Hello, and welcome to Unlocking Markets, the RBC Global Asset Management podcast, where we bring you experts from across our firm, providing opinions on markets, global policy, sustainability, and macroeconomics, whilst highlighting how these feed into our investment decisions. I am Mike Reed, Head of Global Financial Institutions. Today I’m delighted to be joined by Andrzej Skiba, Head of our US Fixed Income team.

It has become clear over the first few months of 2024 that the US economy remains robust and is outperforming the rest of the G10. This has meant that the drivers of US fixed income markets have started to differ from those in Europe. Andrzej, I am hoping that you can share your perspectives as an investor based in North America.

Hello, Mike. Pleasure to be here with you.

Great to have you. At the beginning of 2024, interest rate futures were pricing in six or seven rate cuts from the Federal Reserve, but a series of stubbornly high inflation prints have forced investors to reassess their views, and we are now talking about a rate cycle that looks less like the Matterhorn and is turning into one that resembles Table Mountain. What is your outlook for both the US economy and the impact on US interest rates?

It's fair to say that the US economy has proven many naysayers wrong. A whole plethora of investors were expecting a recession coming to our doorstep or a meaningful slowdown to occur within the US economy, and that has not occurred. Instead, we have seen a lot of evidence of resilience of the US economy, and we think there are two particular factors that have contributed to that. The first one is that so many consumers have locked their mortgages when they were around 3% for a 30-year mortgage, which meant that the rise in interest rates did not really have an impact on your household, when a mortgage payment is one of the largest items that you spend money on a monthly basis. That has been a huge, tremendous source of support in the US, whereas in many other countries, you either have variable mortgages or you could only lock your rate for two, three years.

The other thing that has been very helpful for the US economy is the experience of companies after Covid and the difficulty they have found in finding staff and replacing employees that have left. That has made them much more reluctant to see layoffs, and that kept unemployment low and generally the state of the labour market in a much better shape than previously expected. Those two factors really contributed to what we see as US exceptionalism right now and underpinned the strength of the US economy.

We do expect some of the softening of conditions to occur over the coming quarters, but we do not believe that a recession is likely to occur. The consumer is just too strong and the corporate balance sheets are in too good of a shape to see any major trouble on the horizon. Yes, it will be natural for economy to soften down a bit, but nothing dramatic in our opinion. In this world, investors are asking themselves, why should we see a multitude of rate cuts that were previously expected, like you had the case in previous cycles when those were associated with times when the economy went into a recession or something resembling that?

This time around, if the recession is not our base case scenario, it's also fair to assume that we could be in this higher for longer environment where the economy can tolerate this higher level of rates for the reasons that I mentioned earlier, and inflation remains a bit more sticky than otherwise we could have hoped. So, it is our view that while some rate cuts could be coming our way, we could easily see a repeat of the cycle we've experienced in mid-90s where you only had a few rate cuts and then the Fed was done.

Great place to start. It's very clear from what you're saying that the US is still remaining strong with a recession not imminent and fewer rate cuts. Moving on from that, obviously, we've seen a rise in US core government bond yields over the last 12 months. Most US investment grade and high yield bond marks benchmarks have recorded strongly positive returns. What factors have contributed to this positive outcome? Do you think this momentum will continue?

It's absolutely true that we have seen a rebound in total returns across credit, whether it's investment grade or high yield. Investors have seen some recouping of losses after a very difficult 2022 back last year. We expect this trend to continue. One of the key reasons we have seen a rebound in returns, despite higher government bond yields, is to do with a spread rally. We have seen credit spreads compressing across both investment grade and high yield in the US. But also you benefit a lot in terms of your returns from the yield of asset class.

Whether that's around 5-6% in investment grade or high single digits in high yield, if nothing changes on a forward-looking 12-month basis, that is what you're getting paid within the asset class. Despite the rise in yields, we have seen the carry of the asset class, the yield of the asset class, providing a lot of support in terms of your returns.

Looking forward, we do expect positive total returns to continue. Again, the main reason for that is that the yield of the asset class, whether it's investment grade or high yield, is high by historical standards. It provides a lot of protection from any potential risk to arise in government bond yields and widening in spreads. Our base case assumption is for mid-high single-digit returns within investment grade on a forward 12-month basis and high single-digit returns within high yield. Those returns do not assume any meaningful contribution from a rally in government bond yields and come mainly from the yield of the asset class and maybe a little bit of spread tightening in some pockets of the market.

