Ep 67 | Gibson Smith | How Will the War in Iran Impact Bond Markets? | ROI Podcast

Gibson Smith, founder of Smith Capital Investors, discusses emerging risks and opportunities in the bond market amid heightened geopolitical risk, a new Fed Chair, and a fresh wave of borrowing for the buildout of AI.

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Transcript

Ryan 0:10

Well, there's a lot happening around the world today. There is an outbreak of war in the Middle East with Iran. We've got uh a new Fed chair that has been nominated and will likely, we think, be confirmed in the Senate later this year. And there's tens of billions of dollars being borrowed by hyperscalers. All of this has a big impact on the economy and on the markets. Today I'm joined by Gibson Smith from Smith Capital to discuss how this impacts the bond market and what you should be thinking about from a risk and opportunity standpoint. Thanks for joining us on this episode of the First Trust ROI podcast. Well, Gibson, I appreciate you uh accommodating us in your schedule for uh for taking some time out to discuss um what's going on around the world and how it impacts the bond markets in particular. Um I, you know, as a as an analyst, I've spent more time on the equity market than I have thinking about bond markets. Um and so I really appreciate your insights and um forgive me for for not knowing some of the things that maybe I should know related to the bond market. So I'm gonna keep things as simple as possible as we start off. But but uh again, appreciate you making it on the podcast.

Gibson 1:29

Thank you for having me. It's uh it's wonderful to be with you this morning.

Iran War Energy And Growth Fears

Ryan 1:32

Okay, so um we're recording this on March 11th. Uh, we're gonna post it on March 16th. So it seems like there's a lot going on in the world, things are moving quickly, and you know, by the time we post this in just four or five days, you know, maybe some of what we're talking about will be less relevant. And I say that especially with respect to the situation in the Middle East, what's gone on with uh with Iran and you know some of the other surrounding nations and in the conflict that has broken out recently this year. And I want to start there because that's where we're, you know, we get a lot of questions about what are the impacts on on stocks, what are the impacts on bonds. I think one of the interesting parts about our job as analysts and portfolio managers is we get to see real-world events discounted in the price of securities and get to see what um you know how things are impacted, maybe things that you didn't expect to be impacted are impacted, maybe things that you did expect are not as um impacted. And so uh let's start there. As you kind of think about the bond markets and the the flow through of of current events, of geopolitics, what is on the top of your mind? How how are you seeing um, especially the war in Iran, uh, impact your marketplace and and more broadly, how are you thinking about that?

Gibson 3:00

Yeah, it's a great place to start. And I I think the way you framed it is is really wise. When we go through kind of the events that we're focused on as it relates to markets, I think we have a list that's maybe 10 deep and it seems to grow by the day, whether it's Iran or Iran or AI or you know, the private credit markets or other areas in the market, which hopefully we'll touch on. But I I Iran Iran is is is front and center right now, and it's gonna be it's front and center for a while. Um what I'm finding very interesting, if we step back into December and then moving into January, the market was really framed around this view that economic growth was going to be in a good place and then start to accelerate as time passed based on the big beautiful bill, some lagged monetary stimulus hitting the system, and that inflation was going to come down. Um, once the spike in energy prices took place, the market immediately defaulted to concerns around inflation and started reflecting on the late 70s and early 80s about a repeat, shall we say, impulse from an energy shock. Um, we kind of went the other way in our mindset of thinking more about the economic impact of higher energy prices. Obviously, when energy prices are higher, it retards growth because consumption comes down. And that's really where we've been focused. Um I'm less concerned about the inflationary impact. I'm more concerned about the growth impact. Uh, although I have to be um really conscious around the kind of duration of this conflict, of this so-called war, is the longer it goes, obviously, the bigger impact. And I've been of the belief right out of the gate that um these things will have less impact on markets as time passes and things start to somewhat stabilize. I don't think we're gonna be out of this situation for a long, long time. You know, the market's kind of immediate response of this will be over in two weeks, I think is foolish. Um, this is gonna take some time. There's a lot at play here. Um, so we're focused on the uh the economic impact. Uh as of right now, I'm not very concerned. I think it's kind of a quick impulse, quick repricing of markets, a lot of volatility, which creates opportunity. Um, but I don't see it being necessarily a uh a real change in the inflation outlook, which is what the market's most concerned about right now.

