Last week I interviewed Flavio Carpenzano, London based Multi Asset Investment Director and Haran Karunakaran Australian based Fixed Income Investment Director from Capital Group. We covered a lot of ground including the company’s global economic outlook, hedging a global portfolio, credit markets and global credit spreads, investing in AI, private credit, if bonds still hedge equities and duration.
Key economic considerations
Elizabeth – Perhaps if you could begin by giving us your economic outlook?
Flavio:
- We don’t believe in a recession, the economy is slowing down but growth still remains at 2% on a global basis and we start to see more re-convergence in regions.
The U.S. is still growing at 2-2.5% but it is actually a combination of different offsetting factors.
On one hand you have AI productivity which we believe is going to be positive on growth over the mid, to long term so probably productivity of at least at 3%. That’s positive for the economy, it’s positive for inflation. We continue to remain constructive on AI. We believe the U.S. administration will continue to support growth through fiscal spending this year, particularly before the midterm election. There is an incentive to keep the economy afloat.
- We expect the U.S. Fed will cut rates twice more, possibly three times.
This is positive for all risk assets. We are in environment where you have central bank cutting rates in a non-recessionary environment. Historically, it should be positive for markets and is positive for the economy.
We are concerned to the downside of:
- U.S. tariffs, we haven’t seen the full impact on growth and on inflation.
- The labor market.
We see job creation but it’s not that strong and really it’s just a few sectors, particularly healthcare. So that’s where we see more of the downside, a potential acceleration of the slowdown in the labor market and a spike in unemployment.
What we are more non-consensus on is Europe. In Europe, we really believe there is more upside risk on growth, the fiscal expansion and German spending on defence, we think is really positive for the economy and probably more than the market expects. In Europe, demand is going to be sustained by government in particular and households because unemployment remains quite low in a time where supply is constrained.
The Ukraine and Russian conflict impacts the supply chain. So, in this environment, actual inflation might be a little bit more stickier and will force potential the ECB to hike rates in the second half of this year. And that’s why the last point is like in this global or economy re-convergence, we see monetary policy divergence.
And what I mean with that, we have a situation where the Fed is cutting rates, ECB may potentially hike next year and maybe the Reserve Bank of Australia will hike. That’s why we see a lot of opportunity to have a global approach to capture all these different moving parts and to be active.
Haran: From an Australian lens, I think central bank divergence is obviously a big issue and that hit home hard in financial markets last year. I think it’s really interesting if you look back historically at Australian government bond yields versus U.S. government bond yields, they have been very highly correlated.
It has almost not mattered what the RBA has been doing because it’s really driven more by what happens with the U.S. Fed. Back in October 2025, that changed dramatically and the Aussie 10-year rising against the U.S. 10-year staying flat and the result was it fed through to financial market results where you had Aussie fixed income still generating pretty decent returns around 3 to 4%, but global fixed income more like 7 to 8%.
That divergence is going to continue to be a big theme. For Australian investors, that hasn’t mattered much, but we think it will going forward.
Hedging a fixed income portfolio
Elizabeth:
Are you talking to your clients about hedging or not at this point, because the Aussie dollar might have further to go so in terms of rises against the U.S.?
Haran:
Fixed income clients typically invest on a hedged basis. That makes a lot of sense because if you look at the volatility profile of an unhedged fixed income portfolio, it doesn’t really look like bonds anymore. It looks like currency because the volatility of fixed income is so much lower than the currency.
We’re talking to clients a lot about the cost of hedging which has changed significantly for an Australian investor. If you go back two years ago, it was almost a 2% drag on returns and that was unusual. Historically, you would earn a pick up in yield from hedging U.S. dollar exposure to Aussie dollars.
I think that contributed a lot to Aussie investors going more domestic in their allocations rather than global. Now that FX hedging cost is down to zero and if the current trend continues, it’ll go back to being a yield pick up. I think that’s a really underappreciated but very important factor in thinking about that global allocation in the defensive portfolio.
