Credit, debt cycles and bubbles with Michael Leithead

Welcome to Beyond the Benchmark, the EFG podcast with Moz Afzal.

Moz Afzal:

Hi everyone. Today I have Michael Leithead who's the global head of fixed income for EFG Asset Management. Michael, welcome.

Michael Leithead:

It's good to be back. Moz. Thank you for having me.

Moz Afzal:

A lot to talk about within the fixed income markets. Just in terms of maybe lets kickoff straight away thoughts on US rates as we go into next year. Obviously the bond market more recently has reacted to 10 year US Treasury yields are down to 4% and things looking pretty good, US economies slowing. You're starting to see delinquencies on credit cards picking up a bit, but nothing too dramatic. Certainly does suggest that continuous interest rates are to come.

Michael Leithead:

Yeah, I mean I think everybody's watching the labour market very, very closely to see what happens in the next couple of months. Obviously with the shutdown it's making things a little bit more opaque. The news generally over the last couple of months has been quite negative on the labour market and that's certainly putting a bit of a bid to the bond market in general. So I think rate expectations are kind of understandably where they are in terms of the short run, looking for further rate cuts to come. I guess you've got the interesting dynamic of what kind of Fed setup we have in terms of an FOMC next year and obviously a more dovish chair might see lower interest rates and it remains to be seen whether that would be inflationary. I think inflation is also a very important fact that we are looking at and inflation has kind of come down, it's still above target, but I think it's in a comfortable zone for the economy and it's a comfortable zone for the Fed. I think obviously we got used to very low inflation rates over the last decade or so, but go back prior to the global financial crisis and we are happy with inflation below 3%. So where we are now looks like a bit of a good position for the Fed to cut. I guess the question is how much further do they go? But the cuts are definitely in there,

Moz Azfal:

So it's the 13th of October right now. And just a quick reminder, we are not getting any data just in case Donald Trump does a resolution within the next few days, so I was quite keen to mention the date here. So where do you think the trough rate on US interest rates lands?

Michael Leithead:

I mean my view is we're probably, you're going to see a few more cuts and we'll probably end up somewhere in the three and a half range, assuming we get a bit of weakness in the economic data we've been seeing in the last sort of quarter or so as we go into 26, I think people are generally expecting a bit of a re-acceleration coming through, so that might just put the Fed in a bit more of a comfortable position to go on hold again. Of course, as I say, if we see more Trump friendly FOMC, then there might be a few more cuts. So I think the market's kind of been pricing between those two sort of scenarios. See how the setup goes in the FOMC as I said. So I'd say three and a half kind of base.

Moz Afzal:

So that's certainly lands quite nicely for financial markets, both fixed income and equities. So the US economy continues to slow down a bit. I think rate cuts path certainly is assured. How do you think that will impact in terms of the yield curves? Obviously it has deepened up quite a bit. Where do you feel that the say two 10 year interest rate differential, where do they land say in a year's time or two years time?

Michael Leithead:

I think obviously in terms of the steepness of the curve at the moment, the two years essentially pricing in rate cuts and then a period of rate pause if you like. I think as you evolve into next year then you start to see the market, particularly if growth starts to pick up, then maybe we start to see a little bit more priced into the two year. So you could theoretically see a little bit more of a premium between three month money and two year money. But in terms of the twos and tens, I think you could get a relatively flat yield curve. We're in a point where rates are still in a sort of neutral zone and you maybe only see 50 to 80 basis points of steepness between two years and 10 years. I think that would kind of put you in the range if you assume a sort of three and a half, three and a quarter kind of Fed funds rate to 10 year Treasuries roughly where we are today. That's not to say they couldn't go lower and they can't go a bit higher and we've certainly been quite a tight range relative to the last few years over the last 12 months, but I could see a scenario where the 10 year doesn't do a lot, just moves oscillates around where we are today.

Moz Afzal:

So yeah, steeper yield curve, but around 4% on the 10 years where you land, we see 30 year curves are much, much steeper, not just the US but everywhere in the world. What's driving that do you think?

Michael Leithead:

I think there's a couple of things. I think one is structural buyers of the long end are starting to diminish. I mean you've seen it most acutely in the UK where you've seen defined benefit schemes being taken out by insurance companies. The asset allocation mix is very different. In Holland you've seen a shift of defined benefit mandates as well and that's putting pressure on the long end. So there's a variety of these different factors I think at play as well as the obvious one, which is people are a little bit more concerned about solvency, particularly in places like the US, the UK I think it's down to supply, but actually when you look at it, you've seen these governments try and manage the supply of long end bonds. The UK government for example, curbed the amount of 30 year bonds they were selling to try and manage that steepness of the yield curve.

