Disruption and divergence: Markets in early 2026

BRIAN HESS: Hello, everyone. Thanks for joining us. Welcome to our first macro webinar of the year. I'm Brian Hess, a portfolio manager on our Model team here at Natixis, and joining me today are Jack Janasiewicz and Garrett Melson. Jack is multi-asset portfolio manager and lead portfolio strategist. Garrett is a portfolio strategist and member of the Natixis' investment committee.

And now on to today's topics.

So today we're going to start with the topic that's on everyone's mind, and that's the war in Iran. We're in the early innings of a potential energy shock. And so Jack's going to start off by walking us through the implications of higher-for-longer oil prices and what he's following in the oil market, specifically, as we try to gauge the severity of the situation and potential duration of the squeeze. Jack, what are you seeing?

JACK JANASIEWICZ: Yeah. Thanks, Brian, and we're certainly in unprecedented times. The oil market is experiencing one of the largest physical supply disruptions in history. You've got roughly 20 million barrels per day of oil that normally moves through the Strait of Hormuz. Its closure simply can't be fixed by normal market mechanisms here, and I think that's what makes this situation fundamentally different from past shocks.

And we're going to start off with this first slide here. It shows the severity of what we're going through here. And it's basically showing you the pricing in the futures market for crude oil.

So you can trade contracts out for specific delivery dates over the coming months, and this helps to give some views into what the markets are expecting for prices over, say, the next 12 months or so versus today. And so what you see here, this is the spread in price for delivering oil today versus delivery in 12 months from now.

And that spread is basically trading at close to a 30% premium, meaning that prices today are 30% higher than what's currently being priced in for that same barrel of crude oil to be delivered 12 months from now. And you can see from this chart, obviously, that's basically uncharted territory here. We've never had a gap that's been quite as large.

And so I'm sure we're all aware of what matters at this point. But just to hammer this point home, it's not only just the size of the oil spike that we're talking about, but it's the duration and how long it stays at these elevated levels. And I would argue that the latter of those two, so the duration, is really the more important of the two here.

What's interesting, though, what did the markets and perhaps we miss in this first salvo, oil had been priced already, I think, with some of the geopolitical premium, if you will. But we didn't expect this sustained closure of the Strait of Hormuz here.

If you look back, Brent had basically drifted up from $57 a barrel in January to $65 right before the start of hostilities. So that's almost a 16.5% increase. So the market had been pricing in some of this geopolitical risk, but that changed pretty quickly.

And now we're seeing that the Straits of Hormuz might be impossible to solve via military means. And to put it bluntly, Iran is basically attacking the global economy and holding oil hostage at the same time. And complicating the backdrop, Iran has now been attacking oil and gas infrastructure across the region, permanently damaging some of the key suppliers in those supply chains.

And so you can see here in this Brent oil curve that we're showing again, so looking at the future prices for delivery of oil going out over the coming months here, that purple line represents where we were prior to the attacks. The green is really one month after the attacks. And then blue is basically where we are today. And you can see that each week that we move farther out from the date starting the bombings, the curve is continuing to shift higher and flatter. And so basically, this is telling us that the market is slowly discounting that higher-for-longer strategy or outcome for oil prices here, so obviously not good.

And this chart here is just basically trying to magnify that change in oil, just to show you a little bit more specifics here. But the blue bars here reflect the change in oil prices over the last seven days, and the purple is from the start of the hostilities through last week. And scaling is a little bit different here, but the key point is the shape of the curve.

And so when you look at the blue bars, you can see that the prices are still rising but also flattening out the curve over the next four months. And again, this is just implying that the market continues to reprice higher-for-longer levels of oil and, again, not what we want to be seeing going forward here.

And so pull this to the last point I want to hit home-- and this is also maybe the issue that's maybe not appreciated by markets because we send we seem to be spending a lot of time focusing on crude oil spot prices. And this might be a little bit misleading, so to speak, because, as oil shipping all but has ground to a halt, the dominoes along the supply chain are starting to be impacted here.

And storage capacity, for example, is basically full, forcing a lot of these producers to shut supply. Refineries, especially in Asia, are preemptively cutting runs to avoid running out of crude feedstock, which is causing refined products such as jet fuel prices and diesel to spike faster than crude. And so if we look at this chart here, that light blue line is reflecting Brent crude, while the other lines are jet fuel prices, the green for prices in Europe and purple for what we're seeing in Asia.

And so take note of the timing of the divergences here. You see jet fuel prices spiking well before we really saw that spike in Brent crude prices. And this is maybe what's underappreciated by the markets, that product markets tend to lead the crisis, so to speak.

Consumers don't use crude oil directly. They're consuming refined products. So jet fuel, diesel, gasoline markets, those are all tightening first because they're the ones who are already feeling those shortages. And so refinery behavior is the key transmission mechanism here for the energy shock to roll through the system.

Refineries, their worst-case scenario is running out of crude feedstock, refining units, or what we probably consider these giant flowing chemistry sets that are expensive, slow, and, quite frankly, risky to shut down and then restart. And so faced with this uncertainty about future crude oil supply, especially in Asia, refiners are cutting run rates preemptively to conserve crude and extend the operating life of these facilities.

And because refineries are cutting production to avoid future shutdowns, this tightens supply even further. And so as crude oil flows slowly through the system, cargoes already in transit can take weeks or months to reach refiners. But product markets are adjusting instantly because these refiners change behavior immediately once supply risks start to rise.

So we can see a lag here but in the opposite direction. The underlying shock originates in crude food supply, but the effects are felt much faster and harder in the products market. And this creates a negative feedback loop.

Lower refinery runs leads to less product supply. This leads to higher product prices and more economic stress. And so for us, the canary in the coal mine is jet fuel prices, and that's what we're pointing to here.

