The Debt Dilemma and Why Markets Keep Climbing

Vincent O’Neill: Welcome to SB Talks. Today is Friday, October 9th. I am Vincent O’Neill. I’m joined, as ever, by our trusty Chief Investment Officer, Nick Ryder. Welcome, Nick.

Nick Ryder: Thank you, Vinnie.

Vincent O’Neill: Now, today Nick and I will be discussing developments in the European bond markets. We’ll talk inflation and where to on interest rates in the US and at home, as well as private credit back in the headlines.

Welcome to all our listeners.

Let’s pick up where we left off last time we recorded, and that was particularly talking about trends in government debt markets. France’s bond market has brought government debt back into focus. Would you see this more as a localized issue towards Europe or something that we should focus on more broadly?

Nick Ryder: I think this is one of those things that resurfaces in financial markets on a periodic basis. We’ve seen this a little bit in the US recently, as well as France. We saw it probably about 18 months ago in the US, and unfortunately it’s a global trend where populist politics mean that it’s very difficult for people to put up taxes or cut spending.

We have aging populations in much of the Western world. It’s putting a lot of pressure on budgets. And so, at the moment, France is having their turn, and we’re seeing that in the spread between French bonds and German bonds, which has doubled this year, particularly in the last month, to around 140 basis points, the yield on French bonds…

Yeah.

…versus…

So that is…

Vincent O’Neill: German ones. That is the premium the bond buyers or the investors are seeking to hold French government debt versus German government debt.

Nick Ryder: Yeah.

Vincent O’Neill: How does the picture of the French economy and potentially their deficit and debt loads compare to other places around the world? Just to put a bit of perspective on it.

Nick Ryder: Yeah. So their debt-to-GDP is approaching 120%, so it’s pretty high. It’s certainly not the highest. Japan’s over 200%. The US is probably at a similar level, although if you take out the debt owned by the Federal Reserve, it’s on a net basis around 100%.

It is an issue in many countries, but the French bond market is getting a bit of attention at the moment because they’re going through a sort of budget process where they’re looking at the current budget deficit, which I believe is around 5.4%, which is very high.

It’s…

Vincent O’Neill: Getting right up there…

Nick Ryder: Yeah…

Vincent O’Neill: Like the US.

Nick Ryder: And particularly, that’s the sort of number you might expect to see in a recession, but in an environment where growth is solid, they should really be using this opportunity to bring the deficit down.

Mm.

And so there’s a lot of focus on that at the moment. And also, they’re heading towards a presidential election in April of next year…

Yeah…

…and Marine Le Pen’s Rally National Party looks like it’s the front-runner, and so there’s, I guess, a bit of concern about what she might do.

Vincent O’Neill: In terms of the history of the politics of…

Nick Ryder: Yeah…

Vincent O’Neill: Her and that party.

Nick Ryder: I mean, to put it in context, France has never had a surplus since 1974. And so they have a history of spending on social issues and running deficits. But I think it’s getting to the point now that there’s a much more acute focus on it, particularly from the bond market.

Vincent O’Neill: Yeah. Interesting that Marine Le Pen has come out to make particular policy statements regarding this, though.

Nick Ryder: Yeah. I think she’s trying to assure, be seen as a better financial manager, maybe, to help boost her popularity. Although what she can do in terms of getting the deficit down remains to be seen.

Vincent O’Neill: Now, we talked, I guess, on the last podcast around, I guess, you know, are you comfortable as an investor in bonds given this sort of direction of travel, the…

I don’t want to say spiraling debts, but the creeping up levels of government debt, the lack of political will to bring deficits under control. But you’ve talked in your quarterly about, I guess, the reasonably attractive return that you’re getting on this debt, and you have to factor that into the investment decision-making.

Nick Ryder: Yeah. I mean, I think you can have… and I talk about this in the quarterly… rising bond yields and rising equities is fine if the growth backdrop is strong, and that is certainly the case that we have at the moment.

