Unlocking markets: following the fundamentals

Unlocking markets: following the fundamentals

by Marc Stacey, Senior Portfolio Manager for Investment Grade, and Mike Reed, Head of Global Financial Institutions.

Mike Reed 00:02

Hi, I'm Mike Reed, head of Global Financial Institutions. Today, I'm delighted to welcome Marc Stacey, who is a portfolio manager in the investment grade team here at BlueBay. Welcome, Marc.

Marc Stacey 00:16

Hi, Mike. Thank you very much for the opportunity to be here.

Mike Reed 00:18

Great to have you. I think we have to open our discussion by getting your thoughts on the impact of President Trump's ‘Liberation Day’ tariff regime. There was initially a huge volatility in the financial markets, but how will the investment grade companies you invest in be impacted? Have you seen any evidence of an economic slowdown in the data you and the team follow?

Marc Stacey 00:39

Yes, well, there's no doubt that there has been a huge amount of volatility. I think aside from ‘Making America Great Again’, President Trump is certainly making volatility great again. And yes, there has been a huge shock to the system. I would say there's been a shock akin to the Covid supply chain shock that we had back in 2020. And there has been a huge slowdown in data. If we look over the course of April since the ‘Liberation Day’ tariffs, you've seen a huge softening of the data, in particular, the soft data surprises have really deteriorated.

Now, we haven't seen hard data move materially low. As we move into June, where we will get the May data, then you're likely to either see soft data begin to improve or the hard data start to deteriorate. Now, I would caution investors to say that we have seen this once before in the back end of 2024. We saw the soft data moving materially lower, and hard data continue to improve.

I think it's going to be very interesting to see what the data looks like. There's no doubt it will be somewhat softer because of the sort of turmoil, volatility, and uncertainty that the tariffs have caused. But will investors just look through the deterioration and say, "Well, there's sunny uplands here with deals being negotiated, and tariffs are going to be much lower," in which case you're going to see the data start to improve and hard data pick up, or are we heading into a much lower, even recessionary-type environment.

I think it's important probably to take a step back and just try and assess what the Trump administration is trying to achieve here. I think there's no doubt that the tariffs are a way of raising revenue. In the first instance, I think the target here is to raise around about 300 billion, anywhere between sort of 0.8%-1% of GDP. This will allow President Trump to enact some of the tax cuts, or certainly extend the tax cuts that he'd implemented before.

The other part of this is no doubt an ideological change where they want to reshore some parts of the supply chain. I think there's a growing awareness that there is a vulnerability in the US. This was highlighted during Covid as well, when it came to pharmaceuticals, and just onshoring some of the necessary equipment that they needed, they were vulnerable to the rest of the globe. I think there is going to be somewhat of a targeted sector-specific approach when it comes to tariffs as well. My base case is really a 10% universal tariff to raise that revenue, but equally then a 25% sector-specific tariff, looking at steel, looking at AI and chips, and making sure that the US is pretty sustainable in terms of that production, as well as pharma being the other main target that they'll have.

I think when that happens, what's under pressure from an IG perspective, I think European autos, industrials, certainly would be pressured, any companies that are exporting to the US, perhaps companies that are exposed to China. I think while we've had a delay to the Chinese tariffs, my base case is certainly that we end up with round about a 50% tariff on China. That certainly starts to put a little bit of pressure on the Chinese economy, and certainly the ability for them to grow at the pace that they have before.

One of the elements, though, that I think the administration is taking note of and keeping them in check, to some degree, is less about the equity market and the S&P. I think various members of the administration have been quoted as saying that this is not a MAGA problem, this is a Mag 7 problem when the equity market was tanking. But I think what kept them in check was the bond market.

If you look at the distribution of wealth by percentile of the US base, you can see that the top 1% of the population own close to 50% in equities and only 12.8% in real estate. If you flip that around, and you look at the bottom 50% of wealth distribution by percentile, you can see that they own 50% in real estate and only 5% in equities. If you're thinking about the large weight of the voter base that Trump appeals to, they're very much invested in real estate and the housing market. That's much more dictated to by the bond market and by interest rates. So, I think when interest rates move materially higher, that obviously puts pressure on the asset base for his voter base, but equally, it worsens the certain high amounts of debt that the US has to service, and higher interest rates obviously exacerbate that.

Mike Reed 05:49

That's very interesting. Thank you. It's a really good way to kick off the conversation. You mentioned MAGA there a couple of times. Although President Trump has attracted a lot of attention towards the US with his MAGA project, I'm also conscious there's been some seismic shifts in the European landscape. I'd like to talk a bit about those. It would be great to hear your thoughts on what has happened and the impact on Europe's investment landscape. Is it going to be ‘Making Europe Great Again’? Is this MEGA versus MAGA?

