Hello everyone, and welcome to the PH&N Investment Perspectives podcast, where we discuss interesting and relevant topics for institutional investors. My name is Jeff Roberts. I'm an institutional portfolio manager on the PH&N Institutional team, and I'm also your host today for what is quite an exciting topic: The U.S. election and, specifically, the impact on fixed income markets.

It's my pleasure to introduce our guest today, Andrzej Skiba. Andrzej is the head of U.S. fixed income on our BlueBay Fixed Income team (BlueBay) within RBC Global Asset Management (U.S.) Inc.

Andrzej is also a key leader on BlueBay’s global credit strategies as well. Andrzej, welcome. Thanks so much for joining us today.

Hello, Jeff. It's great to join you for the podcast.

As I've alluded to, today we're going to be discussing your perspectives following the U.S. election on fixed income and credit markets. For institutional investors, the bond market is hugely important. And so who better to bring into a discussion than one of RBC GAM’s leading global fixed income and credit experts? For audience clarity, we're recording this on the afternoon of Thursday, November 7th. So we haven't quite yet had two full days of reaction to the election result, but what we do know is that following a very eventful election campaign, Donald Trump and the Republican Party have delivered a fairly resounding win, not only in regards to the presidency, but also it's looking like the Republicans have captured the Senate, and while control of the House of Representatives still hangs in the balance, it looks like the Republicans have the edge there as well.

And so, Andrzej, we'll aim to work through how this outcome affects your thinking with our time that we have today. So we'll start at a high level and then maybe work deeper into markets as we go. So as an investment professional, has anything really captured your attention in regards to the outcome of the election, this decisive Republican victory, so to speak?

I would say that there were two particular aspects that surprised us. First, while we did expect Trump to win, and generally our view was that with polls in battleground states running neck and neck between the two candidates, given the history of Trump vote being underrepresented in polls compared to actual elections, we felt that close race suggested that Trump is likely to win the election.

Having said that, we were surprised by just the extent of the Republican sweep and the fact that Republicans managed to capture the House as well as the Senate, and the white House. And the other aspect that was quite surprising is more to do with key voter groups. What kind of developments we have seen in this election, and the first one being a very major shift, especially in the Latino voting block towards Trump, with men actually voting for Trump in the majority for the first time in many, many, elections.

And the other aspect, significant underperformance of Democrats in younger vote on the 30s vote compared to previous elections. Those two factors contributed to the extent of Democratic loss in this election and really opened the question for the future about the ability of Democratic Party to recapture those groups and what it means for the midterms and elections, presidential elections, in the future.

So, interesting results from a demographic perspective. It sounds like the Democrats definitely have some work to do in order to catch up there in the future.

And if we can turn then to the bond market specifically where you and I are both focused in our roles. I know it's only been a couple of days, but how have global fixed income markets reacted so far?

I know in the months leading up to the election, we saw government bond yields rising and credit spreads tightening modestly. But what have you really been seeing in markets these first few days post election?

Well, the initial response of the market has been a move higher in Treasury yields, and the main reason for that move was just the extent of Republican victory and the fact that Republicans now having pretty much a blank cheque to drive policy across Congress and the White House are able to tolerate higher deficits and push more of administration's agenda through Congress without opposition.

So, the expectation of upward pressure on deficit levels has led to a move higher in Treasury yields, especially further out the curve, even though in the preceding weeks we have seen quite a rise in Treasury yields already, but just the sheer extent of the red sweep in this election, meant that investors further wanted to just, particularly for longer duration, Treasury bonds.

And in preparation for this week specifically, I know you and in your team had been considering all sorts of potential outcomes for this race. Just based on the scenario analysis for the result that we've seen – this decisive Trump and Republican win – have you seen that markets have largely behaved in line with what you really would have expected coming in?

Largely, yes. Selloff in Treasury yields and rally in credit; those really describe the experience of the last two days. The first one to do with the fact this we've just addressed in the previous question, and rally in credit essentially benefitting from positive equity sentiment, and that filtering through to credit markets where equity investors are particularly focused on the benefits of lower taxes, less regulation, and more M&A ahead. And that led to strong performance for equity indices, and that positive sentiment has filtered through into spreads tightening in the aftermath of the election as well.

And in that kind of equity-driven credit performance that you've seen, have you noticed any sort of material difference between the behavior of, say, investment grade credit versus high yield assets or maybe regionally between U.S. or non-U.S. credit assets?

We have generally seen strong performance across both investment grade and high yield. When it comes to regional differences, definitely U.S. assets outperforming European assets, it should not come as much of a surprise because what might be a boost to U.S. economy, could actually, spell trouble for Europe, especially if Trump administration were to pursue aggressive trade policies.

So it was actually fascinating to watch that on a day where Treasury yields increased aggressively, the night after the election, in Europe, we've actually seen German government bonds rally on the day and investors positioned for a potential 50 basis point rate cut from the ECB, as Europe prepares for what U.S. policy changes will mean for European growth.