Ryan 5:25

So um let me just paraphrase what I what I just heard you say. You you you don't you're not as concerned about inflation and therefore maybe less of an impact on what the Fed is able to do because of that inflation. Um, and and maybe I'm putting words in your mouth there, but but your greater concern is maybe it has a greater impact on economic growth as a result of an extended period of time that we're actually focused on the war. And of course, wars have high costs and they're unpredictable and they maybe slow down economic activity. Um so how do you think about um is there a direct linkage to that in terms of the types of securities that you're more focused on? Like what's the what's the flow-through impact on um on markets when it comes to the potential for slowing economic activity if the war should drag on, especially? Is there is there a you know a simple way to think about that?

Credit Spreads Rates And War Costs

What A New Fed Chair Changes

Gibson 6:27

Yeah, it's a very complex situation, and I don't think we can really think about this in a linear context that kind of if-then outcomes. I mean, there's a lot of, shall we say, spillover or compounding impacts on, in particular, the bond market. And I would say this somewhat biased in that I'm a fixed income manager, but I truly think the bond market is the most important market right now because we are working through an ongoing process of repricing the cost of capital in the system. And we all know what's happened with real rates. But the initial response of any time you have a shock to the system is that risk assets, defined as credit and or securitized mortgages, tend to the spreads tend to widen. And then you tend to see a flight to quality trade where the treasury market rallies. In this instance, um, things have gone the other way where we have had the spread widening, but we've had a spike in rates over the last two weeks. And I think some of the call it secondary effects of what's happening here is the bond market is looking through the lens of the cost of war, and ultimately that's going to lead to bigger deficits, which are going to need to be financed in the treasury market at a time when we have significant financing needs in front of us for this year, next year, and the year after in terms of treasuries coming due or maturing. So the market's initial impact is one of concern about the supply side, along with the inflationary impact that I described. Um, the truth is that when we fast forward three months, five months, six months out, and I look back, this is where I'm not complacent, but I'm less concerned about this having a massive systematic impact on the bond market and or markets in general. Again, I think things will ultimately kind of go towards a path of more predictability, more stability over time. And ultimately the backup in yields is likely a buying opportunity. We had the inflation data this morning. CPI came out this morning, and what was interesting was the headline numbers were aligned with consensus. But when you dig into the inputs into the CPI data, very similar to what we saw on the PPI data, they're moving in the right direction. So this post-COVID healing process, the post-COVID kind of normalization of inflation is happening. And I think that's gonna be net net a positive for the bond market. It will give the Fed the ability to execute on a lower interest rate campaign in time. It's not gonna happen quickly. I mean, some believe Warsh is coming in and he's just gonna start cutting rates, you know, right out of the gate. That's likely not gonna happen. He's gonna get the Fed reorganized and repurposed, and then they'll look at the economic data and make decisions as they see appropriate.

Ryan 9:19

Okay, so I'm glad you brought up uh the new incoming Fed chair. Um, I want to you know parse out some of the things you said, but let's start there. Um, the the the nominee for the Fed chair hasn't been uh confirmed yet. And uh I guess that's my first question. Is it um is it your expectation that confirmation won't be a problem? And then you know, what are some of your expectations for uh for Kevin Walsh as the new Fed chair? And and you know, will that be meaningfully different from what Jerome Powell did?

