Joe Cass   00:00:00

Hello, and welcome. My name is Joe Cass, Senior Director at S&P Global Ratings and the host and creator of the FI15 podcast. On this episode, we have Lori Heinel, Global Chief Investment Officer at State Street Global Advisors, and Yann Le Pallec, Global Head of Rating Services at S&P Global Ratings. A quick reminder that the views of the external guests are their views alone, and they do not represent the views of S&P Global Ratings. Lori, let's kick off with you. Would you be able to kick us off with your view on the state of the global economy right now? What are your biggest areas of interest, but also your areas which you may be concerned about?

Lori Heinel   00:00:37

Well, first of all, our view is that 2024 is going to be a really challenging year. Certainly, we see global growth slowing pretty much everywhere around the globe. We also see that inflation pressures remain a bit elevated, which compromises the ability of monetary policymakers to really start to lower rates, which we think would be important to restimulate that growth. And we also know that this is going to be a year that's going to be rife with geopolitical tensions of all sorts. Clearly, we have two wars going on around the globe in Ukraine and in the Middle East, but we also have a lot of very big political events happening, notably the presidential election here in the U.S., but also important elections in other key areas around the globe. So we think that on balance, it's an era where growth is slowing, challenges remain and these outside sort of, geopolitical tensions are likely to remain elevated.

Joe Cass   00:01:32

Thanks, Lori. And Yann, from your position at the top of the ratings analytical team, what topics do you hear coming up again and again with both the issuers and the investors?

Yann Le Pallec   00:01:44

So let me size up what you mean by again and again. It's not just my own meetings with issuers and investors, but our analysts, about 1,700 globally rate more than 13,000 issuers. And around about every year, they talk to investors through about 26,000 touch points. So that's the scale of what we're talking about. And we monitor those key questions voiced by investors all the time. So in ranking order, I'd say that investors, in particular, are focused on the downside for this year. And downside, Lori talked about macro. I'm going to focus on credit. And you will hear some big similarities. The first downside risk is geopolitics. Two-thirds of humanity are going to the polling stations this year. That could create downside risk, and those tend to be more concentrated towards the second half of this year. Second big concern on the downside from investors is weak borrowers. We've got a higher cost of funding. Interest rates are going to stay higher for longer. That means that for some of the weaker borrowers, there will be some deterioration in their credit quality and some of them might default. So to give you an idea, our forecast for the default rate of speculative-grade companies in the U.S. by the end of this year is 25%. Bringing this number in perspective, that's about three times what it was 18 months ago, but that's half of what it was post great financial crisis. So downside, not a credit crunch or a crash in credit quality, but potentially some companies and the weaker ones defaulting in larger numbers than what we could anticipate today. The other risk is a hard landing of the economy. The U.S. kept surprising on the positive side in '23. '24 is going to be a lot more difficult and some of the other economies may go through more difficult times than what we forecast. And the third important risk at the sector level is real estate, commercial real estate in the U.S., in Europe, construction in China remains an area of potential downside risks for investors. So we're keeping a very close eye on all of those.

Joe Cass   00:04:27

Lori, what are the profiles of your main clients at State Street Global Advisors? And how do you engage with them? And what kind of topics are they raising with you at present?

Lori Heinel   00:04:36

Well, first of all, we have a very large global footprint, working with a wide spectrum of clients, from individuals with financial advisers to large institutions like pension plans, sovereign wealth funds, and central banks. There are common themes across this client base and some idiosyncratic ones. Common themes start with managing volatility. With expectations of more volatility in 2024 amid a global slowdown, many clients are asking how to handle it. For individual investors, the focus is often on sticking to long-term plans without making rash moves. For institutions like pension plans, portfolio drawdowns can have direct impacts on capital contributions, making volatility management more urgent. The second theme is inflation. Many clients are still concerned about inflation, even as we believe pressures will abate, eventually allowing policymakers to reduce rates. In the short term, ensuring portfolios keep pace with inflation is crucial for both individual investors and entities like sovereign wealth funds with regular disbursement needs. The third common theme is seeking growth opportunities. With slowing growth and extended valuations in areas like large-cap U.S. equities and technology, clients want to capture growth without taking undue risks. On idiosyncratic issues, income-sensitive clients see opportunities in the current high-rate environment. For instance, pension plans may use this moment to pivot into derisking frameworks or fixed-income strategies. Retirees moving to the decumulation phase are focused on locking in income that also keeps pace with inflation. So the themes range from volatility and inflation management to balancing growth and income opportunities in a challenging environment.

