Hello. Welcome back to Unlocking Markets, our RBC podcast series. This is where we bring you our experts from across the firm, provide their opinions on the macro environment, and discuss how top-down themes help influence the way they invest. I'm Mike Reed, Head of Global Financial Institutions. Today, I'm going to be talking to Kaspar Hense, who is a Senior Portfolio Manager in our Investment Grade Team, where he's responsible for both government bond and investment grade portfolios.

Today, we'll be covering a range of topics that we believe all those involved in high-grade bonds should be thinking about. Investors have been focused on the actions of central banks for the past two years, and the discussion has now moved to the topic of peak rates. Added to this, we have rising global tensions with the conflicts in Ukraine and the Middle East. Today, we will consider these big-picture themes, and also discuss how the differing dynamics across the asset class can help drive returns. Welcome, Kaspar.

Thanks, Mike for having me.

Looking at investment grade, investment grade, and also government bonds, both suffered big drawdowns in 2022. Despite 2023 being billed as ‘the year of the bond market’, highly rated bonds have barely eked out positive returns. With core inflation sticking on both sides of the Atlantic, the Fed and the ECB have continued to hike rates, and investors have been hoarding cash or buying very short-duration bonds. Are we now at the top of the rate cycle and do you think investors should be looking to increase duration?

Times are certainly different now. Three years ago, globally yields had been close to zero and we had three years of consecutive negative returns in US Treasuries, which we have never seen before. Now, we think bonds are for the bold. Globally, default rates are rising. Interest rates cost for government and corporates are high, and especially, government supply will be ample. We will see crowding out effects and financial assets with central banks continue to squeeze liquidity.

Even in Japan, we expect yields to rise to 2% over the next two years. With government debt of 250% debt matters. The path to lower rates is still rocky and huge returns and fixed income are still rather fuzzy for the second half of next year. But yield compensation is already high and we think from an asset allocation perspective, it's the time to buy already now. We expect most central banks to cut rates next year, starting with EM and then followed by developed markets.

Thanks. That's a great setup to the macro-outlook. Sticking with macro, energy price rises as a result of the Russian invasion of Ukraine were the initial trigger for the inflation spike. We now have another conflict in the Middle East. Do you have concerns this may lead to a second bout of energy-led inflation?

I would add the first and most important driver for inflation was the pandemic when supply came to a sudden stop. We had oil prices falling even below zero. When demand picked up again to support growth, we have seen an unprecedented monetary and fiscal stimulus. You're right, the second inflation wave was triggered by not directly the Russian invasion, but the economic war between Russia and the West, with Russia cutting gas supply and damaging gas pipelines.

We think that is quite important to understand in light also with the recent terror attack on Israel from Hamas. The prevalent reason for the timing of the attack has been the upcoming deal between Saudi Arabia and Israel to open economic ties which certainly has not been in the interest of Iran, Lebanon, and Hamas. Focusing on the interest in Middle East is key. The most important economic weapon of the region is obviously oil, but the key to Western oil prices currently hold Saudi Arabia, and Saudi Arabia alone.

They had cut their supply going into the deal by two-and-a-half million barrels per day. Iran, for example, just produces 1.2 million per day and that goes mainly to China and the region. With that regard, we think that the risk for higher energy prices is rather subdued.

We're talking about demand and supply in the oil market. Let's move to the bond markets now. Fiscal spending is rising in the US and there have been concerns about the level of treasury issuance that we require to fund it. Who's going to buy all these bonds?

The US budget deficit is certainly ballooning and indeed concerning. We think that interest rate payments will be one of the largest expenses of the US budget over the next years. They will rise up from 1 trillion to 2 trillion and increase by 10 percentage points as a share of overall tax receipts. There is hardly any room left for discretionary spending as an automatic stabilizer, and discretionary spending really will become marginal to support growth. On the other hand, though, we think the market has now adjusted to these very high issuance level.

Issuance will also rise from roughly 1 trillion to 2 trillion next year, but you have to have in mind that there are ample of domestic savings parked in money market and in bank deposits and also in stocks. Money markets have grown to 5½ trillion US dollars. Fund deposits are currently at $17 trillion, and domestic stocks or stocks which are hold mainly domestically of 45 trillion give you some buffer for the supply to be absorbed. We expect indeed some crowding outs at this higher yield levels.

Right. Really interesting. Sticking with budget deficits and supply and now bringing it a little bit close to home. Some observers are expressing concern about Italy now, with its huge budget deficit ballooning at this moment and all the supply that's required around it. Do you think Italy can avoid a downgrade to junk status?

Yes. Italy budget deficit is not ballooning in the same way as the US is. Obviously, the US is a reserve currency and you have to look at savings, which in the case of Italy also have been very high, which is very important to understand in that regard. We had seen 60 billion net issuance from Italy this year, but 100 billion retail interest where really the crowding out has been seen where Italy domestic savers have sold foreign assets to buy domestic debt. Overall, the US debt to GDP trajectory is actually going down.

That's why focusing on the overall European fixed-income market we think is also very important with very positive developments. We have seen in some countries, especially in terms of debt to reduction in Portugal and Greece stands also with a stellar recovery, that debt to GDP has 220% some seven years ago. That has gone down to 165% now, and we are expected to go down to 140% over the next two years when most of their debt will be hold by the EU at very attractive funding levels for Greece.

Okay. Let's get a little bit more granular now. Within the high-grade space, and you look at both eyes of the equation here, investors have a choice. How does leverage look for investment grade companies and does the extra spread they get paid to hold these bonds over governments look attractive versus possible default risks they could be taking?

Good question. Overall, we think that the clouds of a recessionary outlook will continue to darken the investors sky, but we think it will be rather a slow process of continuous de-leveraging and low demand, but sufficiently strong or healthy labour markets and demand to keep the economies afloat. Investment demands are high also in Europe and will continue to support growth, which indicates also a somewhat better fiscal outlook. That means for investment grade credit overall, we are indeed optimistic, but careful on sector selection. We like European banks with solid balance sheets and in our view, very manageable increases of non-performing loans, but we are still cautious on cyclicals and having capital intense sectors such as autos.

Looking at the different sectors that make up the investment grade world, which ones do you and your team think are attractive right now and why is that?

We like some emerging markets local debt where yields are still double digit, but inflation is already close to target and fiscal policies has not been exuberant. We also like, I said, European banks on the corporate side and we think that next year US agency MBS will be quite interesting with good credit quality yields up to 6.5 % in weights volatility. Nonetheless, with refinancing rates high, we are focusing rather on the bottom-up analysis than on asset allocation really. We do not like a merger market hacked currency debt, for example, too much because overall valuations are not very attractive. We like Romania, which has low government debt and rates as twice as wide as the index, to give an example for our stock picking at this current juncture.

There's a lot to digest there. There's obviously an awful lot going on both from macro and micro, so we really appreciate your insights on that today. I'm sure that 2024 will continue to bring a wealth of discussion points, so thank you Kaspar. I hope you can come back on the show next year.

Perfect. Thanks a lot.

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