And ultimately strategic reserve releases really don't solve the problem here. Releasing crude doesn't instantly create jet fuel or diesel refining capacity, logistics, regional mismatches. All this limits how quickly crude can get released and relieve these products shortages here.

So why this shock is harder to fix? Well, each day of refinery cuts compounds the damage, and product shortages persist even if crude flow resumes. Restarting refinery systems, rebuilding inventories is going to take months, not days, and basically, the bottom line here is timing is the enemy, right.

It only makes matters worse. The longer this persists at higher levels or shortages, the worse it's going to get. So the bottom line this is not just about oil prices. It's really about fuel availability.

Refined products are where the economic pain point shows up first. Refinery behavior, not speculative issues, are driving market extremes. And so the jet fuel and diesel prices, I think, to us are those early Warning signals of deeper global stress here, and the risk is that these prices remain elevated for a sustained period of time.

BRIAN HESS: Thanks, Jack, for drawing attention to some of the factors beyond just the front month crude oil contract price, which is, in our calculus, an important factor, thinking about the severity of this crunch. And so far, it doesn't look like there's a whole lot of relief in the refined product prices just yet.

So, Garrett, now that Jack's discussed what he's focused on in the energy markets, can you talk a little bit about what you're looking at in the US economy itself to gauge its sensitivity to this energy shock? And I think also, if you could touch on the Fed's role in all of this as they try to set monetary policy, that would be helpful. We just had the March Fed meeting yesterday, so it's a very timely update.

GARRETT MELSON: Yeah.

BRIAN HESS: Garret, would you—

GARRETT MELSON: Yeah, absolutely. Well, I think what Jack just walked through is really setting the stage for what we're facing here from the economic fallout. If you take a look at markets, it's been actually fairly well behaved.

But largely, equity prices have just been trading in lockstep with oil prices on inverse basis, maybe not front month oil but going out a couple months as the market's really trying to digest just how long these disruptions are going to persist and how long we're going to be dealing with elevated energy prices. And that really, at the end of the day, is what's going to dictate the severity and the extent of the economic fallout.

It's the magnitude and the duration of these disruptions and their effect on how elevated and how sustained these elevated prices are, from an energy perspective. And when you think about energy, I think, obviously, we have some recency bias. We had some experience with this four years ago with the latest energy shock, stemming from the invasion of Ukraine. And obviously, there's plenty of charge rolling around with the double wave of inflation back in the '70s as a result of the conflict in Iran in 1979.

So there's a lot of comps here that I think investors are rolling out in their mental models here. But I think the key for us is that initial conditions are really, really critical. We spend a lot of time talking about this, whether that's in regards to market conditions and investor positioning or economic fundamentals.

How you enter a crisis has a huge bearing on what the impact of that shock will be. And so I want to spend a little bit of time walking through what that looks like today and really focusing in on the economic standing here and what our buffers are to this shock. First off, this is not your parents' energy shock.

So whether you're looking back in 1979 or even just four years ago in 2022, we have found year after year ways to do more with less energy. And so when you take a look at energy intensity, which is basically a measure of how much energy is required to generate a given unit of GDP, it's been a straight line down for decades now.

And so across sectors in the economy here, just think about fuel efficiency gains for cars. Now extrapolate that out through the broader economy. You can see how that intensity has declined pretty materially.

So looking back to 1979, intensity has fallen 63% in aggregate. And even from 2022, it's fallen a further 7%. So even in the recent history, we've continued to get more and more energy efficient. And at the end of the day, that just means that energy price shocks have an effect, but both in the positive and negative direction, they're generally smaller than what we're used to, even in our recent history.

And that's true for the consumer as well, on this next slide. If you just take a look at energy spending for goods and services as a share of total consumer spend, it's the same chart. You continue to see this downward grind. And ultimately at the end of the day, we spend less of our wallet share on energy goods and services here.

Again, much lower than what we saw back in the '70s, peaking out around 9.5% in 1979, and even lower than we were entering 2022, which was around 4 and 1/4, 4.3%. Today, we're at 3.7%. So it might not sound like a huge delta, but that does matter.

And at the end of the day, it just means that ultimately, the mindshare of energy prices for consumers is much, much larger than the wallet share of expenditures, which means it really has much more of an impact on consumer sentiment and how consumers feel. But at the end of the day, that doesn't really translate to consumer behaviors because it just has a much smaller effect on crimping demand and crimping budgets here.

Now, that's not to say that there isn't an impact. And here again, tying back to initial conditions, you can see just how different the conditions are today versus just four years ago. Take a look at both nominal, personal disposable income, excluding government transfers-- so think of that as basically organic wage income for the US consumer. That's the purple line in nominal terms and then in real terms deflated in the light blue.

When you look back at 2022, we were basically at the peak of the inflationary surge coming out of the COVID recovery. So we had a nominal economy that was growing gangbusters, nominal GDP running somewhere around 10%. And that nominal growth was really supported by a very tight labor market.

We're just starting to see that tightness start to ease off, very strong wage growth. And households have only really just started to tap into that $2-plus trillion of excess savings that they had accumulated through the pandemic era. So a very, very different economy to where we are today, where the labor market is really on a lot shakier footing, certainly not cracking.

But slack continues to build. As the unemployment rate grinds higher, you continue to see hiring intensity remain weak. That means that leverage has really shifted from employees back to employers. That continues to press down on wage growth. Excessive savings are a thing of the past.

And you take a look at where the saving rate has been, we've seen a pretty steady compression in that over the last year or so. So in that sense, consumption has really outpaced income growth, which means that you probably have less buffers for consumers to really be pushing back against potential increases on the energy front. So yes, the effects might be more muted, just given the fact that consumer spending on energy is smaller, but at the end of the day, it still is a tax on consumers in real terms.

