we can see that banks in the longer-term have performed like
dogs. (Fig2)
This perfectly illustrates the distinction between trading and investment: Time some of these
banking stock moves right and there’s good money to be made. Time them wrong and hefty
losses await. By comparison, hold on to these stocks as for the longer-term and woe is yours.
It is as simple as that.
Which is basically what we said last year:
Please be careful out there, it’s an ill-wind that is starting to blow.
Low bank profitability remains a contributary risk to Euroarea financial stability and to the
banks themselves. This combination of low Return on Capital and low profitability is the
primary driver of the dog-awful performance of European banks over the past 15-years.
Moreover, periods of low bank profitability in turn degrade the bank credit transmission
mechanisms upon which the UK and Euroarea are heavily reliant.
There are also risks to credit intermediation with clear repercussions for medium-term UK
and Euroarea inflation, economic recovery, and public welfare.
Mark Page