Gibson 9:50

Yeah, I think the market's anticipating it will be meaningfully different. And if we look back at Warsh's comments and his time at the Fed and kind of his philosophical views of how the Fed should be engaged in markets and what their so-called purpose is, um, it should be different. Um, I don't know if it's going to be dramatically different. We uh we can't really predict that yet. Uh, but we know that he is not a big believer in the use of the balance sheet, except in emergency times. And the Fed probably kept the balance sheet in place for longer than it should have. And I think there will be some new policy around the balance sheet. And I'd say one of my bigger concerns is that uh the Fed and the Treasury, um, they've been in line since the great financial crisis, but there's gonna be even greater alignment. And some of what the Fed has done in the past may be transferred to Treasury instead of the Fed, in essence, using that additional policy tool and more to follow on that as we get more transparency. But I do think the Fed's gonna be different. I think this is gonna be a restructuring or retooling. Um, I'd say the thing I'm I'm probably also concerned about is whether or not the Fed maintains its level of transparency. Um, I see Warsh as more Greenspan-esque than Powell and or Yellen or Bernanke. And so it'll be interesting to see how this all plays out. Um, as it relates to confirmation, um, every confirmation goes through the uh political theatrics uh that brings in kind of the uncertainty and whether they're going to be confirmed or not confirmed. I don't see anything on the horizon that should lead to, you know, Warsh not necessarily kind of being confirmed and getting the job. Um, obviously we're subject to surprises on that front, but the political theatrics will be entertaining at the least. Um, we all get the chance to watch politicians um question and kind of go after the Fed chairman. And uh sometimes it doesn't lead to a whole lot of confidence in our system. Other times it uh it brings a smile, and then other times you can see the seriousness of the politicians taking this appointment um really at heart and how important that role is. But I just don't, I just don't think it's gonna be a problem.

Ryan 12:04

Okay, so you were talking also about um funding of the government and Treasuries, um, you know, the Treasury Department needing to issue um quite a bit of of bonds. Um, you know, before COVID, we had these quaint little deficits of under a trillion dollars. And uh, you know, then we saw the massive blowout in uh multi-trillion dollar deficits during some of the the uh spending on COVID to make sure that you know everyone was able to uh kind of get through that, and you know, whether you think that's a good or a bad idea, um, many of those spending programs have continued, and I think you know, the the 2025 uh deficit, something like $1.9 trillion. I'm not sure what we'll have for 2026 and beyond. Um, so what are the impacts then on on demand for those treasuries? Are you know, is the Treasury, uh, US Treasury going to have an easy time um issuing uh debt given the the size of the deficits that we're running? And and um, I guess secondarily, if I can throw a couple questions at you, um, do you think at some point we start to see those budget deficits um start to maybe get a bit smaller?

Hyperscalers Fund The AI Buildout

Gibson 13:14

Well, that's the hope. Let me work my way backwards on your question. Um the the one thing about deficits is they're they're not um party party, shall we say, driven. Uh both Democrats and Republicans have become accustomed to running deficits. It's what we do as a country. And so you can't really look at that through party lines and that the Democrats are more aggressive than the Republicans. I think that uh that is uh just a fact and we have to deal with it. The question on the kind of risk of issuance of is there going to be enough demand for U.S. treasuries going forward to finance our deficits? I think in the environment we're in right now where you have actually yield that has come back to the bond market, you think about a four and a quarter, four fifteen 10-year treasury, a four almost and three quarter 30-year bond, you think about a two-year treasury that is just inside of 4%. And then you think about an inflation rate somewhere between 2.5% and 3%, you have reasonable real yield available in the bond market again. And so I think that will continue to attract capital. And with some of the uncertainty we talked about at the beginning of our time together, I think there is a general view that most investors are underweight fixed income after the last three-year experience. Um, and they're looking at a market that has maybe not as exciting returns ahead of it for the equity market or other segments of the markets. And I think money is going to continue to flow back into the fixed income space and there will be demand. The $64,000 question or the ultimate wild card is we have historically been dependent on the kindness of our trading partners and our neighbors to basically facilitate the borrowing needed by the U.S. government. Japan and China at the top of the list. We all know Japan is a very close ally and will likely continue to be a buyer of treasuries as they manage their currency in the global markets. China is the wild card. Uh we've instituted tariffs and trade tension in the system that is directed at China. Uh, they have reduced their holdings in U.S. treasuries over the last 18 to 24 months. We know that as a fact. The question is, will they once again resume buying of U.S. treasuries if we have some trade stability or you know, some outcomes that could be positive? Um that's something to keep an eye on. But as it relates to just net demand for the refinancing and financing the deficit, I am not concerned about it right now. Markets are fickle, that could change. There's a lot of financing needs in the markets today with all of the capex and investment that's taking place in corporate America on top of what's needed with the U.S. Treasury. So we're watching that closely, and I think it should be on everyone's radar here over the next six to 12 months.