I mean, particularly in the US, growth there is strong, and so that is creating some inflation pressures in addition to everything that’s going on in the Middle East. So that is pushing bond yields up.

And also central banks are raising rates because of the inflation and the growth backdrop that was there before, even in some cases before the conflict in the Middle East.

So that’s not scaring the equity market. You can have high bond yields because of the better growth backdrop. It doesn’t necessarily mean we get a situation like in 2022 where interest rates went up, bond yields went up a lot, and that really spooked the equity market.

Mm.

Particularly growth equities, where a lot of the earnings, the cash flows, are in the distant future, and so you’re applying a bigger discount rate…

Yeah…

…and that can really hit valuations.

Vincent O’Neill: Equity markets have been incredibly resilient, and we’ve had fresh highs in the S&P 500 in recent days. What do you think is particularly… We’ve talked about it before here. I guess earnings and economic solidity, but that picture remains largely unchanged for you?

Nick Ryder: Yeah, and I think also you’ve got to remember a lot of what’s driving growth and the stock market is the whole AI investment boom. This is potentially the biggest investment boom we’ve ever seen, bigger than the construction of the canals in the 1830s, the railroad boom, the electrification in the Roaring Twenties, and the dot-com boom.

They all pale in significance compared to the amount of money that’s projected to be spent on AI and data centres, and that investment is not rate-sensitive.

Mm.

Whether the bond yield is five or six doesn’t really make a lot of difference…

Yeah…

…to those investment decisions.

So I think that’s one of the reasons why we’re seeing this sort of growth momentum and this equity market momentum continue, even in the face of higher interest rates and bond yields.

Vincent O’Neill: Yeah, very much so. Central banks remain in focus. You’ve touched on it briefly before there. Rates are certainly moving up, but probably the question is more around where to from here. What are we seeing out of the Fed minutes? What guidance is the market expecting from here?

Nick Ryder: Yeah, I think there’s no doubt that the Fed is probably going to lift rates again. The timing on that is a bit more uncertain. So we’ve seen in the last couple of weeks a little bit of softness in the labour market and a core PCE inflation print that was a bit more benign, so less scary.

Mm.

So it probably buys them a bit more time to just sort of sit back and wait. That said, it’s very rare that they do a 125-basis-point hike.

Yeah.

It’s normally a few more than that.

Several.

Yeah, yeah, several. So there’s a bit of a question mark over whether it’s two…

Mm.

…three, four.

Vincent O’Neill: Do they go back-to-back, and how…

Nick Ryder: Yeah… how…

Vincent O’Neill: Quickly do they get…

Nick Ryder: There? I think that’s looking… because they need to…

Vincent O’Neill: Be…

Nick Ryder: Looking less likely.

Mm.

We’ve had Fed speakers in the last couple of days suggesting it doesn’t need to be at consecutive meetings. That said, at the September meeting, we did get the dot plots from FOMC committee members, and it did show the median dot had an additional hike before year-end.

But the market’s only putting about a 34% chance…

Yeah…

…of that happening now.

Vincent O’Neill: So heading up, but potentially at a more measured pace.

Nick Ryder: Yeah.

Vincent O’Neill: What about closer to home? Where to from here?

Nick Ryder: Yeah, I think, once again, the RBA’s in sort of wait-and-see mode. The market’s sort of split, and economists are split between whether the four hikes we’ve seen this cycle are enough or whether there may be one more.

So once again, market pricing for another hike this year, I think, is around… it’s roughly 40%.

Yeah…

…by the end of the year. So not, yeah, sort of split.

Vincent O’Neill: Far from guaranteed, but it will really be watching closely where the trends are.

Nick Ryder: Yeah. And we did have, actually, an ex-RBA board member, Ian Harper, speak in the last day or so, and he suggested that the RBA’s decision-making framework has shifted.

They’re actually way more worried that it’ll take longer for inflation to get back to their target, and they’re more sensitive to short-run inflation expectations than they were previously. So that was interesting, I thought.

Mm.