Okay. And maybe if we can stay on rates but more pivot to your view going forward. We've just seen a 0.25% (25 basis point) rate cut by the US Federal Reserve earlier today, just a couple hours ago as we're recording on November 7th. That cut was already expected regardless of who won in the White House.

But, what about going forward? How does a Trump win affect your outlook for rates markets such as U.S. treasuries and possibly beyond?

From our perspective, it's a big deal. Yes, we have seen a 25 basis point cut at the November meeting. We also expect a 25 basis point cut at the December meeting. However, the picture for 2025 is much less clear. From our perspective, the reason why this election matters so much when it comes to Fed policy ahead is all to do with Trump administration decision about how aggressively to pursue a trade escalation with a variety of trade partners and imposing potential tariffs on a variety of goods.

If the actions of this administration will match what Trump was repeatedly stating on the stump, we would expect a meaningful increase in inflation. On our team’s modeling work, we see up to 1% increase in headline inflation in the U.S. And 1% does not sound like a lot, but actually, from Federal Reserve's perspective, it can make all the difference between being able to cut rates in 25 and not.

So, we strongly believe that there is a good chance that Fed might want to take a pause early in 2025 to assess the implications of Trump administration policy mix and its impact on inflation before deciding how many cuts are we going to see in 2025. So the idea that we had four cuts scheduled in the dot plots released at the September meeting, that could easily turn into no cuts where Trump administration to pursue a very aggressive trade policy ahead that prevents the Fed from cutting rates. So, we strongly believe that this election and the policies of the incoming administration will have a huge bearing in terms of ability of the Fed to cut rates in 2025 and beyond.

Okay, so maybe this idea of rates remaining a little higher for longer, so to speak, continues to stay in the narrative for a while.

And, then maybe moving beyond rates and pivoting to corporate credit, how does this result affect your outlook for credit specifically? Can you contrast maybe U.S. versus non-U.S. assets, given that you look at the U.S and look globally every day in your role?

Sure. So we absolutely see a number of implications for credit markets. The first one is the fact that, as we mentioned earlier, you would expect a spike in M&A activity. So that could lead to an increase in issuance in the U.S. fixed income market, something that the market might have to contend with. So that's the first kind of most basic impact that you should expect.

The other one is to do with the outlook for rates and what that means for demand for fixed income investments further out the curve. In the U.S., we have seen hundreds of billions of money invested in longer duration products in anticipation of multiple rate cuts in 25 and beyond. So, if the market needs to reassess the likelihood of rate cuts happening, for example as a result of the trade war next year, that, in our opinion, would lead some of those investors taking money back to be invested in cash or money markets or short duration assets. And that could be disruptive from a spread perspective and where we see vulnerability there is in longer duration asset. So your 10- and 30-year bonds, that could be under some pressure if the market indeed needs to go through a period of readjusting positioning from longer duration assets to hiding in shorter duration assets until we have more clarity on the policy front and dust settles for that process. So that would be the second thing to consider. And actually, in that context, we are actively booking profits on some of the longer duration exposures across our strategies where we've seen strong performance of 10- and 30-year bonds of late and reinvesting those profits in shorter duration assets.

The last point is to do with the regional, preference. While we see a scope for more stability in European investment grade and high yield opportunities, as ECB actually might be forced to be even more accommodative in response to a changing U.S. policy mix. We also believe that Europe will not be immune from the volatility that could ensue in the U.S. So we're not talking about the situation where spreads would tighten in Europe if there are widening in the U.S., it's just that the magnitude of that widening could be lesser given clarity over ECB policy. So, other things being equal, we have redirected some of our strategies towards holding more euro-denominated assets to shield themselves during this period of U.S. policy adjustment until the dust settles.

Perfect. So help could be on the way from the European Central Bank then. And if we stay on the topic of credit, year to date, credit markets have been really quite resilient. And I know you've mentioned volatility before in your comments, but they've been resilient despite some quite challenging headlines at the macro and geopolitical level so far this year.

Why do you think that is? And do you maybe have reason to believe that this election may start to upset that dynamic going forward?

It could be the risk for sure. The two main reasons why we believe credit has been doing so well. Firstly, just how much money has been put to work further out the curve. So we've seen re-engagement with fixed income and credit across a variety of investor groups. A good test of that thesis was recently during the autumn supply window when we had an avalanche of issuance within the U.S. investment grade market and normally you would expect that period to coincide with seasons of indigestion, where there's just too much paper coming to the market and spreads have to widen to find a new equilibrium. And this time around, despite record levels of issuance, we have not seen any meaningful spread widening during that issuance season. So that confirmed to us very strong demand from investors to buy U.S. fixed income assets, to buy credit assets, in anticipation of rate cuts ahead.

The other reason why spreads have done so well is to do with the resilience of U.S. corporates, to the fact that quarter after quarter, they have beaten expectations. They have shown a lot of resilience in terms of their profitability and cash flow generation. And, we have not seen any evidence of weakening of credit metrics even though many market commentators were expecting a more aggressive slowdown and much more cautious tone emanating from corporates; it just hasn't happened and spreads are now reflecting the extent of that resilience, which is also helped by the resilience of the U.S. consumer.