Joe Cass   00:07:35

Yann, we're often asked about future risks in the economy on a macro and also a secular level. So in your opinion, what future risks should market participants keep an eye on at the moment?

Yann Le Pallec   00:07:51

So to your point, Joe, I'm not sure it's emerging or future risks. It's more secular trends, and we've been identifying those on a quarterly basis through what we call our Credit Conditions Committee report. So let me go through a couple of those that we've been talking about for at least the last couple of years. The first one is everything related to physical asset risk and energy transition. This is typically a long-term trend that has started to impact the credit quality of certain entities in certain tech sectors, but that we would expect to gain in importance and impact over the next few years. And we know that, around the world, across all regions, participants in the markets are increasingly paying attention to what might become material in terms of credit impact when it comes to the exposure of certain entities to windstorms, wildfires, landslides, and, at the same time, also all the investments they are making to manage their energy transition. The second secular trend that, for the time being, we consider to be a tail risk, but that over time might become really credit-relevant, is cyber. Cyberattacks, from our own observation, don't leave a lasting trace in the finances of a company, but that could change. That could change as hackers improve their techniques, their penetration tactics, and, as the frequency of those cyberattacks continues to increase, that may start to impact the credit quality in a more meaningful way. The third type of risk is supply chains, which is another way to look at, ultimately, the weak entry points into an organization. And if you look at potentially carbon footprint, cyberattacks, your supply chain, beyond creating economic risks for you in terms of providing the right sources of supplies, could be a significant entry point into your own organization and ultimately have a great impact. So these are some of the secular trends that we're focusing on. And the wildcard, of course, both on the positive and the negative side, is Gen AI. But in this case, because I knew you were going to ask me, so I want to preempt this one: it's far too early to tell. It could go positive, negative, probably both ways. And, depending on the entity, it could be one or the other.

Joe Cass   00:10:42

Great. Thanks, Yann. Lori, there's obviously different investments for different needs. But given the longer-than-expected perhaps period of inflation, what are State Street Global Advisors thoughts on the harder assets like real estate or commodities like gold?

Lori Heinel   00:10:59

Well, I think there are different ways that you need to look at different of those assets. So Yann mentioned this concern about the real estate space and commercial real estate in particular. And that's a place where, while we've seen some pullback in valuations, we still think that there's a lot of vulnerability there and in certain sectors where perhaps from a legacy standpoint, there wasn’t. So think even Class A office space in large metro centers continues to be a bit under pressure. So real estate is a place where we’d be very selective. It’s all about what style of real estate, specific properties. There are perhaps opportunities in things like warehouses or other things, but we’d be very judicious in how we’re deploying assets there. If you look at other kinds of things like hard assets, like gold or things of the nature like that, they do offer a variety of good benefits. So first and foremost, gold is one of the few true diversifiers that doesn’t respond to the same impulses that drive equities and fixed income. Secondly, we have seen that there are sort of organic drivers of gold demand. So central bankers buy gold, gold is used in industrial and fashion things, for example. So gold tends to be an asset that in small amounts can play an outsized weight in helping to diversify the portfolio. And then the last thing I would say is really look even within your asset classes for natural diversifiers. So if you think about fixed income, for example, a lot of the major indices are very heavily weighted towards sovereign debt. And one of the risks that Yann didn’t talk about that we’re often looking at is the sovereign debt crisis, the idea that many of these large global economies, including the U.S., which is where I am, have borrowed heavily over the last several years, creating perhaps some challenges if interest rates do stay higher. So thinking about your fixed income portfolio, for example, through the lens of what kinds of exposures do I want, and maybe I don’t want to just buy a broad aggregate index, maybe I want something else that can give me good income but also some of that capital protection.

Joe Cass   00:13:12

Great. Thanks, Lori. Yann, we've seen a really marked interest in private markets recently over the past few years. How are S&P Global Ratings typically being asked to assist in this area?