Ryan 16:10

Yeah, I'm glad you brought that up because that was something else I wanted to talk about today. Thinking about all of the capex on uh you know, building out the AI infrastructure and the data centers across the country and and even around the world, um, you're starting to see more and more uh bond issuance and announcements for plans to borrow from some of the big hyperscalers, some of the big technology companies, where you know, once upon a time, those companies had a tremendous amount of cash flow that they could maybe make investments with. They were not necessarily as dependent on fixed income. That doesn't mean they didn't issue bonds, but but it seems like we're in a whole different environment going forward. So is is that um as you kind of survey the opportunity in the in the corporate market and the credit market, um, how does how does that increase demand for borrowing from from those big technology companies in particular? How is that going to impact markets as we think about that over the next few years?

AI Disruption Hits SaaS Credit

Gibson 17:14

Yeah, definitely a concern or a risk factor for markets, but let's let's take a step back and really remind everyone why they are borrowing. All right, there's there's two there's two phenomena here or two paths here. Number one, we published a piece uh back in December that we titled Don't Fight the Administration. And if we think about some of the policy positions of the current administration around the deductibility and the accelerated depreciation, there is an incentive for companies to invest and then ultimately to use the bond markets to borrow. Bessent was very clear about call it the re-leveraging or the use of leverage in corporate America to take advantage of the policy as well as the objectives of the administration in terms of reshoring and developing segments of our economy for national security. So that theme is going to be with us for the next three, four years. And the borrowing needs for corporate America are quite high, and they're incentivized to do this. Uh, the returns on invested capital are much higher than the cost that they will pay in the bond market. So we're gonna have this borrowing need with us for some time. As it relates to the hyperscalers, um, I don't think any of us can open up a newspaper or open a browser and look at the newspaper and not see the two letters AI. Um it is with us. It is going to be with us. It is one of the most dynamic technologies uh that we've seen, at least in my career and maybe in the last couple generations. So all of these companies are investing aggressively to take that leadership position because they see the opportunities, the productivity gains, the margin enhancement, the kind of ability to change the world as a core objective of the company. So Amazon, Microsoft, Meta, Google, they're all running very, very fast to be the leader in this area and ultimately will be the one that controls kind of the outcomes of artificial intelligence. This, in addition to what's happening in robotics, what's happening in nanotechnology, big data, other areas of technology technological advancement. So there's an enormous amount of funding needed needed in the in the system. Now, the good thing is when we look at just the hyperscalers, bringing it back to your question, the hyperscalers, they run the economy. I mean, it's really hard to imagine a world without Microsoft or Apple or Google, you know, or Meta or other companies that are really engaged in the AI space. And because they are such great companies, they're highly profitable. They have high margins, they generate an enormous amount of free cash flow. But the free cash flow they're generating and the cash on the balance sheet, they want that as stability. So they're going to come in and borrow and enhance that liquidity so they can make these investments. Um, as it relates to will the bond market um absorb it, um, Amazon did a $37 billion deal yesterday and it flowed through the market without without a wince. Everything went great. And I think there's ongoing demand for that paper the next day. So I don't see that necessarily as a big threat, but it becomes a threat if market liquidity is bad. So again, it's a day-to-day issue. And I think the folks that really need to borrow large scales of money, like an Oracle, you know, per se, they're going to be very sensitive to the market dynamics and make sure they, you know, price it on the right day at the right yield, uh, so that there is demand for it. But these are just dynamic times. Um, they're really exciting. It's fun to be in the bond market. Uh one of the things that uh we're talking a lot about, and this will maybe relate to your listeners. We we all know the Mag 7 are a massive influence on the returns and the kind of outcomes of the equity indices. Those Mag 7 companies are now becoming the largest issuers in the credit markets. So the dominance on those companies for returns in the equity markets are now becoming dominant in terms of the returns in the credit markets. And so what's happening is the headline indices that we follow in the credit markets aren't showing a lot of volatility because these are really high quality companies. But underlying, kind of under the surface of the headline indice valuations is some real tumult. There's some real dispersion building, there's a lot of variation, much more than we've seen in the last three or four years. So therein lies some just incredible opportunities for us as credit investors in the marketplace.