Credit markets and global credit spreads
Elizabeth:
That’s really insightful. Could you talk a little on market implications, such as credit and global spreads?
Flavio:
Credit is an interesting topic. We are in a situation where credit spreads have been tight for a while and they continue to tighten even more. It’s not just spreads that are tight. It’s also dispersion, which apart from few names remains low, dispersion across the capital structure between high yield and investment grade (IG) is a historical minimum level. So that’s the environment that we live in.
Are we constructive on credit? The answer is yes. Because the low spread environment is a function of:
- The economy doing okay, so the risk of recession is relatively low.
- Fundamentals in the corporate sector are very strong with very low leverage. If you take a high level view, that’s the interesting trend that you see over the last two decades, post financial crisis.
You had this trend of deleveraging on the banking sector and the deleveraging of the corporate sector, the deleveraging of the U.S. household. You see governments take on more and more debt to bail out economies constantly, during the financial crisis, and COVID.
Private credit markets didn’t exist pre-financial crisis, now they are large part of the universe. If you look at direct lending in the U.S., it’s US$2 trillion. It’s the same size, even bigger than the U.S. ideal and you see massive growth in the U.S. leverage loans market. So, these are the parts of the market that are now quite important.
This is where you start to see some cracks. Think about First Brands in the U.S., this is a company that basically just issued bank loans. The US bank loans market has 4% in software. You can see now in all the volatility how software is impacting the market.
The high yield and IG market fundamentals are pretty strong. Even the high yield corporate market, they didn’t increase their net debt. The size of the market has remained stable, meaning that basically they didn’t take extra leverage and more than 50% of the market is double-B rated, which means there’s a high quality with a basically very limited risk of default.
Central banks cutting rates in a non recessionary environment, has led to credit performance. We believe it’s going to continue to do well this year even if spreads are tight.
So, it’s important to still invest in credit. We prefer the IG corporate bonds. It’s not worth the extra few basis points to go down the capital structure.
Exposure to high yield still make sense because it still has a yield of 6- 7%. So still invest in high yield but have a more conservative approach.
Haran:
The only thing I would add to that, it’s like, I think we’re also prioritising liquidity.
We’re in this pretty positive, benign kind of base case outlook for global macro, but what’s clear is also that tail risks are increasing so the tails of the distribution are a bit better and how you can protect against that is by being
- diversified
- agile and ready to shift and you need liquidity for that. If you see a widening in high yield spreads and the fundamentals stay the same, we would probably see that as a buying opportunity.
Flavio:
We are in this environment when you look at demand and supply, the supply particularly in the IG corporate market in the U.S. is the highest historical level. And the expected supply for this year is more than a US$1 trillion dollars. These bonds will be oversubscribed despite tight spreads.
Buyers are institutional investors like pension fund, insurance endowments. These investors think in terms of yield. If I’m a pension fund, I just need to match my liabilities from a yield perspective. If I’m an insurer, I have more a buy and hold approach. So, I buy bonds, lock in yield for five years for the return. So as long as the yields remain universally elevated, even if spreads are tight, you will continue to see this constant demand for bonds and that’s also what is driving range-bound spreads.
Fixed income AI investment
Elizabeth:
Excellent. Are you investing in AI companies if you could talk a little bit about that?
Haran:
Last year AI was really an equity market discussion. Our tech analysts had never covered them before because they didn’t issue debt but that’s all changed dramatically in the last quarter.
I think selectivity is really important both between companies but also in the type of bond structure.
Our top 10 holdings for our multi-sector strategy, which you can see on our website, contain two AI-related names. One is Meta and the other is Oracle. And they are really, I think, on the two opposite ends of the tech spectrum.
Meta is a very solid company, highly cashflow-generative. It’s a AA-rated credit, very safe, trading at a slight spread over treasuries of about 50 basis points. Current issuance plans in the next two years, may mean it is slightly negative free cashflow but it generates so much cash, that will change quickly. We own Meta for defensiveness, security and attractive yield. Then you have Oracle, which has for some reason become the lightning rod of everyone’s fears about AI.