Yann Le Pallec   00:13:26

So private markets for us is really a strategic area of investment. And why is that? We did a strategic exercise last year, and we came to the conclusion that private markets, as we know them today, are going to stay there. They will ebb and flow, but they will be part and parcel of the totality of credit markets going forward and issuers will move in an opportunistic way from one pocket to the other, and that's exactly what we are seeing at the moment. There are some transactions that were financed through the private markets that are now coming back into the broadly syndicated loan market. So what that means for us is that because our mission is to provide transparency to credit markets that we should increasingly find a way to put the spotlight and bring more transparency to that space that, again, is increasingly important. So how do we do that? We've got existing windows into private markets. And if you look at the U.S. where private markets are the most developed, we actually rate some leveraged loans that end up in middle market CLOs. We rate business development companies that have exposure to some of those privately funded companies. We rate asset managers that specialize into private market. And we do have many, many points of entry. So the name of the game for us going forward is to make sure that we connect all those dots and that from a credit perspective, we really understand how the quality of the underlying leverage loans evolve up to the balance sheet of the life insurer or the pension funds that ends up owning the asset. So that's really making sure that instead of having a sector-by-sector view, we really try to understand how the credit risk migrates from the underlying asset onto the asset owner. Also, what we are doing is that we are trying to provide more transparency through our research on the relative level of liquidity or the absence of liquidity on the private markets. So that requires us to leverage a lot of data sets. And across S&P Global, we are fortunate to have through Wall Street Online, some great aggregate data that we're going to be able to analyze and publish research on to help market participants understand the relative level of liquidity in some of those pockets of private markets. Why do we believe this is important? It's very simple. As I said, we would expect to see some weaker borrowers to default. And as a result, we believe that some of the existing asset owners of private assets might want to manage their exposure more actively in the future. And as a result, as they do that, having better indicators of the relative degree of quality of liquidity in the market is going to be very important for them to be able to manage their exposures more actively. So watch that space. We've only started to publish that aggregate data on private markets on the liquidity of those private markets. But starting in June, we will accelerate the pace and the substance of those research publications.

Joe Cass   00:17:08

Great. Thanks, Yann. Lori, I wanted to talk just a little bit about cryptocurrency and digital assets. What's your current view of the crypto kind of universe? Is there an opportunity you see in terms of long-term investing and returns for your clients?

Lori Heinel   00:17:29

your favorite—are very speculative investments. And so to the degree that an investor wants to be involved in those kinds of assets, you should think of them similarly to how you would think about buying a very volatile, highly speculative individual stock. So size the position accordingly, recognize that you’re going to have a bumpy ride, and over time, you may have a massive winner, but you also may have a massive loser. So we still think they really belong in the realm of speculative investing. We have not integrated those assets, therefore, into our model portfolios or our strategic or tactical allocation programs. Again, the history for these assets is still too short. It’s hard to know what the real correlation of these assets is versus other kinds of assets, so we’re still a bit more cautious on that frame. I want to pivot, though, because I think that there’s a lot of interesting development in more of the broad kind of tech finance or fintech space, right? So if you think about things like blockchain, that has incredible promise to provide platforms that will enable us to do really, really interesting things in the future around investing. And one of them ties back to even the point that Yann was making a minute ago, which is imagine a world in which all of your private or illiquid assets were actually captured on a blockchain kind of a platform. And that would facilitate different kinds of liquidity, it would facilitate instantaneous monetization opportunities, it would facilitate all manner of things that you can’t do with those assets today, which would make them much more attractive for investors going forward. So I would separate out the enthusiasm, or lack thereof on our part, for crypto from what I think is incredible enthusiasm about the future of this kind of fintech sorts of platforms.

Joe Cass   00:19:35

Great. Thanks, Lori. Yann, I know firsthand that you are a tenured public speaker. I mean you regularly speak in front of hundreds, if not thousands of people. So what kind of advice would you have for others to be confident when public speaking and just to be generally a good communicator.

Yann Le Pallec   00:19:54

Well, that's really a tough question. Thank you for that one, Joe. I think I have three pieces of advice. And the first one and by far, the most important is prepare, prepare, prepare. The second point and that ties in with what we do at S&P is simplify, simplify, simplify, cut through complexity, avoid jargon, don't use acronyms. And I'm sure I did in my previous answers, but really try to simplify as much as possible to make yourself understood very easily. And the last one, which is probably the toughest is try and arrive at least 30 minutes before because it's important to connect with the room. It's important to feel the vibe in the room to be able to connect with the audience. And you know that lots of communication is nonverbal, and that's part of it. It's not always possible to do that, but that greatly helps.