And so at the end of the day, the bigger risks here aren't on the inflationary side of the Fed's dual mandate. It's really on the price side of the mandate-- or excuse me, the growth and labor side of the mandate, which those downside risks were already somewhat present entering this year with momentum somewhat slowing in the economy. Now this just exacerbates that.

And for the most part, when you take a look at markets, they're basically reflecting that. They're pricing in this short-lived energy shock, which you can see in one-year inflation swap. So what's the market expecting for inflation to average out over the course of the coming year? That's what you see here in this light blue line.

But that ensuing one-year period, starting one year from today, you're really not seeing those expectations move. And so what that's saying is that markets, for lack of a better term, expect this to be transitory. They expect that this will be a one-time price increase that eventually will fade away as these tensions are resolved and you start to see a resumption of normal physical flows for crude and distillate.

So that's really what the base case is. The risk, though, is that if this continues to drag on, you start to see the market getting a little bit more concerned about those downside risks. And that's when we would actually start to see a little bit of more of a divergence here, what we saw akin to April of last year, where you got those one-year, one-year forward swaps rolling over, which is basically a function of the market pricing in downside growth risks, maybe some demand destruction because of elevated energy prices really starting to eat into real disposable incomes here.

So that's the risk. It's not pricing in there right now. But if we do start to see those one-year forward swaps starting to roll over here, that's probably a sign that the market's getting a little bit more concerned with the growth prospects and a risk that you might start to see more outright earnings impairments start to get priced into risk assets. Not there yet, but something to keep a close eye on.

Now, moving on to the Fed, obviously a pretty challenging market reaction yesterday. And again, those initial conditions can matter. We judge how hawkish or dovish the Fed was based off the market's reaction, when that generally is driven by positioning and expectations entering the event.

But I think the key takeaway for us is that we were just starting to see some of that uncertainty and tension in the Fed's dual mandate fade. And now we're right back to where we've been a couple times in the recent past, which is to say, if you look at the risks weightings for the Fed in terms of their dual mandate-- so what are the risks to inflation, and what are risks to the unemployment side of the mandate? Well, they're both skewed to the upside, which is to say that unemployment rate is skewed to the upside, which means a softer and less robust labor market, and also that inflation rate skewed to the upside here.

So that tension is really right back with us here. And I think the real critical issue for markets is that essentially that easing bias is intact, but now it is far, far more conditional and reactive. We're not going to be seeing basically good news cuts, where they're cutting because inflation rates are cooling off. We are already starting to see some stickier prints to start the year even before the inflation shock.

This obviously will exacerbate that. And that's at a point where the Fed, most members, think we're somewhat close to that neutral range or maybe mildly restrictive. So it just reinforces their sentiment to just hold pat. And so it's no surprise that you've seen the market push out cuts into next year.

And at the end of the day, that just means that you're starting to open up the tails of the distributions. The more reactive the Fed is, the lower that strike price is for the Fed put on labor market conditions. It just means you need to see some cracking in activity before the Fed is really going to step in and durably look through those price risks.

So the market pricing here, I think, does, in a way, reflect that. If you take a look at what the rates market has been doing, you're pricing out cuts for this year, pushing them out into next year, somewhat pricing them out altogether. And that does make sense.

But you really do need to think about the market's pricing in terms of the distribution of outcomes. Markets don't price a discrete outcome. They're pricing all the probability weighted distribution of outcomes. So you see this bell curve.

And this bell curve is just simply looking at, what are the probabilities for the Fed funds rate at year end at all of these different levels? And the key here is take a look at the tails right. The mode of the distribution, the box I've highlighted here, the base case hasn't really shifted all that much.

The base case has really just been for zero or one cuts for 2026. But where you've seen a really sharp repricing is the tails. Most notably is on the right tail, where the fact that you're having this energy shock and the fact that the Fed really can't look through it in the near term, well, now the market has to reprice for the potential of actually shifting to hikes.

And so if you take a look at the cumulative probability of hikes by year end, that's now sitting at 34% as opposed to 8% prior to the conflict, so a really sharp change in pricing. And that's really come at the expense of some of these good news cuts, where the Fed continues to slowly ease back to neutral because inflation is continuing to make progress back to 2%. And maybe they're starting to see a little bit more concern around the labor side of the mandate.

Well, that's been flattened on the left side of the tail, and the right side of the tail has been really opened up significantly here. And in my opinion, it does make somewhat some sense to do this just because of the shifting probabilities. But it looks to me like the market's getting a little bit over its skis here.

And so when looking for opportunities in the market, to me this is suggesting that the markets are growing myopically focused on some of those upside inflation risks, where, at the end of the day, the bigger risks still lie on the growth and labor side of the mandate. You're going to see it hard pressed to have the Fed actually flipping to outright cuts. And this suggests to me that the market's getting a little bit overdone in terms of pricing the probability of those cuts.

So tying this back to opportunities in the market, it feels like we're actually getting a little bit of an opening to actually lengthen duration in here. It might not be the most compelling opportunity, just given the fact that we still have some upside risks on the inflation front. But it does feel like it's an opportunity with just, given the sense of where risks are, to actually start lengthening into duration here.

And there's a couple reasons why. To the extent that a lot of the movement in the curve has been a function of repricing the rate outlook, well, you can see this in decomposing rates further out the curve. If you think about the 10-year yield as basically a function of where short rates are going to be on average over that 10-year period and then that nebulous term, premium kicker on top of that, well, much of the backup in yields here in the light blue line, going back to the beginning of the conflict-- this is where rebased to 227-- well, much of that has actually been a function of repricing that policy rate backdrop.