So I think there's definitely an element of risk premium, but I think it's also that the fundamental buyers of the long end of the curve have started to retreat. I think that could change if we were to see a growth slowdown, then your natural kind of bias will be to go longer duration and the easiest way to do that is to buy long bonds. But as a sort of structural base, there's more inflation risk out there, there's more solvency risk out there. There should be a much higher term premium and therefore you'd expect to see the sort of long end bonds to be that much steeper.

Moz Afzal:

And you can certainly see then the 10 30 year spreads are very wide compared to history and pretty much everywhere. You can't really pick out one country whether it's a little bit better.

Michael Leithead:

Yeah, I think it's surprising relative to how maybe where we are in twos tens.

Moz Afzal:

So let's talk a little bit about, by the way, I guess in Europe in particular, rates are basically coming to a trough. Maybe there's another 25 in there, but not much, much more than that.

Michael Leithead:

Yeah, I mean I think the ECB forecasts have been for low inflation, but I think they're still very much in the comfort zone. They don't need to cut rates with I think expectations of growth to come through. I think the German fiscal spend is going to be an interesting one to see how much of that actually hits GDP. The market's already priced and you saw it a while back, the additional spend that the German government going to do. And since the ECB have been on hold, we are actually seeing a relatively steeper German yield curve. So I think that actually speaks to roadmap for other countries as well of seeing maybe a little bit of steepening from the base rate to the rest of the curve as we go. But I think we're probably in a fair range for Germany right now.

Moz Afzal:

Yeah, well it's interesting isn't it the ECB and how at least the German bond market and European bond markets have reacted are fairly normal. I would say I can't remember in my career where the ECB has been ahead of the game relative to the Federal Reserve in terms of rate cuts is usually ECBs following the Fed this time around it means like the fed's following the ECB, which is quite counterintuitive. We're not used to that.

Michael Leithead:

No, I certainly can't remember.

Moz Afzal:

So moving on, maybe two or three items we really need to discuss first is credit spreads. Obviously they're very tight thoughts around credit spreads, can they get tighter? I think historically they have got tighter, but what's your thoughts and maybe the technicals to it as we have falling interest rates, people then hunt for yield and so their spreads get tighter. So what's your thoughts for the next couple of months and also couple of quarters?

Michael Leithead:

I think that's absolutely right. I think a lot of fundamental buyers of bonds are looking at the yield in its entirety, not just at the spreads. If you are expecting yields to come down, you're thinking I want to buy now regardless of what that spread is because in six months time my yield's going to be 50 basis points lower or whatever. So I think there is a lot, there's something in the credit spread valuation where essentially the direction of rates, the direction of risk is in your favour and therefore you can afford to have slightly tighter credit spreads. Can credit spreads get tighter? I think they probably can get a little bit tighter. We look back to the sort of 1990s and even if you go to the sixties where perhaps it wasn't the same type of credit markets that had evolved, credit spreads were 10 to 20 tighter on triple Bs, so maybe 10% tighter.

 

But from the perspective of the downside risk, the reason people are nervous about where credit spreads are today is because 90%, 95% of the observations are higher than they are today. So from a direction perspective, you're looking at the price change and thinking, look, this is likely to be a drag on returns, but if you go back to the nineties, we had a period of very tight credit spreads for a very long period of time and there wasn't a lot of volatility in it. And actually in terms of volatility, credit volatility is much lower than equity volatility right now. So you look at things like the crossover, the iTraxx is a lot lower and a lot less sensitive than people might have expected and a lot of people are saying it's not such a good hedge for equity markets, for example,

Moz Afzal:

Which you would've done historically.

Michael Leithead:

So I think we could be an environment where we see little pockets of credit spread widening, but absent a real material shift in the economic outlook, it is difficult to see a proper widening. So if the base case comes out that we get a little bit of a tick up in unemployment, growth is a little bit slower, that's fine. If you're a credit investor, the companies you invest in are going to continue to get paid. The risk of default is remaining quite low overall on a systemic basis. Clearly they're always going to be those companies that have overlevered who have misread the financial balance sheet they've got or that commit fraud and those are going to be there. And I think you're going to see a lot of headlines around is this the credit cycle given any individual defaults.

Moz Afzal:

So let's talk about defaults. So first brands is getting all of the headlines at the moment and for those who don't know maybe actually why don't you go in terms of First Brands and the impact this having?

