Dollars and Sense podcast

Mike Reed 00:05
Hello, and welcome back to the RBC BlueBay podcast Dollars and Cents. I’m Mike Reed, Head of Global Financial Institutions. Well, it’s difficult to take your eyes off markets right now as the impact of the war in Iran plays out in economies and markets around the world. Bond markets will continue to suffer as yields move higher, driven by inflationary concerns due to rocketing oil prices and obviously disruptions to supplies for key commodities from fertiliser to jet fuel.

Meanwhile, US stocks have rebounded sharply as investors continue to embrace the potential of AI and the growth of the hyperscalers. Meanwhile, European assets, both bonds and equities, have struggled as they deal with the problems associated with weaker economic growth due to higher energy prices and a lack of world-leading tech firms.

With so many of our European clients having significant holdings of investment grade credit bonds, I’m really pleased to welcome Marc Stacey, managing director and senior portfolio manager in our investment grade credit team, back to the show. Marc, welcome back. We have very much to discuss today.

Marc Stacey 01:15
Thanks for the invitation, Mike. Good to be back. Good to have this discussion.

Mike Reed 01:18
Great to have you. Well, I suppose we can’t really start a discussion about any asset class right now without considering the impact of the ongoing war in Iran and the disruption in the Strait of Hormuz. One of my colleagues refers to it as the Dire Straits. Well, puns aside, and trying to move the focus away from the ongoing day-to-day machinations in the Gulf, what is likely to be the medium-term impact on European economies, and how resilient are corporate balance sheets?

Marc Stacey 01:48
Yes. Look, I think the first thing to say is we don’t have any real competitive advantage in ascertaining when the Straits will open. When it comes to financial markets, I think the only important factor that we need to focus on is when will the Straits open and when will we get the free flowing of oil through that Strait. And it’s not just oil. It’s any part of the supply chain that gets affected, fertilisers is something that comes to mind, urea etc etc.

So look, I think from a financial markets perspective, that is the key question. I would say balance sheets are in rude health. I think whether you look at high yield or investment grade, part of the resilience within the market is because we have such a strong fundamental backdrop, and so the starting point is very good. By definition, what the consequence of this war is, is that inflation will be higher and growth will be lower. Now, when we think about various different regions, they’re going to be affected in different magnitudes, but when it comes to Europe, we have a rough gauge that it’s every month it adds 0.1% to inflation and takes 0.1% of growth.

Certainly, the longer this has a bottleneck and the longer that we have higher oil prices and really a shortage that is causing demand destruction, I think that is being limited more to poorer nations right now and emerging market economies. I know that there was a fear that we were going to run out of jet fuel at one point, but that seems to have subsided just because you have the richer countries that are paying up for jet fuel, and that’s at the consequence of those poorer countries losing out to that said jet fuel.

Look, I think the way that we’re looking at this is that obviously, the sooner the Straits open up, the better for risk assets and for markets, but growth is certainly going to be lower. We’re not calling for a recession in Europe, but certainly the strong optimistic growth forecasts that we had at the beginning of the year are being tempered because of the Iran situation.

Mike Reed 03:54
It’s a good intro, so helps me set the scene. Taking it back a little while now, I guess the Berlin Wall fell 35 years ago or so now. Since then, Europe has benefited from a peace dividend, and that’s gone for several decades. Now, we’re going to appear to have entered a prolonged period of insecurity, and Europe is having to re-arm and increase defence spending, which is well noted. There is an obvious, I guess, direct benefit to companies involved in the defence industry itself, but what about the indirect beneficiaries? Will this help other parts of the economy as well?

Marc Stacey 04:30
Yes, look, so I think the backdrop that we have here is this almost deglobalisation where every nation needs to stand for itself, or every block needs to stand on its own two feet, and can’t rely on the superpower that is the US from a defence perspective. You’ve seen that shift and pivot from a NATO perspective. You’ve seen Trump really force the hand of various different nations to up their defence spending, and that’s really coming across quite strongly.

In particular, I would say that the largest pivot was probably from a country like Germany, where you had this myopic focus on the black zero and to limit their spending in any shape or form because they were always so fearful of inflation, and that’s out the window. When you look at the amount of spending that they projected to spend, it’s akin to the German reunification in the early 90s. A cumulative effect of around about 20% of GDP in infrastructure, in defence, is going to be absolutely massive.