So to the extent that markets are now getting a little bit overly hawkish, that suggests that, as the market has to shift back to focusing on downside risk to growth in the labor market, that you're going to probably start to see a big comeback into duration and maybe start to price back out that probability of cuts and-- excuse me, of hikes and start to price in an incremental probability of cuts here.

So a lot to unpack here, but to sum it up, I'd say the market was already overly sanguine on the growth outlook entering this shock and probably overly myopic on upside inflation risks now, as opposed to some of those downside risks. So to me, that suggests that you're starting to see a greater case to see a bid come back into the longer end of the curve, even maybe at the front end of the curve, as you have to reprice for an environment that has some really material downside risks, maybe not outright recession risks but certainly headwinds to growth as you start to move through this year, given the uncertainty around how elevated and how long those prices will be higher for on the energy front.

BRIAN HESS: So, Garrett, when investors are thinking about if they're comfortable extending duration, I think a key consideration will be, like you mentioned, the health of the economy, the underlying growth momentum. And just this month, we've gotten some very mixed signals. So we had a weak jobs report at the start of the month, with a lot of job losses. I think 92,000 jobs were lost in the month of February.

We had downward revisions to prior months, and the net effect was that there's really been no job creation since May of last year in the economy, so a definite weakening in the labor market. Yet at the same time, we got the PMI surveys from the Institute for Supply Management right at the start of the month, and they were actually quite positive.

So we printed above 50 on both manufacturing and services. The new order subcomponents, which are thought to be forward looking, were quite healthy. Which of these indicators or which of these inputs is telling the truth here? And how healthy is the growth backdrop?

Because if we get still above-trend growth against a price shock like in the energy markets, you can imagine how that could be inflationary, and maybe it's right, that the market that the Fed anyway is concerned or the market pricing is legitimate to be pricing in greater tail risk of Fed hikes eventually. So what's the true growth outlook for this economy right now?

GARRETT MELSON: Yeah. I think you laid out the reasons why it's been hard to gauge where the economy has been headed this year. But I think the base case for the markets entering this year certainly was for this stabilization in labor markets and a re-acceleration in growth.

And the data has been a little bit more mixed, to your point. You've seen some maybe green shoots of growth picking up. I will point out some of the PMI data it hasn't really reliably mapped to actual output and actual activity in the economy for years, so take that with a little bit of a grain of salt here.

But at the end of the day, I think the trends underneath the surface suggest that growth is OK, but those risks are still skewed to the downside, even before this energy shock. And so a couple of things that I would just highlight-- and we've already alluded to some of these in terms of thinking about the initial conditions.

But first off, you alluded to recession risk. I think those risks are still low. Can the events that are unfolding now maybe argue for slightly higher risks? Sure. But certainly I don't think it's anybody's base case at the moment. And again, that boils down to initial conditions. But balance sheets at both the household and corporate level are just too robust, and that's the first line of defense that helps to keep those recession risks at bay.

The first line of defense, though, is really the growth trajectory. And I think those are-- when you look through some of the noise to start the year, that to me still suggests a trend of cooling here. And the first one I'd point to is strip out the noise of GDP, and just look at some of the core elements of GDP. That's the concept of real, final private domestic sales.

Kind of a mouthful, but basically it's core GDP. So that's going to be a function of consumer spending, CapEx, so nonresidential investment, and then the housing market, residential fixed investment. And you can see it's been choppy, but it's still fairly healthy, the Q4 data probably a little bit distorted by some of the government shutdown. You get some payback in Q1 of this year.

But you can see at the margin somewhat of a cooling trend in here. I think the bigger story, though, is the composition of the bars. Yes, the consumer is always the key driver in the economy, but when you peel back the layers of the pillars to the US economy, a lot of it is still somewhat on ice.

The housing market is still somewhat in stasis. Demand has been sidelined by affordability issues. Home builders are facing growing inventories of completed homes. And so that means they're just refocusing on selling the completed homes they have on their balance sheets, as opposed to breaking new ground.

And it's that construction spend that really flows into a growth impulse for the economy as well as a hiring impulse. And I think there, the story is still somewhat of a story of stasis. AI CapEx is alive and well, but outside of that, CapEx intentions are still pretty muted even before this energy crisis. And the uncertainty and cloudiness around the growth outlook, I think, is only going to keep some of that non-AI-related CapEx on ice for some time here.

And even when you start to pull fall back in some of the more volatile components, some of the non-core components like government spending, again, you'll get the payback for the government shutdown for federal spending Q1. But on the state and local government side, that's been really the bigger driver of a fiscal impulse, and that budgets there are continuing to contract. So on the whole, that just suggests that you have an economy that is increasingly sensitive to trends for the consumer, and that outlook really starts with the labor market.

Here, I think the story is still one of linear cooling. We've been beating a dead horse on this one, but there's a lot of optimism around a stabilization in the labor market early this year because you had a pretty strong print in January on the back of a fairly strong print in December. I think the story really, though, is that those two prints probably overstated the strength, just as February probably overstated the weakness. The truth is probably somewhere in the middle.

But you look at the trend, that trend is still moving higher here, and I think the path of least resistance continues to be to the upside for the unemployment rate. What we're seeing play out now certainly doesn't help things, but I think it's important to keep in mind, even with very strong, robust growth over the last three years, that still wasn't enough to stop the unemployment rate from rising 30 basis points every single year.

So what's to stop that process from continuing now that you're looking at a somewhat softer growth backdrop? So to me, I think the path of least resistance is still higher. We talked about the wage growth dynamics.

The more you continue to see slack building in the labor market, the more that just continues to shift power back to employers. And that places downside pressure on wage growth. It also suggests that the story really isn't about immigration. It's about labor demand being weak.