Fundamentally it’s a different company. It’s trying to transform its business and catch up to the big cloud players. But there’s a sizable market share gap between Amazon and Microsoft and Google and then Oracle and it’s not as cashflow-generative as the others. It was cashflow negative from the beginning and continues to be. But offsetting that, it’s trading at spreads of about 200 basis points wider than treasuries at the moment.
So, as an investor, you are being compensated significantly more. Two things I’d highlight with Oracle, one is they’re announcing a lot of Cap Ex plans over the next five years and I think the market may under-appreciate that there’s a lot of flexibility in that Cap Ex deployment. They’re not buying the land and property for data centres, they’re leasing them.
The bulk of the Cap Ex actually comes from compute power so the GPUs that go into the data centres. And they’re really the last thing that gets installed. From the installation of the GPUs to revenue generation is really only a few months’ time.
The main risk for Oracle, is that their clients don’t come to the party with the demand that they’re forecasting, in particular, Open AI who’s one of their larger expected clients. But the flexibility valve is there. If Open AI is not looking like it’s going to come through, they can always scale back their Cap Ex plans.
I would really emphasise it’s a different perspective for credit investors versus equities, with credit, you get some flexibility. The second point is that Oracle announced plans to raise equity capital this year to finance part of the Cap Ex spend. They’re very much prioritising their investment grade status, so they’re watching their leverage levels.
Equity markets didn’t react well to the equity raise, as you’d expect, but from a bondholder’s perspective, that’s exactly what we want hear.
When jumbo AI related issuance come to market, we are looking at the detail of the company and then the pricing. If there’s not much of a yield pick-up, then it’s something we’ll pass on.
Private Credit
Elizabeth:
Perhaps, Flavio, maybe you could touch on private credit and the difference between private credit and high yield and private and public market credit as well?
Flavio:
First of all, Capital Group, doesn’t invest in private credit directly, but we recently entered into a partnership with KKR and we launched in the U.S. and we are planning to launch, a public-private solution for non-U.S. investors.
We are launching this solution because the reality is that:
- Private credit is attractive and is important to have on a strategic level as a part of your fixed income allocation.
- It is more important to have an holistic view of the credit markets, public and private, because that line between public and private is becoming more and more blurry from an issuer and borrower perspective.
Meta is an example where they optimize the capital structure and funding is a mix of public and private debt.
Sometimes you ask why companies would pay high rates to issue in the private market. The reality is that it goes back to the speed of execution, the privacy of the deal, the customisation in case of a default or restructuring and a one-on-one negotiation.
What does that mean from a client perspective? You really need to partner with the right private credit investors and the right originator.
We don’t see a big shock in private credit. I think the market overreacts. Similarly for leverage loans, you see an uptick in default risk but it’s more idiosyncratic rather than more a systemic breakdown. If anything, sometimes it’s underestimated. You might see private credit risk more as a risk to the system.
If you think about private credit, ultimately it could be viewed as a lender of last resort at a good price. What happened in the regional U.S banking crisis two years ago? We saw a period of heightened volatility.
Credit spreads in the public sector are also a function of private sector pricing. As private credit markets, particularly in the U.S., become more crowded, spreads compress, in a way creating a ceiling for public credit spreads.
Haran:
Private credit is a pressure valve for the economy and also for public debt markets. High yield default rates are near historic lows at 2%. Partly due to the strong macro economy. But also, if a company needs to refinance and they can’t access that financing they default. Now those companies have a whole new channel to refinance and there’s plenty of capital to do it.
Flavio’s comments are about U.S. and global private credit. The Australian private credit market is a completely different and heavily concentrated in property lending. So that changes the risk profile.
Portfolio allocation
Elizabeth:
Listening to you talk about the equity market are you seeing your clients taking profits out of equities and boosting fixed income? Or are they still keeping roughly similar allocations?
Haran:
I wouldn’t say they are fleeing from equities, but they are reallocating a little. One of the reasons for that is if you look at last year’s private returns, the ASX 200 returned about 10%. Global credit returned about 8%.