Yes, I want to come back to you on the credit stuff in a bit, because I know that's an important part of what you do. I'd like to turn to politics now, and obviously, the US elections are in November this year and the pollsters are predicting that President Trump will return to the White House for a second term. If this were to happen, how do you think bond markets would be affected and which sectors would you highlight as potential beneficiaries and which could suffer if Trump regains office?

I think first thing worth highlighting is that the polls are still relatively close. However, we do agree that on the margin, they indicate a preference for Trump amongst the electorate. If indeed Trump were to win this election, there are a couple of implications that we see within our investment universe.

The first one is to do with M&A. When you're looking at mergers and acquisitions and the outlook for deal activity, what has been clear to us is that the current Democratic administration has been very active in challenging a number of transactions across the US investment horizon. Even those that involve financial bias for industrial assets, so not questions of market share or control over specific industries, even those have been challenged by the government authorities. With Trump in power, you would have expected a different backdrop where deal activity could pick up and the barriers for transactions would be reduced. That's clearly a positive.

In terms of negative potential implications, to us, a lot of that is to do with trade. Whereas both parties are quite similar in terms of fiscal policy, the times of Republicans cutting down spending, forcefully trying to balance the budget are well behind us. If the economy sees any softness, you would expect fiscal deficits to continue and both parties being pretty comfortable with that.

However, one key difference in terms of platforms between Democrats and Republicans could be to do with trade. What we are hearing from a number of policymakers affiliated with the Trump team is the willingness to use tariffs much more aggressively on a variety of trade partners. We're not just talking about trade relations with China or some other government but more broadly, whether you're a friend or foe, an active use of tariffs within that administration.

Clearly, that would be not only inflationary but also that would be detrimental to a lot of industries that import goods. If you think about the retail sector, if you think about those sectors that import manufacturing components, like auto industry from other locations, that could be problematic. The caveat that we would give in this respect is that we actually haven't heard specific comments regarding trade policy from Trump himself. So far, it's only people in his economic orbit. That is the reason why we're not losing sleep over that yet.

It will be interesting to see closer to the election, whether he takes a position in regard to trade policy that could resemble what we're hearing now from his advisors, since that would be a meaningful impact on the US economy, and something that wouldn't have just implications for individual sectors, but also potentially would have implications for interest rates, for the Federal Reserve, and the approach to US economy. Something worth closely watching.

That's very interesting because actually, that highlights to me how important it is to understand both the macro and the micro aspects when constructing your portfolios. Staying on politics to a certain extent here but more towards geopolitics, with investors cautious, basically due to a lot of geopolitical tensions in Russia and in the Middle East, and the increases in central bank interest rates over the last 24 months, the total assets in global money market funds are now estimated to have risen to more than USD9 trillion. With so much money parked in risk-free assets, what do you think will actually encourage investors to move back into the fixed income market and which areas do you think they will focus on first?

Absolutely we do see a potential for some of the assets within the money market industry moving into other parts of the fixed income universe. Generally, the experience from the past is suggesting that any meaningful shift of assets from the money market space will only occur when the actual rate cuts happen. In an environment where let's say no rate cuts occur, you should not expect a lot of the outflows from that space. Investors would be very happy staying at the very front end of the curve and capitalising on historically high level of yields within the space.

You do need rate cuts to materialise for some of the money to move further out the curve. As you can imagine, it's quite unlikely that people will be moving assets from money markets straight into distressed investing. You would have expected various forms of investment grade, whether that's in corporate credit, securitised, or government debt to be the prime beneficiaries from initial reallocations further out the curve. It's been interesting for us so far to witness that meaningful inflows that we have seen further out the duration curve into products like intermediate core, which is one of the basic building blocks of US fixed income investment space.

Those inflows did not come from the money market space yet. So, investors that do wait for the rate cuts to occur and we're seeing that on a day-to-day basis, we manage money market funds within our franchise, they've seen meaningful inflows, but that money is not leaking out yet.

Okay, so let's watch for the first rate cut there, I think is the signal we're expecting. I said I'd come back to credit and many of the funds you manage are invested in corporate bonds, either investment grade or high yield. The underlying health of the companies that issue these bonds is key to how your portfolios perform. How would you assess the current state of the balance sheets you're looking at in corporate America and which sectors are giving you most cause for concern currently?

In simple terms, the answer is very strong. By historical standards, whether you're looking at investment grade and even more so on the high yield side, we are seeing strong credit metrics. A good example here would be within US high yield, leverage is not just back to pre-Covid levels, it's actually lower at one of the lowest points since the global financial crisis. Companies have been actually very conservative in using all the extra profits that they accrued as we were emerging from Covid, not to distribute that to shareholders or engage in M&A, but actually to strengthen balance sheets.