Perfect. And so you may be kind of hinting here, but beyond the U.S. election. So thinking about really what excites you about global fixed income and credit markets as a whole. Is there anything that's really exciting you?

There's always something to be excited about in fixed income markets, especially when you're an active investor like ourselves. So look, I would say right now there are three areas of opportunity that we're focusing on. The first one is shorter duration credit. We feel that with the relatively flat shape of the credit curves, whereby going into 10-, 30-year securities you're getting less and less extra spread compensation compared to being at the front end of the curve. We feel that the short duration credit looks quite appealing and a good place to hide in until we have more policy clarity.

The other area that is increasingly interesting to us and where we've been repositioning our high yield strategies is our floating rate exposures. So leverage loans, in this higher-for-longer environment that very much could be our reality as we're heading into 2025; as long as you are really careful in terms of your name selection and you do not focus on issuers that are vulnerable to trade escalation, we think that leverage loans are one space where investors will show more and more demand and reflect that higher-for-longer concern.

And the last one is more to do with what might happen as we're seeing increase in volatility, increase in dispersion between credits as the market is evaluating the new administration policy mix, we're absolutely certain that we will see times of dislocation and that is something that is particularly interesting to us because those are the times when active investors can source interesting assets at valuations we might not have seen for a while. So part of our plan is to keep enough dry powder to be able to take advantage of those dislocations when they occur and we have a very high degree of conviction that 2025 is likely to bring multiple periods when that volatility spike could be occurring, and for our teams to be ready to take advantage of those for our clients.

Perfect. So that's what excites you, Andrzej, could we look at the other side of the coin as well and discuss what you might be watching, maybe a little bit more carefully?

Look, I think there are two areas worth mentioning. First one is geopolitics and how that can impact credit. We've seen so many serious developments on that front over the recent few years that we can easily have a repeat of that as we're heading into next year. And so we have to be careful not to be complacent about these risks as we evaluate our portfolios.

The other area where we think there could be some pressure as we are moving into next year is direct lending private credit. Particularly in the U.S., where the cost of funding is elevated, a combination of an economic slowdown with higher-for-longer rate backdrop could be quite a toxic mix for that space; especially given the overleveraged nature of direct lending private credit universe and the fact that vast majority of companies are not generating any cash flows within that space under the burden of high funding costs, one of the key reasons why we've seen so many of portfolio companies there resorting to pay in kind interest in order to avoid paying cash interest to the lenders.

So those are two areas that give us pause and we want to make sure that we're not complacent regarding those as we invest across the strategies we look at.

So maybe still more to be excited about than scared about, but certainly things that you've got on your radar there. And I know we're coming closer to the end of our time today, but I think if we can stay focused on credit and I certainly know it's dependent on every individual investor’s circumstances, but if I'm an institutional asset allocator, in your opinion how should I be thinking about tactically positioning my credit portfolio to achieve that best risk-reward balance based on the present opportunities that you're seeing in the market right now?

Well, I would mention two things. The first one is emphasize flexibility. As we mentioned, there's quite a lot of uncertainty ahead, whether, for example, Trump administration will follow to the full extent with its promises on the trade policy front or not. And in each of those scenarios, you have pretty different outcomes for fixed income.

So, having an ability to adjust your portfolios aggressively to respond to those changing circumstances is quite important. It also helps to fully take advantage of opportunity set as it evolves if we were to see dislocations. The other point worth making is that while we can see quite a bit of volatility ahead, we are very confident in the fact that eventually, once there is clarity on the policy front, once there is clarity regarding Fed's response to the new administration, there will be a season where investors re-engage with fixed income, where a lot of investors will look at the current environment, look at the yields on offer, and actually state that with mid-high-single-digit yields on offer, depending on which manifestation of fixed income you're looking at. But from a medium-term perspective those are really attractive yields to gain exposure to, so we would expect re-engagement to accelerate as the year progresses, and we would caution investors from looking at that initial period of potential volatility not to prevent them from pulling the trigger when the dust settles and actually, by historical standards, you can gain exposure to solid assets at attractive valuations within fixed income universe.

So for us, this is all about being flexible, nimble and recognize that with the yields on offer, the total return outlook for the asset class still looks robust and very, very different compared to, for example, a painful year that 2022 was for many investors.

This time around, it's completely different. And at worst, we see flattish total returns on a forward-looking basis, with a potential for positive returns as we gain more clarity on the policy front.

Great. Those are excellent insights. Andrzej, that is all the time that we have. But I want to thank you very much for joining us today. It's been much appreciated. Getting to hear from you at such an influential time for markets is really always valuable for us.

Well, thanks a lot. And, we wish all the best to the listeners in navigating through this evolving environment. Thank you so much for having me on this podcast.

Yes. As Andrzej mentioned, thank you to our listeners as well. We hope you found this discussion timely and insightful. And if something you heard today piqued your interest, or if you have any questions, please don't hesitate to reach out to us at PH&N Institutional. We're here to help.