And so that's why you continue to see leading indicators of wage growth-- like the purple line here is the Indeed wage growth tracker. That's posted jobs that people are looking to fill-- that tends to lead what you're seeing for the broader wage growth backdrop. So continued weakness probably ahead for wage growth, and when you take a look at the other source of a buffer for consumers to continue spending, it's the savings buffer.

And you've already seen, as I mentioned, a pretty material drawdown in that savings rate. And that's driven by that wealth effect. It tends to move inversely with household net worth. So as household net worth moves higher-- that's the purple line here, a scale to disposable income-- what do you see?

Well, consumers are more willing to draw down their savings rate. They're more willing to spend ahead of their incomes. Well, now you're at a point where there's been some turmoil and disruption in markets even ahead of the conflict in Iran, given the rotations on the AI themes here, and I think you're at a point where you're probably more likely to see the saving rate stabilize, if anything, maybe move a little bit higher in here.

So all that suggests that, at the end of the day, consumption probably converges towards income. And so that leaves you really with one last pillar to help support the growth outlook. And that was really the fiscal impulse from the Big, Beautiful Bill.

And we've been, again, hammering this point for months and quarters at this point. But again, a lot of reason for optimism that you'd get a meaningful fiscal impulse, maybe both on the CapEx front because of more favorable expensing, that doesn't matter if the growth outlook isn't there. But more importantly, on the consumer side of things, you're off to a pretty slow start for refunds.

This is just simply tracking 2026 refunds in red versus the pace in 2025. Sure, we're running a little bit ahead of where we were last year, maybe on the order of $18-18.5 billion. But scale that to the size of consumer spending, closer to $22 trillion, and that's maybe basically, 8-9 basis points of a kicker. And that's assuming all of it gets spent in here.

So yes, it's still maybe a little bit early in the refund season. But think about who files early. It's those lower-income cohorts that rely on those refunds and are more likely to spend those dollars. It's been a pretty underwhelming tax refund season here.

So to the extent that investors were hoping that the consumer is going to start to re-accelerate, you'd see this boost to consumption and growth on the Big, Beautiful Bill, I don't think you're going to get that bailing out the consumer or the economy this year. Those effects are going to be pretty muted in here.

So all told, I think it just boils back down to what I already laid out, which is that the consensus was overly sanguine on the growth outlook entering this year, overly hawkish on the rate backdrop now, thanks to some of these energy risks. And so I think the bigger risk as you move forward here is maybe some belated overreaction and maybe some growth scare to get priced into the markets here as opposed to an inflationary spiral. And we're not seeing it just yet, but I think that's probably the risk to keep an eye out for.

BRIAN HESS: OK, Garrett. So I guess I sense like a medium degree of concern here from. You said at the outset of your comments you're not calling for a recession, but as I look through the charts you just showed, they were pretty much all highlighting different risks to the economy.

So you're definitely in the camp that we're at risk of a slowdown. That supports your idea of the call for duration, extension in portfolios, particularly if the market starts to price them much more aggressively, hawkish Fed. Is that a fair characterization?

GARRETT MELSON: Yeah, I think that's fair. Not alarmist here, I think there's still enough momentum within the economy to buffer some of these shocks. But I think certainly the risk is, at least relative to market expectations, that growth probably underperforms some of those expectations, which still look a little bit too optimistic in our view.

BRIAN HESS: OK, that sounds good. And, Jack, feel free to interject. You tend to be an optimist, I think, especially on the economy. So if you have a difference of opinion, please chime in and say, hey, well, what about this? What about that?

JACK JANASIEWICZ: I'll add one quick comment. If you're still bullish on the tax refund story, that's probably going to get eaten up by the potential for paying a lot more of a higher price at the gas pump. So unfortunately, it's just going to be redistributing that spending from one place to another, which is probably less impactful for the overall economy. 

BRIAN HESS: Yeah, that's a good point. That's a counter, an offset to that upside surprise or that upside factor we had going for us. All right. Well, one thing we want to be sure to talk about today is the recent stresses in the private credit market and specifically how they're affecting business development companies.

So, Jack, you've done some good research in this area. Can you bring us up to speed on what you've discovered?

JACK JANASIEWICZ: Yeah, and there's a lot going on here. So bear with me because we have to crunch some numbers, I think, to really fully appreciate the story.

And we've been seeing the headlines left and right. It seems like every other day there's a new BDC that's getting redeemed upon. People are throwing up gates or at least trying to accommodate and are simply limiting the amount of money that can flow out the door here. And so that's creating a little bit of a tricky environment here.

But this first chart is just really, I think, a culmination of a summary of everything that's been going on with regard to that. Historically speaking, these non-traded BDCs have roughly a 5% redemption limit per quarter. And you can see, starting at the fourth quarter of last year, we saw the average redemption requests pushing higher, and then as we get to the first quarter of this year, you can see certainly breaching through that.

So what's going on here? Well, I think you need to understand who owns what. And that's really becoming a critical component here in terms of explaining the risk, the volatility, and really what's driving private credit.

And so if you think about this, ownership constraints, really not fundamentals are increasingly setting these marginal prices, and the difference in ownership structure across the $17 trillion US credit market and the retail institutional split help explain why, for example, investment grade, high yield, and loans can trade on different signals at the same time and why spreads can sometimes move independently of the underlying credit fundamentals.

But needless to say, fundamentals still matter. But pricing may at times be set by the investor, who may be driven by liquidity needs that actually exceed those fundamentals. So let's level set here, and let's talk really about, what are the risks causing the credit quality deterioration that we're seeing in private credit?

And there's three of them, I think, worth talking about here. The first one, AI disruption, we all know the software story. The second one it's the macro environment, higher for longer because many of these loans are floating rate loans. And so I think there was an expectation that eventually rates would start to come down and so that cost of funding would start to drop along with that, and then obviously the liquidity.

