Fear dividend

Portfolio managers are not paid to sleep soundly but to select premiums that attractively reward their volatility budget.
Fatally, opportunities arise when nerves are tested.
When panic shatters the risk assumptions that prevailed the day before.
When fear pulverises asset prices below their most conservative fundamental value. 
The exaggeration of investors’ animal spirits, to use Keynes’ phrase, is the dividend of fear that the contrarian investor seeks to perceive.
Provided that his valuation model ends up being verified over time. 
And provided that he is not right too soon…
Nevertheless, as extreme as it may be, the markets’ intemperance towards the financial sector is not without logical meaning. 
Because, more than in industry or services, the statistical distribution of operational events is leptokurtic. The frequency and intensity of extreme losses are higher than elsewhere. Banking or insurance capital is thus a naturally volatile substance. 
It is therefore difficult to say whether the actuarial yields (between 8% and 20% depending on the issuer!) of AT1 bonds offer fair compensation for the fear of creditors. 
After all, they are the first, after shareholders, to absorb losses in bank capital in the event of insolvency.
While some investors are returning to the asset class, even seeing it as a historic opportunity, one should not underestimate the self-reinforcing effect that panic can have on a narrow market, which is difficult to quantify in the absence of a comprehensive index. 
On the basis of the funds tracked by JP Morgan, the US bank estimates the outstanding hybrid or financial subordinated debt in Europe and the UK at around 40 billion euros. 
In 2018 (Italian political crisis), 2020 and 2022, they suffered withdrawals of up to 13% of their outstanding amounts… Recent events could weaken the deposit. The deterioration of liquidity is a vicious circle. It can be very dangerous to be right too soon…
Being right too soon is also the game of structural policy reforms. While there is no doubt that the pension system must be adapted to the structural ageing of the population, it is clear how delicate it is to push through a major reform for which the population still seems ill-prepared. 
Are the tensions and social movements worrying investors? Is there fear on French stocks? 
Since the beginning of March, the performance gap between domestic and internationally exposed companies has widened: nearly 10% cumulative underperformance since the rebound that began in November 2022. The same is true of the CAC Mid et Small, which is less internationally oriented than its big brother with its 40 champions (16% of sales in France only).
And yet, there is no sign of panic according to the bond markets. Hovering around 0.5%, the spread between 10-year French Treasury bonds and those of Deutsche Finanzagentur remains contained. 
In support of this, INSEE has published a study showing that the social movements of 1995 and 2019 had little effect on growth. Each time, the hotel industry suffers first: it already reports a cancellation rate of 25%. Nevertheless, recovery often takes place in the quarter following the outpouring of resentment.
Perhaps the reason for the downturn in French domestic stocks is their high valuation. Based on their earnings over the next 12 months, the MSCI France (64 components covering 85% of listed companies) is trading at a historic premium to the rest of the continent: 13.7x compared to less than 13x for the Stoxx 600 Europe.
There is no fear dividend on French equities, which since Emmanuel Macron’s first term in office, have performed well above the long-term average of their relative valuation. 
Nevertheless, the year has its share of surprises in store. And in the face of potentially more robust growth than expected in Europe, the spectre of a double shock is looming.
Monetary and inflationary (in the event of a rebound in gas prices in the winter of 2023-2024), it will probably be the one that will put investors’ nerves on edge.
It will then be necessary to arm oneself with courage to go and earn this salary of fear!

Thomas Planell, Portfolio manager – analyst at DNCA. This article was finalised in March 31st, 2023.

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