Joe Cass   00:20:52

Yann, you joined S&P in 1999. So we've obviously witnessed kind of very big changes in the market between now and then. Interested to know what has been the most challenging time for you personally? And how did you work to push through that period?

Yann Le Pallec   00:21:09

So I must admit that I've got a very short memory, Joe. So the last one that I can remember, but that was a very significant one was the first lockdown during COVID. And for me, that was quite a tough experience because almost overnight, you lose the human connection with your customers, with your colleagues, your entire environment. And what I mentioned before about connecting with the room for me in the way I conduct my business, the one-on-one and the in-person interaction is extremely important. So that was a complete switch. I had to learn basically how to operate, and that was very alien to me. So it took me quite a few weeks. But what I realized is that I had to be a lot more purposeful and thoughtful about how to manage my interaction. So previously, when I was in the office or meeting with clients, there are things that I was taking for granted, but not anymore. In order to connect with the people I wanted to connect with, I had to dial through Teams or Zoom and basically have a plan about how to do that. And I think when we came back into the office and now that at S&P, we have a hybrid work model. I think for me, at least, it's helped me being a lot more again, organized and structured on the time I spend, in particular, where I'm in the office and making sure that the time that I spend in-person is really leveraged for those in-person interactions as opposed to being on calls on Teams or Zoom, which home is the perfect place to do. But when you've got this unique opportunity to be engaging with people in person, so you should really make the most of it. So I think for me, that was really a big change. And I must say that the way I do my business today, both in the office and with customers is very, very different and a lot more thoughtful and purposeful.

Joe Cass   00:23:15

Great. Thanks, Yann. Lori, the last question goes to you. Yann has touched upon this previously, but I'd be interested to know how you are thinking about AI as a tool and in your perspective, how to improve the returns and also make the investing process maybe more efficient?

Lori Heinel   00:23:33

Yes, there's a lot to unpack there, and we could probably spend an entire podcast just on this topic. But I'll give you a couple of quick thoughts that I think point to the direction of how we can leverage some of these kinds of tools. So the first thing I would say is we've been using machine learning and other sorts of techniques in our quantitative processes for many years to digest data, to look at natural language processing, to look at all sorts of things that make it very expedient for us to conduct the research activities that we're conducting. So that's been part and parcel to our journey, if you will, for many years now. The other thing that's become, I think, more interesting is how the companies that we evaluate from a fundamental standpoint are deploying AI in their own businesses. And some of them are quite surprising or at least not necessarily the things I would naturally think would have been the case. So I'll just give you a quick example of biotech. And so you'd say, well, one of the things that a biotech company needs to do is think about compounds and drug developments or things of that nature. And so, geez, I'll just put a bunch of different compounds into the AI, I'll let it sort of churn itself, and it will give me some promising ones that I can do some more research on, right? So that's the kind of obvious use case that I would have come to. Turns out that a more interesting use case in some ways is how to use AI to shorten the development cycle so that the ability to monetize the patent on the resulting compound is actually enhanced. So that's not the kind of sexy part of the pharmaceutical development, but it's actually the part where an AI sort of application can drive meaningful revenue capture for a company. So really thinking through, kind of industry by industry, what are the use cases and who are the leaders that are deploying those use cases that are going to give them competitive advantage. I think that's a really interesting linkage here. And then in a similar vein, the other places that we're really looking into are use cases around operational enhancements. So think about in our business, we have thousands and thousands of clients. And maybe many of them want a large-cap U.S. exposure, but they might want it tailored in some way. They might want it to be a little bit lower tracking error. They might want it to be a little bit tilted towards some ESG thing that they want to capture, or they might want some other customization. Well, imagine if you could have a portfolio who developed the model portfolio and then have a copilot, an AI copilot for lack of a better term, who could then help think about how to manifest that portfolio into all these different customized environments globally where you might have certain kinds of diversification rules or you might have other kinds of regulatory constraints. So to me, some of those things are sort of less interesting than the ChatGPT to build a better alpha mousetrap, but I actually think that they are the perfect example of the marriage of man and machine in a way that will ultimately drive this industry forward.

Joe Cass   00:26:50

And thank you so much, Yann and Lori, both of you for your time today. For everyone watching, everyone listening, see you next time on fixed income in 15.