I think the other part of this is you’re also going to have a huge amount of supply from a bond market perspective to fund that. You’re also going to have increasingly support on lower income families and the parts of the population that are being affected by higher inflation that comes through as well. That is going to increase the amount of spending that governments make, and so the amount of issuance from bonds to gilts to BTPs etc is going to be huge.

I think we’ll probably get on to the supply side of corporate bond issuance, but certainly you’re going to have a lot of bond issuance and sovereign issuance as well, which is going to keep yields high. I think the pressure will still be on governments from a fiscal perspective. What does that mean for markets? It means there are going to be certain sectors that are winners and losers with a higher-rate environment. Certainly, the higher inflation is also leading to central banks to change their views as well.

And so, we’ve gone from pricing in cuts at the beginning of the year to hikes now almost across the board. We’ve started to see those hikes come through from central banks as well, which again is going to mean that some sectors are going to benefit from this higher rate environment as well. You’ll know better than most, Mike, that the banking sector is one that I particularly like. I think from a macro perspective, higher rates and steeper curves is one that’s going to benefit the banks.

Mike Reed 06:56
Yes, it’s definitely an interesting thing. I’ll try and pick up on a few of those actually as we go forward because there’s some stuff in there you just said that I think is very important. I wanted to pick it apart a bit more. You touched on bond issuance, in one area in particular you spoke about is government bond issue, and obviously, that’s going to be high.

Another major theme running through credit markets is the colossal sums being raised by the hyperscalers to build out the infrastructure required for the expansion of AI. The big five, Alphabet, Amazon, Meta, Microsoft, and Oracle, are now expected to spend around USD750 billion on capex in 2026, which is double what they spent last year. The investment grade bond market, which most of these are in, or I think all of these are in, is expected to provide nearly USD200 billion of that, which is a huge amount.

With credit spreads at post-GFC tights, is this extra supply squeezing out other issuers and putting downward pressure on the secondary market?

Marc Stacey 08:07
Yes. So look, it’s unambiguous that the supply side in the corporate bond market is going to be absolutely massive as well, as you’ve pointed out. To put some numbers on this, back in 2024, net supply in US corporate bond issuance was around about USD450 billion. In 2025, that jumped to around about USD655 billion. Over the course of this year, notwithstanding the war and closed periods, but we’re expecting net issuance to be in excess of USD1 trillion.

Now, as you mentioned, we’re at the tights in spread, but I think for the last two years, the buyers of credit have really been yield buyers. When you look at total returns and the yields on offer, they’re still fairly attractive in context of historical averages that we’ve seen over the last 10-15 years. From that perspective, there is still demand for these bonds. The bulk of this issuance is coming from single A-rated issuers that are the most profitable, biggest companies that we’ve ever seen that are still free cashflow positive in a large degree. They aren’t adding much to the leverage, certainly in 2026.

Look, I think you have a point that does this crowd out some other parts of the market? These are certainly issuers that I think are less sensitive to pricing. If they’re paying USD200,000 for an electrician at a data center because it’s really a rounding error in terms of their bigger picture, do they pay 10, 15, 20 basis points to get billions of dollars out in the credit markets? I think that’s certainly the case.

From our perspective, we like the space. We’re trading it from a tactical perspective. I think you’re supposed to buy them when they come at new issue with some new issuance premium. As they tighten in, you reduce the risk and wait for the next one to come again and you go again. Look, there’s no doubt that there’s going to be a huge amount of issuance. There is a lot of demand in the sidelines as well. There’s still USD7.5 trillion sitting in money market funds in the US. That’s more than doubled since pre-2022 when rates started to increase.

Does some of that money find its way back into risk assets, whether it be equities and credit? Certainly I think that could be the case if you saw spreads starting to widen out or yields move even higher.

Mike Reed 10:30
You’ve talked about the issuance in government bond markets as well. Often, total returns in investment grade bonds are dominated by movements in the interest rates of government bonds. I presume also, and we touched on this a little bit earlier, there are opportunities for an active manager such as yourself to generate alpha by focusing on the underlying fundamentals of individual companies. It would be interesting to get your thoughts on the sectors in Europe you think will be the winners and losers over the year. We spoke about defence, but is there elsewhere that’s of interest or of concern?

Marc Stacey 11:08
Yes, look, I think certainly for concerns, anything that’s interest rate sensitive and is reliant on rates coming down for central bankers is going to be under pressure. I think some parts of the infrastructure complex are going to really benefit from the fiscal spending that’s coming through as well.