Ryan 21:48

So in the equity markets, in particular this year, one of the things that we've seen is investors are beginning to reckon on what the Disruption will be as a result of AI. And I think particularly of the software industry, we've seen a lot of these software companies where investors have begun to scratch their head and wonder well, you know, if if maybe Anthropic's clawed code can can do the same, uh provide the same service at a lower cost, why do I need the services from whatever the software company might be? And so you start to see investors questioning their margins. You start to see, well, maybe the multiples that you're paying for those, for the equity of those companies uh shouldn't be quite as rich as they once were. And so you've seen um price to earnings multiples come down. Um are you seeing something similar in the in the bond market?

Gibson 22:42

Yeah, the the credits of the the the SaaS company, the subscription um companies inside of the technology space, the bonds of those companies have been hit really hard. Um and we don't see a lot of that necessarily in the public markets. A lot of the borrowing is in the private markets. And again, we're reading a lot of headlines around the problems in private credit, uh the over, shall we say, lending or the high percentage of lending to these companies in the private space, you know, versus the public space. And that's gonna be with us for a while. Um what I find interesting is that once Claude introduced certain platforms, all of a sudden the market defaulted to this idea that these companies are all going away, right? That in some in some way Claude is gonna own these businesses just through its productivity and through what it does. I mean, almost an insane mindset, right? These well-established, fully ingrained companies are gonna go away. The reality is that many of these companies are going to thrive because they're going to be able to use this technology to enhance their businesses, largely enhance their margins, and then ultimately kind of drive maybe even a higher growth trajectory through the productivity of using AI. And I think the markets kind of missed this a little bit. There's going to be some really, really great opportunities for these companies in terms of, again, margin enhancement from the productivity gains. Um, we have, you know, two phenomenal programmers on our team that are building out our internal platform we call SmithX. And one of my analysts had the opportunity to sit with them and walk through how they're coding and how they're using some of the AI technology to help guide them. And they have told me the productivity gains are like 10x from using some of these advancements. They can be much more efficient and move a lot faster in their programming. And seeing that and hearing about it gives me a lot of excitement about the opportunities for, again, higher margins, maybe higher multiples, greater valuations. Now, are some companies going to go away? You bet. I mean, creative destruction is part of the process. The companies that aren't offering something that is unique, that is of value to the end consumer, that can be replicated through whether it be AI or some other form of technology advancement, they're going to go away. And the bond market will have to deal with that. They'll have to go through the restructuring process, through the default process. That's just that's how the system works. Our job as active investors is to find the companies that are going to thrive and to not own the companies that aren't going to survive.

Ryan 25:22

Yeah, I think that's such a great point. Um, because, you know, a new technology, what it's supposed to do, the the whole object of AI is to make things more productive and more efficient and to create this creative destruction that you mentioned. Um, if it doesn't do that, then what are these hundreds of billions of dollars being spent on building the data centers even for? Um, but I think your other point is also well taken that the indiscriminate selling, where you sort of lump a whole group of companies and their both their equity and their bonds together, um, and you decide to just, you know, shoot first and ask questions later, does provide opportunities. And so, you know, at First Trust, we we enjoy working with active managers in the bond market in particular, but across our lineup, we've got you know a mix of both active and passive, and subadvisors like Smith Capital have done a wonderful job in identifying opportunities and managing risks, and those are both uh, I think, equally important. Um, I I tend to think, um, and you know, Gibson, correct me if I'm wrong, I think of risk management in the bond market as being really, really important. Um, and and that's not to say, you know, you're you're not taking advantage of some of the upside, but as a you know, an analyst who's more focused on equities, I tend to think of if I'm gonna take risk and really bet on upside, a lot of that tends to come from from equities. But um when you have dislocations in the bond market, I can see you know taking opportunities there as well. Am I thinking about that okay?