And the AI disruption risk is hitting private credit in a disproportionate size because private credit has basically an unfavorable sector tilt towards to the software side of the equation here. Private credit has-- it's been estimated at about a 17% exposure to software. The syndicated loan market is at about 11% in high yield, somewhere between 2 and 3. And then obviously complicating the backdrop here is simply that private credit often addresses middle markets.

So here, there are fewer revenue streams to support that businesses, due to their smaller sizes. In addition, because of their smaller sizes in this middle market, they're more prone to being leveraged. If you look at their capital structure, it tends to have to rely more on funding themselves, and that makes them inherently a lower credit quality investment.

And to hammer this point home, lending to much smaller firms in this area, the average firm's EBITDA that we're talking about in private credit software is roughly about $110 million. If we look at high yield, it's roughly $1 billion. And to talk about the quality in terms of the coverage ratios, in private credit, the coverage ratio for software is about 2.2 times, and high yield is about 4.4.

So you can see a pretty significant difference here in terms of quality with regard to that software component. And in the past, private equity and private credit managers have had cash on their balance sheets, plenty of dry powder, so to speak, and they've been able to fill some of these issuer funding gaps that have been popping up and when these problems arise.

But some of them have resorted in the interim to introducing and leveraging in PIKs, so Payment In Kinds, where instead of taking cash on payments, you're actually extending the principle of the bond you're invested in or the loan you're invested in. Some are doing liability management exercises as a stopgap functions. But all these are simply trying to do is buy time in hopes that we're going to get lower rates, even as a lot of these non-accruals start to climb.

And again, that higher-for-longer backdrop starts to really pressure these floating rate cash flow sensitive and coverage ratio companies. And now with the entire business model called into question, the bar for capital injections has been raised even higher given the increased scrutiny that private credit's under. And that makes things even more stressed. And to top it all off, getting back to those PIKs that we were just talking about, that wall of maturity is starting to approach pretty fast.

So all of this is, I think, being really exacerbated, though by the funding mismatch. And I think this is really the key to the story here. And it's estimated that roughly 23% of the private credit market is now funded by retail, and the investment time horizons between those retail investors and private credit managers is really structurally misaligned.

So if retail is nervous and wants out, the structure of these BDCs and these investments is a bit more complicated, and this puts a huge premium on liquidity. And this liquidity is, I think, what it's really at the heart of what's stressing the market here. And comparatively speaking, when you think about institutional flows, they've remained relatively stable here.

So it's worth really diving into who owns what. So let's talk a little bit more about retail investors and private credit. And when you look at private credit, you can divide the market into four sub asset classes, each serving as a source of funding for middle market companies.

You have the direct lenders and BDCs. Each account for roughly 43% of the market. That's the pie chart we're looking here on the left side. And then on the right, you're looking at roughly 45% of the private credit markets being funded through debt.

So where the rubber meets the road is, who owns what within this system? So good to get into some details here, and again, caveating the data, this is sometimes difficult to get your hands on in terms of the actual data. So these are estimates. So we'll take it a little bit with a grain of salt but probably the best that we can come up with here.

But we're just looking at estimates for who owns roughly $1.3 trillion in the private credit universe. And this is split between debt investors and private credit-- and that's the top table that we're looking at here-- and then the equity investors in private credit, which are down on the bottom here.And retail investors largely get their exposure through mutual funds and ETFs. So you can see that's what I've got circled on both of these tables here. And they contribute about $300 billion to private credit, or roughly 23% of that total financing.

Listed BDCs outstanding equity is currently majority owned by retail. So you can see here on the bottom, you're looking at $62 billion and the $2 billion, getting to $64 billion, of the total $86 that we're seeing, so roughly 74% of this market. And retail funds effectively owned 34% of the debt market, and you can see up top here, that's $22 billion plus $11 billion. That gets you to the $33 billion out of the total $96.

So retail is much more invested in the equity ownership of listed BDCs than the debt side. But from a debt stake perspective, insurance companies still have the largest stake in BDC, as you can see at the top here, at $36 billion. And that's roughly about a split of 38, with retail coming in at around 34%.

But if we look across the entire BDC landscape, both listed and unlisted, retail accounts for roughly 55% of this asset class. So on the top table here on the far right, I've got circled at $58 billion for mutual funds and $29 billion for ETFs. Down the bottom you can see $205 billion for mutual funds and $2 billion for ETFs.

If you add all these up, that comes to about $294 billion. And that's out of the total of $534 billion for listed BDCs and unlisted. And that's roughly 55% of the market. So the point I'm trying to make, retail is a big player in the BDC market but not so much for the rest of the private credit market.

And this is where a lot of the headlines are playing out. And again, this goes back to that liquidity mismatch that we keep talking about. So what investors maybe don't appreciate, regarding the credit quality though, yes, there has been an increase, as we talked about earlier, in the use of PIK bonds. And we hear a lot about of the loosening payment terms with regard to covenants, and these are all implying credit deterioration.

But remember, 90% of BDCs are first lien senior debt loans and with only about 10% using those PIK facilities. So they're the first group of creditors to get paid. So the real risk here filters down really to the bottom tranche, to the equity holders who are really the last ones to get paid. They get what's left over after everybody above them in the capital stack gets paid.

So to summarize here, retail is creating this liquidity mismatch that's creating all of the headlines. They invest primarily through mutual funds and ETFs and contribute about 23% of the total private credit funding. They're heavily tilted towards equity funding, some 30% of all the private equity side-- I'm sorry, to all the private credit equity versus just 15 on the bonds.