Right now our equity market forecasts are probably about half a percent higher than our credit market forecasts over the coming 20 year period. So, I think clients are realising, that maybe in this environment, give up a little bit of return potential to avoid some of the volatility and get a more diversified exposure in credit.
Do bonds provide a hedge for equities?
Elizabeth:
That was certainly one of the things I took away from your capital outcomes paper so very little difference in returns in the future.
I still think bonds provide a hedge to equities, but I’m getting some blow back from some of the investors I write for. Do you still have that view?
Haran:
Last year was a kind of case in point. There were, two or three equity corrections over the year, like Liberation Day. There were concerns about and a sell off in AI. There was an Australian specific one in August which caused a bit of a sell off. Under those scenarios, high quality credit was pretty stable if not positive through those periods.
So, there’s proof that it’s working. That is because you have high yields, which provide a buffer for the income they’re generating. The high yields also provide room for central banks to cut rates to support markets.
Duration
Elizabeth:
One last question – are you taking duration at the moment?
Flavio:
First of all, I will focus more on the U.S. dollar duration. We continue to focus more on the five to seven years bucket. That’s where we see more opportunity. We are underweight more the long end of the 10 years and 30 years.
We don’t believe it’s the right time to take very long duration exposure and it’s not the right time for multiple reasons. We continue to see the long end of 10 years and 30 years on a global basis go higher and for many there is a need for more fiscal spending across Japan, Europe, the U.S. This increase in spending and supply will be negative from a technical perspective.
And the second aspect is more about inflation expectation. For example, if the U.S. Fed independence is put into question, you might start to see the market asking more for a higher premium. So, there is always this concept of a central bank independence that might trigger potential pressure on the 10 years or 30 years so that’s why we’re underweight. The reason we like the five to seven year parts of the curve is because while growth is probably going to be okay there is potential for downside risk. Also more potential pressure for the Fed to cut rates, particularly if the labor market weakens.
And so, this is why we think the two to five year parts of the curve will go down for U.S. and maybe European investors. Australia is slightly different.
Haran:
If you’re a highly active tactical manager, the difference between spreads on the Aussie and the U.S. 10-year presents an opportunity to be overweight. But if you’re a financial advisor who’s not going to be able to be that tactical and active, to me the consideration is more like, yes, the yields are a bit more attractive now, but as you look forward over the coming year, the risks of monetary policy in the U.S. are more to the downside. And as Flavio mentioned, the labor market could deteriorate. You could see more cutting in the U.S. so that’s attractive from a bond investor’s perspective.
The risks in Australia are more to the upside, it’s more around inflation being stickier than anticipated. I think most forecasts are expecting inflation to come down from June onwards. If that doesn’t happen, you’ll likely see yields push up again. So from the medium to long-term perspective, I think the Aussie duration becomes a bit more challenging from that perspective. And I think that the tailwind of the Fed cutting is probably a more attractive structural position.
Elizabeth:
Great, thanks. Are you favoring any credit sub-sectors at the moment
Haran:
Even two years ago, investing was a little bit more sector thematic, but as spreads have tightened, it comes down to the individual issuer because you can’t generalise across the sectors that much as spreads stay really tight.
Flavio:
Some of the sub sectors we like are European banks, we are starting to see some more value in long end Japanese government bonds, but we expect volatility will stay high. Autos, pharmaceuticals and technology.
Elizabeth:
And that’s just where a company like Capital Group has the depth of analysts around the world and you can really be looking at many sectors and many companies and be very selective.
Haran:
Yes, tech is a good example. We have a tech analyst who’s looking at Oracle and other companies, but he’s not working alone because data centres need to be built, power is at the lower end. So, he works very closely with our utilities analyst who’s covering power companies and making sure the story adds up across the whole value chain.
The tech analyst also works very closely with our structured credit analysts to look at bonds across that spectrum. I think we’re getting into this more complex world where you really need to be able to join the dots across different sectors and different industries to get a true view.