Defensive Bond Positioning And Liquidity

Gibson 26:56

You you absolutely are. And you know, our process and our approach when we look at a company, we're not just looking at the debt of a company and determining whether or not it's you know of good value or it's going to create the right return per unit of risk and whether the ratings are right and so on and so forth. I mean, that's obviously part of our process, but we tend to look at the hump the company holistically and we think about it in the context of what is the management team doing with the debt or the money they're borrowing to make investments, and how is that going to enhance the value creation within the franchise, right? Companies borrow money for different things. Sometimes it's to build plants, sometimes it's to make other investments, sometimes it's to buy other companies and consolidate them in for greater efficiencies. Sometimes they borrow to buy back stock because their stock is cheap and they think it is obviously worth more. So our job is to look at the company in a holistic way and ask the question: is the management team utilizing its balance sheet to create the most value for the equity holder? And if they are, we want to be in alignment with that because it means that the bonds will, in essence, do better or have greater protections as they move through the economic cycle. So it is it is interlinked. And I think any fixed income manager that doesn't pay attention to the overall business or the holistic business and thinking about value creation, thinking about margins, thinking about how the company makes money for its investors, you're missing the point. You are basically lending money to a management team to make decisions. And if you're not doing that, you're doing it recklessly, in my opinion. So risk management, understanding risk, focusing on the math behind the market, really making sure you take the complexity of the bond market and make it simple is really tantamount to being successful in fixed income investing, in my opinion.

Ryan 28:55

Okay, so let's uh let's talk more about that because uh again, you're an active manager, you have a few different uh or maybe several different mandates that you pursue. Um, but I think it all kind of flows around your philosophy and the way you think about managing through periods of time where there's more volatility and you have to manage risk and take advantage of opportunities. Um, so in this current environment, take us through sort of a high level. Um, how are you managing through this uh this volatility, this uncertainty today, and you know, thinking about that for over the long term, how does that apply?