By far and away, my favorite sector is the banking and the financial sector, both because we are sitting at the fundamentals at close to all-time highs. Whether you look at it from a capital perspective, there’s 16.3% in CET1. USD1.8 trillion in equity has been raised over the last 15-20 years since the global financial crisis and now sits within the European banking complex. Liquidity is certainly ample. Non-performing loans, 2%, which is structurally at the lows. Now we have an environment where not only are our rates high at the front-end, but curves are steep as well. You’ve had a doubling of profitability since 2020 at European banks. They made around about USD425 billion of pre-provision profits last year. We’re expecting that to be even higher this year. You’ve got return on tangible equity moving from 15% to above 16% and 16.5% in '27 and '28.

And so, I think from the higher rates perspective, it’s one that we like. Certainly, from a technical perspective, as well, we like it a lot as well because the amount of net issuance that we’ve spoken about in corporates is not the same in financials. If anything, net and gross supply is probably going to be 50% of what it was in 2025.

And so, both from a fundamental perspective, both from top-down and bottom-up, this is a sector that we still think is going to be one of the winners over the course of 2026.

Mike Reed 12:54
That’s interesting. I want to move on to the financials sector because you paint a very rosy picture, but there’s been a lot of talk about private credit. It’s very much in the headlines virtually every day at the moment as concerns grow about the loans that many of these funds have provided to various industries that might be negatively impacted by the arrival of AI; software as a service and financial services are a couple that are mentioned.

With several private debt funds actually gating their funds in recent months to limit investor redemptions as they requested, a 5% trigger, they don’t let any more out. I’ve heard some concerns that this might spill over into the banking sector, which also has exposure to a lot of loans. Are these concerns justified, or do you stick with your view that the European banking sector is in a very healthy position?

Marc Stacey 13:50
Yes. Look, so a few things to say here. Firstly, the reason why private markets exist, whether it be credit or equity, is a consequence of the global financial crisis, where really the regulatory oversight forced a lot of these businesses to be unprofitable for the banks because the capital charges were too high.

You had an entire industry and a shadow banking system that evolved out of the global financial crisis, and you have these large behemoths now in the private credit and the private equity space that have really eaten the banks’ lunch in terms of taking this business off banks’ balance sheets.

The first thing to say is really this business has moved off banks’ balance sheets as a result of the global financial crisis and regulatory oversight.

Now, that’s not to say that European exposure is zero. There’s some banks that have some exposure, but the largest exposures, and I won’t mention the names, but certainly the largest exposures sit around 5% of the loan book. It’s just a de minimis part of their overall loan book. When you look at the underlying exposures, these are investment grade rated parts of private credit, and there’s a 60% LTV on average.

Look, I don’t think this is going to be a meaningful driver of returns for these institutions. I think European banks are in a particularly good space, particularly because they’re running a higher degree of capital. They’ve also got a high degree of profitability. Even if there was some impairments and some provisionings that need to be taken, there’s ample capital that’s been generated on a year-to-year basis to be able to absorb that.

And so, I think we also need to differentiate as well between the European banking space and the US banking space. I think US exposure in this particular sector is somewhat higher than Europe. When we think about Europe and the European exposures, we’re a lot more comfortable.

Mike Reed 15:42
I guess, in a way, the banks themselves benefit from the higher rate environment, as you mentioned. You talked about that a lot of these loans were made to companies when rates were very low, so now that rates have backed up a little bit, their business models are starting to struggle a little bit. That is also what’s presumably creating difficulties for them.

Marc Stacey 16:04
Absolutely. I think when we think about the hump of refinancing that needs to occur, that’s really in '28 and '29. There is some time before then, but certainly these are parts of the market that are feeling a little bit of stress.

Mike Reed 16:19
Yes, '28, '29 is not that far away when you think about refinancing. Anyway, well, Marc, it’s been fascinating having you on the show as always. Thank you very much for your insights. Really helpful.

Marc Stacey 16:31
I really enjoyed it. Thank you, Mike.

Mike Reed 16:33
Many thanks for listening to the show. If you have enjoyed it, please like and subscribe on your podcast platform of choice. We will be back next month when Mike Bell will join us. He is head of market strategy here at RBC BlueBay. It’s always fascinating to hear Mike’s views and opinions across the whole spectrum of asset classes, so I look forward to getting his insights next month.

If you wish to listen to any of the previous editions of the 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.