Retail is largely a function of the BDC markets. Unlisted on that side, the market's roughly $200 billion in size. But again, retail accounts for about 55% of that BDC market. So, again, all of this is a mismatch that's really flowing into the BDC market, not the broader private credit market. And it's a function of that liquidity.

So just how big is the BDC market? And more importantly, how big is the risk to the entire system? Are we talking about idiosyncratic problems or systemic?

Well, publicly traded BDCs are roughly $178 billion. They offer daily liquidity, and then the NAVs can trade at a premium or discount. Unlisted BDC is about $85 billion. They're private placements. They tend to have longer lockups and limited terms when you're talking about exit plans.

Unlisted perpetual life BDCs, $226 billion, those tend to be on the RIA platforms through tender offers. And then interval funds, about $85 billion, those are, again, up on the retail platforms as well. And those are mandated to have periodic repurchases of 5% a quarter.

But the problem of the credit quality deterioration does tend to extend beyond private credit to all leverage low-quality public credit issuers directly in the path of that AI disruption backdrop. So again, not quite necessarily limited to just the private credit, but this is where it's being exacerbated.

So the last question to really tack on here is simply, is there a contagion risk to the broader market? And contagion risk is a function of the interconnectedness between private credit funds and other financial institutions that can amplify this financial instability, as evidenced by higher correlations and network connectivity during market stress.

So think about banks who lend to funds, BDCs, and CLOs. And looking at this bar chart here, we're looking at total loans to these funds, BDCs and CLOs, from banks. And so as a percentage of the total loan book, a lot of these range typically between 1% for JPMorgan to about 9% for PNC.

But here's the key. Recall that these loans are made to a diversified basket of lending vehicles. These banks are not directly lending to the borrower.

The borrower is the one that takes the capital from the banks and then turns around and makes the investment. So again, the bank lends the money to the BDC, and then the BDC makes the direct investment. So the bank is lending to a diversified portfolio of credit loans, and they do not necessarily directly lend to the originator or simply the ones who hold those loans.

And in addition, banks have secured credit lines that represent the senior most debt instruments issued by these private credit lenders, meaning that the private credit lenders have to pay off their bank loans first before any of the other debts. So in that respect, even though loans are made to BDCs and other private credit funds that are not explicitly securitized-- so think pooled and sold as securitized assets-- the capital structure of the BDCs and other private credit funds resembles that of a CLO, a securitization with various risk slices or tranches in which the banks hold the highest-rated, lowest-risk tranche.

So let's do a simple back of the envelope calculation here. Let's assume that 10% of these portfolios default. What's the impact to the bank's balance sheet? It's pretty minimal. It's going to be less than 1%.

So to do an actual example here, let's pick on Wells Fargo. You can see they've got almost $60 billion lent to BDCs, CLOs, leverage funds. Let's assume that their total loan book is almost $1 trillion. It's actually $986 billion as of the last filing. So the total loans outstanding to private credit in this case is 6% of their total loan book.

Now, let's assume 10% of that loan book defaults. That's about $6 billion. So $6 billion of the $986 billion loan book, that is 61 basis points of that total loan book here. So the entities who are borrowing against these loans are the ones who are in trouble, not the ones that are lending them the money to buy those loans.

And as a result, this provides a little bit of a layer of insulation from the entities financing them. And I know a lot of the ideas here seem to hearken back to the global financial crisis. That looms large in a lot of the minds of investors. But this is very different.

So I think the key takeaway here for us, the vol transmission mechanism for the market runs through the owners, not the instruments. As I just mentioned, in today's case, the owners are BDCs, not the banks themselves. So these idiosyncratic risks here are largely probably going to remain contained to BDCs.

But complicating matters, it's retail investors have increasingly prioritized liquidity over yield right now. Broad contagion risks? High yield and loans benefit from a higher quality of borrowers and structural stabilizers, and that basically helps to limit redemption runs.

So yes, will we have private credit defaults? Yeah, but probably will remain above public markets. But the ownership analysis is very important in understanding this transmission mechanisms, and we'll probably see specific BDCs forced to unwind.

But we expect this to, again, remain very idiosyncratic, very specific to the BDC vehicles themselves. The risk to creating a further, more systemic, wider, I guess, meltdown, so to speak, again, it doesn't seem like it's set up for that. And again, that 2008-itis, I think, is helping to perpetuate these concerns.

BRIAN HESS: Thanks, Jack. So you made a good case for why this pressure on private credit in the BDCs isn't necessarily a risk to the banking system or the financial system as a whole. How about the stock market? Is this a reason to be bearish on stocks?

There might be other reasons, the energy price shock, the slowing in the economy Garrett highlighted. How about the BDCs? Is it a risk to stocks at least?

JACK JANASIEWICZ: Yeah, I think the three risks that I outlined for the BDCs I think is applicable to the tech sector maybe, for example, or the broader market. You have the AI risks are concerns. Also have the higher-for-longer backdrop there. So I think you've got some of the same concerns that are plaguing both sides of the market here.

But BDCs being certainly a spillover risk to equities, I think that's going to remain contained to the financial sector. And that's as far as it will go.

BRIAN HESS: OK, and you just mentioned software stocks. So BDCs about a volatile year, but it's not been the only area of the market. Software stocks have been under pressure too with concerns about potential disruption from AI.

And so the result of that has been narrowing breadth in the technology sector of the market, with some winners but losers and a lot of rotation. Yet overall market breadth has definitely been improving, and there's been a notable leadership shift in the market overall.

So I think this will probably be our last segment we have time for. But, Garrett, I was hoping you could walk us through these crosscurrents that have been in place in the stock market since the beginning of the year and highlight what's been going on from a leadership and rotation standpoint.