We have seen a meaningful reduction in leverage in recent years and that puts companies in a very good shape to weather any slowdown that might occur in the quarters ahead. With investors almost anticipating every quarter, will that be the time when we start hearing much weaker outlooks from the companies? Is this the time when the music stops? Quarter after quarter, we have seen corporate America showing resilience, and given the strong consumer highlighting still a good outlook for profitability, not as strong maybe as just as we were emerging from Covid where margins were skyrocketing, but still strong by historical standards.

From our perspective, when you're looking at a default outlook, when you're looking at vulnerabilities within corporate space, we're just not seeing too many of them within the public bond space.

The situation is actually a bit different in areas like direct lending private credit because there, rather than benefiting from having refinanced that years ago, like US high yield issuers did at much lower coupons, you are paying a floating cost of debt. The vast majority of companies within that space are paying low teens in the cost of funding. When you think about the fact that most of these issuers are around six, seven times leveraged, then three-quarters of your profits go straight away just to pay interest costs. That's before you spend a dollar on capital expenditure, on working capital, or any other outlay. The vast majority of direct lending private credit companies do not generate any cash flow. In a higher for longer environment, that creates a vulnerability for the system and something that we'll be very cautious about.

In contrast, as I mentioned, high yield bond issuers successfully refinance that at much lower coupons. They are very relaxed about the current environment and the interest cover ratios look very strong within that space. There's a big difference within the leveraged finance space between those that are vulnerable and those that are not.

Purely from a sectoral perspective, one that of course is looking quite soft is real estate. There's been a lot of time spent discussing the demise of the office real estate and whether there are vulnerabilities in the multi-family space. We agree that there are multiple pressure points within these areas. If there are sectors to be avoided, if there are sectors where you have to be extremely careful when you make your selection, it's those exposed to negative trends within commercial real estate and office real estate in particular.

Of course, there are opportunities that some of these dislocations create, however we would be quite cautious re-engaging with those segments of the US economy because they just look so much weaker than the rest of our investment universe.

That's again very interesting. I know it's something that central bankers as well have highlighted on the private versus public credit markets and their concerns around private leverage and private credit, so thank you for highlighting that. Moving more into ESG, which is something we really centre on and focus on here at RBC, many Eurozone-based investors have become increasingly focused on integrating sustainable investments into their portfolios, but I'm aware that in parts of the United States, certain high profile investors have been actively pushing back against this movement. As a US-based investment manager, how do you balance this within your global portfolios?

It's true that there are a whole range of views regarding ESG and responsible investing within the US. In a polarised political environment, some of these issues have been hijacked within the political battle. We're seeing that playing out in very opposing perspectives that we hear from different investor types, sometimes based on your location, sometimes based on the type of an investment firm that you represent.

However, from our perspective, what we would want to stress is that our job is not to evangelise a particular group of investors in terms of the benefits or lack thereof of ESG. Our job is to create an investment process that includes ESG integration, that is credible, that doesn't use any greenwashing and is focused on strengthening the process over time and then listening to the needs of our clients. Some of the clients will have specific needs, for example, to do with climate analysis, carbon emissions analysis, or other aspects that could be contained within ESG work, while other clients might not have any specific demands within the space. Our job is to accommodate those needs, depending on client preferences. One other thing that also is really important to us is not to look at ESG purely as a risk exercise.

We passionately believe that ESG could be really helpful in boosting your alpha generation, in seeing better investment returns than otherwise would be the case. It is true that within the US, that is not a view that is broadly shared. In fairness, when you look at a variety of funds within the marketplace that were ESG labeled, their performance has often dramatically lagged that of strategies that did not have ESG labels. We understand the concern that many US investors have about meeting their fiduciary return duties, while adopting ESG integration or focus.

Our experience has been that across RBC, we can deliver on client ESG needs while not sacrificing on performance, but actually helping to boost our returns compared to if we ignored these considerations. That is something that we're very happy to engage with clients and prospects about. We want to be pragmatic about this issue and see it as an important part of our investment process, but one that it's key to listen first to client needs and client requirements, before choosing how far you go into implementing it within your investment solutions.

Thank you, Andrzej. With investors now somewhat uncertain about the path for US interest rates and also the presidential election coming up, it was great to hear your views on the US fixed income markets. There was a lot to discuss.

Thank you for having me on the show. It's been a pleasure.

Many thanks for listening to the show. If you have enjoyed it, please like and subscribe on your podcast platform of choice. Next month, I will be joined by Habib Subjally, our head of global equities, where we'll be discussing his approach to identifying attractive investment opportunities across large cap global equities. Thank you once again for joining us today. Good luck and goodbye.