Marc Stacey 06:20

It's a great point. I think you raise a seismic shift in the world order that Trump is really exacerbating. I think the idea that Europe needs to boost its defence, it needs to increase the amount that is spent on infrastructure as well, I think it's going to come to the forefront. We're certainly seeing that in 2025 as well.

And to some degree, you've seen a huge divergence in asset class performance as well, with European equities and European spreads outperforming those in the US. This is really based on the fact that there's been a huge pivot, particularly from the third largest economy in the world, I mean, Germany's USD4.5 trillion economy. They've decided to move away from the black zero. They've decided to actually deficit spend for the first time. There's a huge amount of fiscal space that Germany has, to spend on infrastructure and to spend on defence. If you think Germany is part of the G7, has the lowest debt-to-GDP ratio, they can spend up to USD1.6 trillion, and they would just be at the next worst in terms of debt-to-GDP. The fiscal room that they have is enormous. They've said that they're going to be spending around about a trillion over the next decade.

It's not just Germany as well. We could say that there's not a huge amount of fiscal space with some of the European countries, France probably being one of the worst, but certainly at a European level, there's going to be a lot more fiscal spend as well. There's going to be 150 billion that is raised at the European level that certain sovereigns can borrow from to increase their spending.

I think what happened when Russia invaded Ukraine was this huge reliance on cheap Russian energy for Europe has obviously been curtailed. That's never coming back. This pivot to a more sustainable, more reliable energy source for Europe is going to prompt huge amounts of infrastructure spend. I think that's going to happen at a local level and at a European level as well. If we think about the amount of fiscal spend that's going to transpire in Europe, it does mean that there is going to be somewhat of a tailwind from a European perspective.

I think the other part is there's certainly been a question mark around the dollar and the exceptionalism in the US. I think there's been a huge amount of investment in dollar assets and US assets, and maybe just more of a rebalancing across the globe. I think Europe, the UK, to some extent, might benefit from portfolios that move out of dollar assets into European assets, into UK assets, to diversify the structural decline. If you start to see question marks around US exceptionalism and the smooth sailing that they've enjoyed from an exceptional growth perspective over the last 10-plus years.

The other part is when you have huge amounts of tariffs, which is essentially a consumption tax in the US, does those Chinese goods find homes in Europe? Maybe it's more of a deflationary tailwind for the rest of the world. Does the ECB perhaps have more room to cut rates and support markets than perhaps the US will have where you're likely to see inflation ticking up around about the 4%, but the deflationary impact that you have for the rest of the world, and Europe in particular, means that the ECB might be a bit more supportive. Again, that points to an outperformance, perhaps, versus US.

Mike Reed 10:10

There's so much going on in the macro level, and I suspect we could spend hours talking about that. I really appreciate your color there. It's some very interesting things going on both in the US and in Europe. I'd like to focus a little bit more now on investment grade itself and the products that you manage. I'm aware that the main driver of return for investors in investment grade, historically, has been the income they receive from the securities they invest in, or you invest in on their behalf. Given the movements in interest rates, how attractive are the coupons on the bonds being issued this year?

Marc Stacey 10:44

Yes. Look, I think the key driver for investment grade has been the technical, and just flows into the asset class. While we're not at the highs in yield, we're certainly at decade-level yields that we haven't seen for the last 10 years. And so the flows into the asset class have been extremely, extremely high. I think that will continue over the foreseeable future. If you look at euros today, you're getting 3.1% yield in euros, but when you swap that into dollars, if we keep everything as a dollar yield, that's 5.5%. If you look at dollar IG, that's 5.3%. There continues to be flows into the asset class because of these higher yields that investors can enjoy, and the breakevens look pretty good.

I think that, in particular, in a world where uncertainty is higher, where geopolitics is always in the headlines, where growth concerns can be real on the back of tariffs, investing in solid investment grade companies that are large, that have incredibly robust debt levels, in particular, from an interest coverage perspective, means that you can get an element of safe carry in the investment grade landscape.

Just to add to that, I think when you look at the technicals from a reinvestment perspective, over the course of 2025, you're likely to see around about USD400 billion in income returned to investors because of coupons being paid out to investors. If you look at net supply over the course of 2025, that's, again, likely to be around about USD400 billion. You don't actually need any more incremental buyers to step into the dollar market to absorb all of that net supply that's coming. As I said, we are enjoying flows into the asset class because of the higher yields, so the technical there is likely to remain somewhat resilient.

Mike Reed 12:48

I think those technicals are very interesting and really worth highlighting because I think a lot of investors don't really see them or don't focus on them so much. Actually, it can be seen as a little bit of a dull asset class, but dull is often very nice. This compounding of returns should not be overlooked. Especially with, as you say, 5.75%, 5.5% in dollars, that gives you some room if you're not picking the top in interest rates. If they do go a little bit higher, you can make positive returns just driven by the coupon income over the year. That's a very interesting one.