Michael Leithead:

So First Brands is essentially an auto parts supplier, and I think this is the classic kind of financial engineering problem where you are your financing your working capital through essentially invoice financing and things like that. And so all of this was done through various parts of the debt markets. It was done through asset backed securities, it was done directly through the bond market and there was a high degree of opaque financial reporting going on, which essentially meant that there was over financing of the company. So when this all started to unravel, then your creditors who were providing the finance to for the company essentially started to pull away and then you saw the liquidity dry up and the company essentially folded. That's had a knock on impact because obviously there are a lot of companies funds that have invested in the vendor financing thinking they've got asset-backed securities with claims on payments and therefore very secure debt, which turned out not to be secure by virtue of the fact that there was this over-leverage in the company itself.

So that's a classic kind of I guess almost fraudulent, although clearly that's not proved problem of a default in the cycle. The thing is around those sort of financing structures, you've got private debt investors, you've got insurance companies who have got exposure to basically the invoice financing, they guarantee the payments and then you've got the banks as well who've obviously underwritten it. So it starts to have this sort of contagious effect around the market where people start to concern is get concerned that whether this is a more systemic issue or not, I don't think it is, but I think it's a good highlight of how with weaker transparency you can have these types of risks evolve. So it's about credit selection, it's about doing the due diligence. And it's interesting actually on this point that a couple of weeks ago it was reported that Apollo were actually shorting first brands. So there are those managers who can doing the deep dive, finding out what's its skeletons you've got in the closet and actively looking to short some of the bad boys out there.

Moz Afzal:

And there's a lot of people caught on the other side. I guess the other really interesting part here is I guess this is all driven by the tariffs and the trade disruption that kicked off the beginning of the year and presumably a lot of this was as soon as you get those economic cracks coming in, it just highlights a ness usually breaks up after that always needs an economic catalyst to kick this off. And in this case auto parts, definitely auto parts from all over the world coming to the United States.

Michael Leithead:

Yeah, I think people start to look very much more carefully at things when those risks appear and what are your margins, what's this going to, what's the impact of this? How does your business model work? And clearly when you've got a fragile business model and you get exposed, then people start to shy away. And I think that's what we're starting to see. Very quick reactions to negative news in the credit markets on individual names.

Moz Afzal:

So let's talk about another bubble that people are talking about is artificial intelligence and some of the challenges that's bringing about I think's probably worthwhile having that debate. Certainly just coming back from Latin America and on the road over the last few weeks, it's probably been one of the big questions that people are asking with open ai, huge spending in Oracle equipment and obviously AMD now and Nvidia chips and so on and so forth. So buying right across the chain, even down to Samsung and Hynix in Korea seems to be a very, very broad array of suppliers to OpenAI who have been given these huge orders as well as equity as well in some cases.

 

And I guess for me the one that's most interesting is obviously Oracle that recently announced a big order from OpenAI. What's interesting for me is not necessarily whether it's good for Oracle or not, quite frankly, it doesn't really matter that much, but it's more interesting that this is the use of debt as I can see for the first time in building out AI infrastructure. So Oracle is announced, I think 18 billion debt issuance. What are your thoughts around that narrative and how do you think this can evolve? And I'll maybe talk a little bit about the nineties after you've spoken.

Michael Leithead:

Yeah, I mean obviously the big winner at the moment seems to be in video with all the centre of everything with the chips. Other people are going to be buying those chips. Oracle Oracle's obviously one of those, but the whole infrastructure spend in general is going to require a huge amount of CapEx. So a lot of the CapEx is obviously coming from the big hyperscalers and now this is, I think Oracle was notable from the perspective that maybe it was a little bit of a deviation from that. If you look at the likes of Google, they have loads of cash on the balance sheet. So even with I think half a trillion of spending, you kind of think there's enough cash flow and enough cash on balance sheet to underwrite that. And if you look at meta, they're doing these JVs with different people to fund them by debt.

They're just off balance sheet. Those are the types of things that they start to, you start to question whether there's more sophisticated financing coming in, like you say with Oracle, Oracle is probably the one that had the weaker balance sheet of those big tech companies. So triple B rated already a relatively elevated leverage maybe for a tech company. And then to go and do that additional, I think 80 billion is the forecast spending over a number of years and obviously quite front loaded to get the payoff at the end. People start to question how much debt are they going to need to put on their balance sheet. So I think it is obviously one of the first signs that you might think, as you say that debt is starting to be used. The other areas that we're looking at are things like data centres because obviously there's a lot of capital expenditure there to be done as well. But I think probably in terms of the runway, there's still a long way to go in terms of feeling like this is over leveraged. And certainly if you look at the data centres, I think there's a lot of, any capacity that comes online is being utilised. So I think it's a question of when do we start to see over capacity and I don't think we're really there yet. You're probably getting the return on investment at least for the credit markets when you can borrow up 5%.