Midterms Policy Risk And Market Volatility

Gibson 29:31

Yeah, well, let's go back to the the base philosophy and process. Um, we believe that markets move through cycles. And there are points in the cycle where, as fixed income investors, we are paid to take risk. And there are other times in the cycle where we are not paid to take risk. And so we define the time where you're really paid to take risk as opportunistic, and then you have neutral in the middle. And then when you're not paid to take risk, uh we call it defensive. And the way to think about it is that in opportunistic, we're very focused on return seeking. We're being paid for taking the risk, and in times of being defensive, we're really focusing more on protecting capital than return seeking. Um, right now, we've been and have been for the last 24 months in a more defensive posture. Uh, the math behind the market doesn't show that it's a time to be taking significant risk. It's a time to be focusing on capital preservation, be very disciplined, take risks that are appropriate for the current valuations. And it's to be very patient and let the market come to you. If I think about our prior comments around dispersion, go back to 2025. There wasn't a lot of dispersion in the credit markets. You know, triple Bs all traded at the same spread, low triple Bs all trade at the same spread. Fast forward today, now you see a lot of dispersion or different valuations among the different companies that are issuing in those different rating categories or different segments of the market. So that's where we shine in terms of our security selection and security avoidance. So going back to the philosophy and process, we generate returns by security selection and avoidance and what we call sector rotation, which is managing the risk as we move through the cycle. Um, so go to where we are today. Let's let's fast forward to today. What are we doing? Um we're in defensive positioning and we have three core themes uh across all of the strategies that we manage. Number one is to participate and protect. When we look at the market today and the yields that are available, um, the real yields that I talked about earlier, they're very attractive. We haven't seen these types of yields in some time, really in the last three years, and coming off a very difficult time for the bond market, you know, the three years prior. So this is this is an interesting time in terms of the ability to generate some good returns in the bond market without a lot of risk and volatility because of that yield component. So participate and protect is one of our key themes. A secondary theme is heightened levels of liquidity. As we're talking about all the uncertainty and the volatility in markets and the volatility creating opportunity for us, we want to have heightened levels of liquidity in our portfolio so we can take advantage of it. You know, when bonds reprice, we can go in and buy them and use that as an opportunity to enhance the returns for our investors. And then the third theme I kind of hinted at at the beginning of our conversation in that this idea of respect the administration. When you have an administration that controls the White House and Congress, they're able to move and they're able to move quickly in terms of policy change. We all know that. So my thought on this is don't fight it. You know, don't fight it. Understand what the agenda is, respect it, and then relate it to what's happening in markets and how we can actually generate returns and produce results for our investors. That means we have to be very discriminant. There are some things you don't want to own, and there are other things you really want to own. You know, for example, the tailwind in the in the defense sector is a great tailwind with what's going on right now. Those bonds are doing particularly well. Where other segments like food and beverage, particularly with the focus on processed foods, are really struggling. So there's times or places in the market you really want to be overweight, and then other areas you don't want to own at all. That's how we think about it. We really take those themes, we apply them to everything we do across the different strategies, and really focus on a disciplined approach in terms of generating risk-adjusted returns and preservation of capital.

Ryan 33:43

Um, I'm curious about that last point that you made and you're laying out of themes, respect the administration. Um, so none of us really knows what will happen in the midterm elections this year, but there are midterm elections coming. And I'm curious, you know, if if the elections in the midterms end up moving against the Republicans, and let's say the Democrats take the House and we have divided government, um, does that impact the way that you then position portfolios in that sort of third point in terms of kind of respecting the administration and thinking about positioning in um or not fighting the administration? Does that change your thinking at all?

Gibson 34:23

It it does. I mean, it absolutely does. And I think the consensus view right now is that the Democrats will take over the House as we go through the midterms. As you said, we don't know. We'll have to see. I mean, some of these things are real-time in nature, as most people vote party line, you know, most of the time, and then the minority actually determines the outcome of uh the elections. But we are we are watching that very closely. Um my thought on this is that when you have control of the House, White House, and Congress, you can implement policy, and that policy gets implemented quickly, and it can change the outcomes within markets very, very quickly. So respect it, don't fight it. If we move forward, and it turns out the Democrats do take the House, and we have, shall we say, more balanced government in Washington, that is generally a pretty good environment for markets because you have kind of a stalemate. And that allows for markets to function, shall we say, without the heightened volatility of just one side leading the direction of the political outcomes in terms of policy. So I it will change our view. I don't think it will change our theme of respect, the agenda. And I should say this, I don't come to the equation, you know, whether you love Trump or you hate Trump, whether you're a Republican or you're a Democrat, I really don't care. What I do care about is what's the policy position and how this is going to impact the markets and then how we can take advantage of it. So we really focus on keep your opinions in your in your back pocket for right now. Let's focus on the facts, let's focus on what's playing out, and let's figure out how we can make money for our investors in the context of the agenda and how this, you know, how this should play out in markets. So we'll see how it plays out in the midterms. It's gonna be another volatility factor for all markets. Um, it's gonna be day-to-day. Unfortunately, for all of us, it means that our our advertising on TV while we're watching shows or games or golf or whatever it is gonna be polluted with political ads again, which few things enrage me more than uh than the noise on the TV during that period of time. So it's coming.

Ryan 36:29

Yeah, no doubt. Um okay, so shifting a little bit, um, as you think through the different types of fixed income securities, whether it's mortgages or credit or you know, treasuries, um, a lot of different fixed income sectors to consider. Um, are there any that that jump off uh jump out at you where you're thinking about valuations, maybe you're more attractive or less attractive?