I'd like to go further into detail now and focus more on sector-specific. One of the major issuer sectors of investment grade security in Europe is the banking sector. I know it’s one you focus on a lot and is dear to your heart, as you are jointly portfolio manager on the RBC BlueBay Financial Capital Bond Fund. What do the dynamics look like for European banks currently? Are you finding opportunities to deploy capital in this area?

Marc Stacey 13:47

Yes, absolutely. This is a sector that we've favoured for quite some time. I think if we just take a step back, the trajectory that banks have been on from a fundamental perspective since the global financial crisis has really been a huge pivot from a sector that I think was overlevered and mismanaged to some extent to one that now is heavily regulated and more utility-like in its operations than it's been in the last 20 years.

I think from an equity perspective, that was quite problematic because there was, obviously, a huge amount of restructuring that needed to occur over the last 10 to 15 years, where banks were raising the amount of capital that they had. They were pivoting from riskier debts on their balance sheet to ones that are more predicated on net interest margin, on fee, on brokerage, on advisory, and so that more utility-like model. I think we're at a juncture now where not only is the debt investment at banks looking very attractive, but the equity valuations and outlook are very attractive as well.

If you think about the rate environment that we operate in today, it's gone from negative 50 basis points in Europe to as high as 400, and what probably is going to end up at around about 2% by the end of 2025. Now, in that environment, you've seen bank profitability increase by over 70% since 2020. A 200 billion pre-provision profit is likely to look more like 370 billion in the course of 2025. That probably moves somewhat higher in '26 and '27. The reason why we can have so much confidence on this is because of the utility-like nature that banks operate in.

60% of the European banking sector is reliant on net interest margins. It's literally just banks locking in the spread between where they borrow and where they lend. They have locked in these higher spreads, so actually, there's a tailwind from a profitability perspective over the course of '25, '26, and '27, where even if rates moved lower, the sensitivity to a lower rate movement wouldn't impact profitability as much as perhaps it was. Now, part of that is if rates went higher, they wouldn't benefit either but certainly, it gives us confidence that we can have a pretty clear view from a profitability standpoint over next year and the year after in terms of where banks are likely to come out from a profitability perspective.

Now, when we look at valuations, there's a huge amount of upside. You think of European banks' P/E ratios at around about 8. Now, the long-term average of banks going back to 1995 is P/E ratios close to 10. If you think that we're at 8, we've still got 25% of upside before we just reach the long-term average. Now, I would argue that we should be materially above the long-term average because when I look at the amount of capital that banks had, it's at all-time highs, close to 16% CET1 ratio. If I give you some numbers on what that means at a European level, it means that there's €1.6 trillion worth of equity now sitting on banks' balance sheets. That is more than a trillion euros, than they had back in the financial crisis.

At the same time, as I said, the business models of European banks is far, far safer. Not only are they more capitalised to the extent that capital is at all-time highs, but business models are at the safer end of the spectrum as well. You've got capital at the all-time highs, you've got a return on equity story that's 13% plus, and you've got non-performing loans that are 2%. Asset quality is continuing to be incredibly resilient and sits at all-time lows in terms of where they are from that perspective.

I think the reason why asset quality continues to be so resilient is because employment is still incredibly low. The sequencing that you see when asset quality deteriorates is an environment where employment starts to pick up, it's higher for a prolonged period of time, and that eventually filters through into a cutback of discretionary spending, the golf club, the Netflix membership. The last thing you don't tend to pay is your mortgage. I think when you get to that point where you're starting to see mortgage default rates start to pick up, this is predicated on an environment where you've had unemployment high for a prolonged period of time before you get there. It's just not the environment that we see ourselves in. Unemployment still sits towards the lows.

Structurally, if you think about an ageing demographic, it feels as though that unemployment is likely to stay somewhat low for a prolonged period of time, albeit it might get a little bit worse from where we are today, but certainly not to the extent that we're likely to see asset quality deteriorate and NPLs pick up to any meaningful extent. Even if they did, the profitability tailwind that we have from that USD370 billion of income goes a long way to shielding any deterioration in the balance sheet that might come.

At the same time, just to finish on this, the valuations are particularly attractive as well. You're still getting 8% in terms of yields on AT1, which is our favourite part of the bank's capital structure. So, subordinated bonds from investment grade issuers in the banking sector that are well-managed, that are well-capitalised, that are very profitable, and it's still getting you high single digits in terms of total returns. You're getting equity-type returns in what is senior in the capital structure to equity.

Mike Reed 19:48

I think that's very interesting and worth focusing on for potential investors is that if the, as you've outlined, the equity portion is so well-capitalised within the balance sheet that they secured out the implication for the security and the returns on the more senior, whether it's subordinated financial debt or even senior financial debt, that de-risked that situation quite considerably.