GARRETT MELSON: Yeah, absolutely. I think it's interesting because it feels probably a whole lot worse than it is out there, and I think you could probably summarize that by just taking a look at the distribution of year-to-date returns. You take a look at a lot of last year's winners, and it's been a pretty rough year to start for those.

And so if you actually take a look, this is just every single constituent of the S&P 500 here, ranked by year-to-date returns from the lowest to the highest on the right-hand side here. And I think what's really stands out is you always see this dispersion. That's the norm for a market of stocks.

But the magnitude is pretty eye opening. You only have 23% of the index that's trading up or down 5% for the year. And as a result of that tug of war, where you have 77% of the index trading outside of that, you end up with a market that's basically fairly close to unchanged on the year. Obviously, we've seen that turn a little bit further south in the last couple of sessions here.

But it's a huge, huge rotation under the surface. And I think having exposure to those areas that maybe on the left-hand side, it certainly makes it feel a whole lot worse when some of these smaller constituents are on the far right-hand side. They don't necessarily have the same impact in terms of the broad market just because of weightings here.

And I think that's the takeaway to start the year is that some of the weakness within the growth complex and some of lingering AI concerns that have now morphed into AI disruption fears have really masked that broadening out that you've seen basically throughout the rest of the market here. So it's not just cyclicals that have benefited from that re-accelerating growth narrative early in the year.

But you can see defensive as well. And I think that's probably a byproduct of some of those lingering AI fears and maybe this being an area of the market that can hide out from some of those disruption risks here. Now, that said, I think it's really important to think about what really set the rotation in motion here.

And we've seen this broadening out really going back to the end of October last year. But I think it really kicked into high gear, really post the launch of Claude Cowork from Anthropic, and this vibe coding and AI disruption fears really took on a whole new life. And that's been a huge headwind for the software space here.

But if you actually look at a broader basket of areas that have really been punished heavily because of their association with being potential targets for AI disruption, you can see it's kind of been moving sideways for much of last year, and now this basket has just fallen off a cliff here.

So software is certainly a big driver of that, but it's not just software. Basically one week in February, we saw the market punish-- go door by door for all these different industries. On Monday, it was insurance brokers. Tuesday was financial advisory firms. Wednesday, it was commercial real estate brokers. Thursday, it was transport and logistics companies. And then, as you mentioned, basically any day that ends with a "Y" is targeting the software names.

Now, we've seen that alleviate more recently, but this certainly was the fundamental trigger. But we'd like to distinguish catalysts from the drivers of the move. And I think the big reason why the move had so much to it and so much runway is because of that initial conditions.

Again, coming back home to roost here, technicals were the driver. And when you take a look at the market, increasingly market structure has shifted where these systematic strategies that employ leverage tend to be the marginal bid in the marketplace. And so what you tend to see is these are momentum strategies, where they tend to add gross and net leverage into positions that have been working.

And so that helps to keep an upward trending market. It also helps to dampen volatility. Strong returns starts to lure in hot money and retail money, and so feeds on itself in this upward trending low-vol environment.

But that works until it doesn't. And so that tends to lead to episodes of crowding. And that means that you're setting yourself up for a much bigger reversal when that trend starts to shift here. And I think that's what you saw play out.

Take a look at the high momentum names here. So this is just looking at the percentage ranking of 65-day returns for high-momentum names versus low-momentum names in purple and then high-value or deep-value names versus not so deep-value names in light blue. They're basically the antithesis of each other.

Value became basically the anti-momentum because momentum was all about the growth in the AI and the tech trade over the last couple of years in here. And where did you enter this year? Well, basically you'd hardly seen better returns for momentum and hardly seen worse returns for value. And that's all you need to really, once you get a catalyst, to fuel a really sharp rotation in here.

So I think the narrative around AI was certainly the trigger. But the technicals, in our opinion, was the driver. But the tide's turning. And so when you think about what's been playing out over the last couple of weeks here since the end of February, you're starting to see a shift in the marketplace.

So basically some de-risking on both the gross and the net basis is translating to the winners so far this year turning into the losers. So all those darlings, new darlings in the defensive and the cyclical complex, with the exception of energy, no surprise there, has really come under pressure. And on a relative basis, the growth complex is actually holding up fairly well in here.

So again, it feels probably a whole lot worse out there when you look at some of the defensive and cyclical sectors that have sold off more meaningfully in March. And yet the headline indices are actually holding up OK because you're starting to see that rotation back into the larger weights within the growth complex that's helping to keep the broader indices buoyed in here.

And I think that's really the theme moving forward is you've seen certainly a shift in the outlook here, and now you're starting to see a rotation back into potentially the growth complex here at the cost of some of the winners earlier in this year. So I think this is probably a theme that has some legs, particularly as some of those growth risks start to grow, should we continue to see this conflict linger on.

BRIAN HESS: Thanks a lot, Garrett. And we did get a question on how the Natixis asset allocation targets have changed since the beginning of the year, and they reflected a lot of the comments we talked about today, where we maybe came into the year with a bit of a growth tilt. We recognized that rotation into value. We made some moves into emerging markets in other places.

But now we're potentially looking to go the other way and get a bit more defensive back into large-cap growth. So anyone interested in that, we just did a trade in our models on Monday and Tuesday of this week. We're working to get the trade rationale up on our website.

So if you go to the Natixis Investment Managers website into our Models section, you'll be able to see our monthly commentary, our trade rationale for the latest change, as well as the link to the podcast Jack and I do called Tactical Take, where we also get into a lot of these topics.

I want to thank everyone for joining us. I want to thank Jack and Garrett for the insightful commentary and the excellent slide deck. We wish everyone well, and we hope to see you again next time.

If you have any other questions related to what we covered today, please reach out to your Natixis salesperson. They'll be happy to help. Thank you again, and we'll see you next time.