Vincent O’Neill: Is that the theory there, that the short-run inflation expectations can sort of beat their way through to compound into longer-term inflation challenges?

Nick Ryder: That’s right, yeah.

Mm.

In the past, the RBA had sort of said, “Oh, inflation expectations, the long-run ones are pretty well anchored.” And so they didn’t really look at short-term expectations from, say, the bond market, but now maybe they’re paying a bit more attention to that.

Vincent O’Neill: And one last item. Private credit has very much been in the headlines this year, and we’ve seen a number of developments in private credit, particularly offshore.

And we talked about the SaaSpocalypse and concerns around the levels of software company exposure in global private credit players. Locally, Metrics has very much been the leader in the headlines. We’ve seen some developments there. Just keen to get your take.

Nick Ryder: Yeah. So we have clients invested in Metrics, so we’re very up to speed on what’s going on there.

It’s still a bit of a fluid situation, but from what we understand, there was a bit of a disagreement between their valuations that they were using for the unit pricing, where they had their own sort of framework for valuing assets, and particularly assets that maybe had a few issues.

And they had an independent valuer to kind of opine on that. They had a valuation committee that did all the work around that. Then for June 30, KPMG needed to sign off on the audited accounts, and they took a more conservative view, particularly around the assets that are on the watch list or where there’s some uncertainty over the ultimate recovery on those loans.

Vincent O’Neill: So could you put a little bit of context into that? They have over 350 loans, you’ve talked about previously. What portion of the portfolio had the question mark drawn over it?

Nick Ryder: Yeah. So in the main lending fund that you’ve referred to, there’s about 3.5%, 3.8%, I think, something like…

Percent, yeah.

…percent of the portfolio is on what they call the watch list. I believe that’s six loans…

Mm.

…out of the 350-odd.

Now, those loans aren’t necessarily in receivership or anything like that.

Mm.

But they’ve definitely got issues.

Vincent O’Neill: But the assets are theoretically good to sell.

Nick Ryder: The assets are theoretically good to sell. So loans like that, KPMG took a red pencil to and wrote down the value.

Vincent O’Neill: And Metrics are arguing that potentially some of those conservative valuations on loans and positions such as that are more conservative than certainly they, as a house, would expect the outcome to be in terms of return of capital. But that’s the short term, and that’s where we sit today.

Nick Ryder: Yeah. And their argument is that KPMG is an audit firm. They’re not professional experts…

Mm.

…in valuing real estate developments and things like that. And Metrics does have those capabilities and can outsource them using third-party consultants.

So it becomes very subjective…

Yeah.

…over what those loans are worth and what the ultimate recovery will be.

So that’s where we’re at. Yeah.

Vincent O’Neill: Of course…

And it’s key. The question is, I guess, your confidence in private credit as an asset class more broadly and, I guess, to any Metrics investments we might have.

Nick Ryder: Well, look, it’s a risky asset class. These are borrowers that can’t get cheap funding from the banks, and so they go to non-bank lenders like Metrics. They’re riskier loans.

Typically, a fund like Metrics pays the cash rate plus 4% or 5%.

Mm.

So of course there’s more risk. You have to expect a certain percentage of those loans to go bad. That’s normal. We expect that.

Yeah.

But we expect that we’re compensated for that through the higher returns.

Mm.

So we’re comfortable. But the best protection for investors is just to have hundreds of loans.

Diversification.

Diversification.

If you have a book, in the case of Metrics, with around 350 loans and six are on the watch list, that’s probably what you would expect.

Mm.

So long as there’s not a systemic problem, we still remain reasonably comfortable with the asset class if it’s managed properly.

Vincent O’Neill: And as an investor…

Yeah.

…you also obviously don’t have all your assets, or too heavily concentrated a portion of even your private credit money, with any one provider.

Nick Ryder: Yeah, that’s right. Yeah, definitely.

Vincent O’Neill: A very important point and well worth revisiting. An excellent summary, as always, Nick. Thank you very much.

Nick Ryder: Thank you.

Vincent O’Neill: And thank you to all our listeners.