Okay, we've talked many positives here. I always have to ask the people I interview, for the listeners to get some balance, what are the potential downside risks here?

Marc Stacey 20:20

Yes, look, and I think there's still a huge amount of uncertainty in terms of the Trump tariffs, the growth trajectory, the inflation trajectory. We just don't have the details and the ability to really assess exactly what the first- or second-order effects might be. I think some of the things that we're looking at are one, the US Treasury curve. I think there's no question that US treasuries are still the risk-free rate for the globe and global markets, and I think if that becomes unhinged and moves materially higher, that has to put pressure on equities and fixed income alike.

We saw this in 2022 when interest rates repriced and moved materially higher. It didn't matter whether you were in equities or fixed income, anything long duration got particularly hurt, and I think that's the environment that we're in. If there starts to become question marks around how high 30-year treasuries could move, and we're at 5% today, could the 10-year move from 4.5% to above 5%? I think if you start to see that, that could put pressure on risk assets, and I think you can see a repricing there to some extent. It's less about what happens in the JGB market or the gilt market or the bond market. I think overwhelmingly, the US Treasury market is still the global standard for risk-free rates, and I think everything gets benchmarked off that. That's a key factor to watch. If Treasuries move materially higher, of course, that's going to put pressure on risk assets.

The other part is the growth and inflation dynamics. I think recession is not our base case, but certainly the implementation of tariffs, this quasi-supply shock, or consumer tax on the US, is likely to mean growth is somewhat lower. Does that mean recession? No, but it does mean that growth is going to be somewhat lower, and inflation is likely to be somewhat higher. You're likely, as we said, to see inflation anywhere between 3%-4%, which means that the Fed and central banks perhaps, well, certainly the Fed, have less room to cut rates and backstop the market if growth starts to slow because inflation is still high.

The other category that we need to watch and look for potential downside here is, with all the uncertainty that has been caused by the Trump administration, does corporate America start to lay people off? Do they sit on their hands and not do the capital expenditure that is needed to grow and move forward? Do we see unemployment start to pick up? I think, in particular, for the banks, that's something I've stressed, in that if you see unemployment start to pick up and it's high for a prolonged period of time and continues to get worse, then that could put pressure on non-performing loans and risk assets generally.

I'd say those are the three key potential downsides that we need to be alive to and aware of, and be monitoring in our portfolios.

Mike Reed 23:26

Now, I know you and the team will be monitoring those very, very carefully. We all appreciate that. Just finally to one final question, looking out for the next 12 months, and I know this is a hard one to answer, but what do you think will be the biggest drivers of return for investment grade bond funds that you manage?

Marc Stacey 23:45

Yes, so look, I think there's still a lot to play for here. I think we still haven't had the details of what the Trump tariffs will end up looking like. As I said, my base case is a 10% universal tariff, 50% on China, call it, and then 25% on certain sectors. I think in that environment, as long as growth is still lower but positive, and yields are attractive in investment grade because you've got sort of Treasuries around that 4.5% in the 10-year mark, that means that the flows are going to continue.

While I'm not banging the drum from a spread perspective, I think when you look at fundamentals of the IG space, when you look at the technicals, they will continue to be robust. If you look at the money markets in the US, there's still USD7 trillion sitting on the sidelines in money markets. Now, if I look at one-month T-bills versus the IG yield, you're picking up 100 basis points by investing in US investment grade versus T-bills. If we do have any Fed cuts or we do see the front-end and money market yields start to move lower, there's a huge amount of money that can pour into investment grade.

When I look forward 12 months, I think IG is still likely to be somewhat of a safe haven. I think the fundamentals are robust. I think all-in yields are high enough to provide a buffer from any volatility to give you positive total returns. It might be sort of yield minus in a bear case, but you're still sort of protecting capital and producing positive returns there. I think the flows will continue to be fairly robust and positive as you have this huge shift out of equity markets, out of money markets, into fixed income because you're picking up these yields that we haven't seen for over a decade, as I said before.

Mike Reed 25:44

Yes. Thank you, Marc. That's really helpful. It's great to get your thoughts on what is an incredibly interesting investment backdrop at the moment. It's frequently said that volatility creates opportunities, so hopefully, you and the team are able to identify many of these for your clients. Thank you for today.

Marc Stacey 26:01

Thanks for your time, Mike. I enjoyed that.

Mike Reed 26:03

Many thanks for listening to the show. If you've enjoyed it, please like and subscribe on your podcast platform of choice. We will be back soon with further insights into the investment world from our team of portfolio managers. If you wish to listen to any of the previous editions of the Unlocking Markets podcast, they're available on our website, www.rbcbluebay.com, or can be found on Apple, Spotify, or Google. Thank you once again for joining us today. Good luck and goodbye.