Moz Afzal:

Yeah, absolutely. Be interesting to see though ROA numbers over time so far at least the hyperscalers have shown that actually implementing all this spend has actually improved their ROI certainly that's been the case so far. So as you think about AI and AI bubbles, which is obviously a question that I'm getting a lot of, I think we agree with you, we're still very early stages now if I draw the analogy to the 1990s when it was a telcos that was spending all this money on fibre and dark fibre as it was called subsequently because it never got used or didn't get used and then had this huge amount of over capacity, that then obviously led to orders being sort of cancelled. And of course many of those telco companies, global Crossing comes to mind who are building these huge infrastructures, pipeline infrastructures never really came to fruition. That whole process took a long time and there was actually no cash flows because they had to build it first before they had the cash flows. And here there seems to be a much, much more coordinated of growth I guess until we start hitting dark capacity and data centres.

Michael Leithead:

Well I think that's the danger is if you are, and this is the interesting thing is if you look, the other discussion is about circular financing and who's lending to who to basically buy the hardware. And you wonder with Oracle for example, how much might be actually Oracle's debt on Nvidia's balance sheet and whether if that demand doesn't come through at the end of the day, it would be a problem for Nvidia as much as it's for Oracle, probably not in this instance, but you could see further in the supply chain around the individual data centres that might become more of a problem.

Moz Afzal:

Yeah, and exactly now that open AI also gave a big auditor at AMD, you've got AMD, Nvidia and others all coming together, all providing chips for data centres. There is that chance to get over capacity very quickly and staying with the technology is going to be quite important I think.

Michael Leithead:

Yeah, it'd be interesting to see if there's some of the basic technology that goes into, you mentioned the Hynix of the world, which obviously do the memory storage and things like that. Whether or not it's the lower elements of the value chain that we're starting to see broaden out into the area. Infrastructure G basic gas turbines are now a core input to the energy for these data centres as well in places like Texas. So it is those types of guys who might feel, they think they've got a runway when the capacity runs out and you think you've got an order book and it gets cancelled, that's when you start to have a problem.

Moz Afzal:

Yeah, well certainly there's no real evidence of that. I mean there's various talks about Microsoft sort of moth balling a few things here and there, but nothing that is substantial. And obviously you've got this one big play open AI seems to be driving all the narrative, so we'll watch that very, very carefully. So maybe to drawing that particular chapter here to a close, any other key points you think in terms of credit and markets fixing income markets that we should be paying attention to over the next year or two?

Michael Leithead:

I think in credit, obviously we are looking for particular sectors to try and maybe improve. Give us a bit more of a steer on how the more cyclical parts of the economy are doing. So places like chemicals and autos have been under the microscope most recently, so we're kind of watching those to see whether or not there's more stress to be seen there. I don't think they're big or systemic enough really to cause a major economic problem. You don't see the contagion effects that you maybe saw in the past. I think one other big theme is obviously if the US dollar continues to depreciate, that's probably pretty positive for other markets such as emerging market, local debt, I think lower fed rates probably give central banks elsewhere in the world more opportunity to cut as well. So you could see stronger growth there as well. So I think that would be positive.

Moz Afzal:

Yeah, I was just going to note that we actually upgraded emerging market local currency now in house allocation over the last investing committee. So we certainly buy into that viewpoint.

Michael Leithead:

So I think that's on the EM side, that was quite positive. I think on the hard currency side of things, we've seen quite a strong rally in terms of the lower quality frontier markets and we're starting to see issues from places like Angola, which they only issue when they can really get a decent financing rate. So I think spreads, that's sort of telling me that spreads are tight. There's still a little bit of value I think because investment grade spreads have been tight and there's no fundamental risks. So we could see a little bit more further compression, but I think the bulk of the hard currency money has been made, if you like. So the local currency is definitely the preference on that side of things.

Moz Afzal:

So last question on Argentina. Obviously us coming to the rescue, what are your thoughts around the Argentina was at 20 billion or so, what's your thoughts around that?

Michael Leithead:

Look, I think you've got a mate in Trump. If you can call on him for 20 billion to Donald Trump's probably something he takes out of his back of his pocket. But in all seriousness, I think with Argentina it's all about the political risks. What caused this initial I volatility if you like, was local elections in Buenos Aires and that sort of spooked the markets, at least the credit markets and we saw quite a lot of volatility in the Argentinian hard currency debt straight away. And I think thinking about risks, I think what it's telling you is watch the idiosyncratic risks if the macroeconomic backdrop is relatively healthy, what you need to be looking and the common theme throughout this first brands Oracle Argentina is idiosyncratic risks what we're looking at now because it's those things that are going to be a bit of a dampen to your returns. Whilst everything else is fairly stable,

Moz Afzal:

It's a good place to end. So Michael, again, thank you very much. We covered quite a lot there. Anyway, thank you very much. And you are listening to Beyond the Benchmark, the EFG podcast.

 

 

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