Private Credit Risks Illiquidity And Defaults

Gibson 36:54

Yeah, I mentioned defense has been an area where we've been significantly overweight across all of our strategies. That's worked out really well. Um we have started a process of considering, you know, lightening up on defense and moving into financials where we think there's some deregulation coming that's going to be very positive from a, shall we say, revenue and cash flow generation within the financial sector. Um, you know, there's uh a construct underlying the big beautiful bill of a support system as it relates to economic growth, as we as we somewhat referenced earlier. Um, the outlook for growth is pretty stable and it could accelerate if things play out in a positive way, particularly if things in the energy markets calm down here a little bit. And so we have been slowly adding cyclical exposure, whether it be through autos or industrials. We've done an enormous amount of work in chemicals, not quite there yet on the chemical side, but um there's going to be those types of opportunities to take advantage of. And what we really want to do is focus on where the economy is going and where the greatest leverage exists within certain sectors. And uh that's where we are right now. Um, one of the areas that's getting a lot of our attention is the retail side of the business. Um, retail sector is really ripe for some outperformance if the consumption that is expected based on the tax refunds and some of the stimulus in the system, it should do really, really well. Um, we don't have high conviction on that right now. And we've got some small exposure there, but it's an area that I'm watching very, very closely in terms of potential ads in the future. And then lastly, I'll just say, you know, we can't talk, we can't talk about uh you know sectors without bringing the elephant in the room to the table, energy. I mean, the elevated oil prices that are an outcome of what's happening in the Middle East are really, really good for domestic producers. The drill baby drill mandate as part of the administration is playing out. And these higher prices are actually a gift to our domestic producers. And it's gonna make them even more profitable, it's gonna make them free cash flow even more than they are expected to. And so there's gonna be some just incredible opportunities within the energy space, even if oil comes back down to the 60, you know, 65 uh, you know, area from the elevated you know, 85 to 125 that we've seen over the last week. So can't lose sight of that. The energy sector is is really, I think, being positioned here in the near term as an opportunity, and we'll see how that plays out.

Ryan 39:27

So, Gibson, what about the private credit market? There's been a lot of uh a lot of discussion about kind of what's going on there. I'm curious if you have any thoughts and uh perspective to offer on private credit.

Career Curveball And Closing Thoughts

Gibson 39:39

Yeah, well, go if we go back and we we ask the question, why does private credit exist? Private credit was an outcome of the great financial crisis where the private equity firms filled the gap on the areas that the commercial banking sector could not participate anymore. And it created this wonderful lending opportunity where they were able to take advantage of lower quality borrowers that needed financing that could not easily tap the debt capital markets to get the financing. So, in filling this gap, they were able to create a lot of higher yielding, in essence, kind of free lunch type opportunities because of the regulatory environment. Now, because of the growth and capital moving towards private credit, all this money flowing into the space, everyone getting excited about these higher yields that were available, that excess capital chasing yields led to some poor underwriting standards. It led to some, I would say, we're learning today, reckless lending. So we're in the early stages of what looks like a normal credit cycle, where some of the companies that borrowed money shouldn't have been borrowing money. Some of the folks that were lending the money shouldn't have been lending that money. There's a little fraud in there. There's a little, you know, shall we say, uh, natural selection of lending to bad companies that has to play through the system. I think this is gonna be a source of volatility for the next nine to 12 months. And to think that we're not gonna see restructurings and defaults and some more headlines around this would be foolish. Um, it's coming. The I I said I've said this over the last few years. Many investors look at private credit as this independent segment of the market versus the public credit markets. But they're credit. Credit is credit. It doesn't matter if it's public or if it's private, it is credit, and in credit reacts a certain way as we move through a cycle. So I think there's some problems ahead on the on the you know private credit uh front. Do I think it's systematic? Probably not. Do I think it's gonna create some volatility and some opportunity? I do. Um, do I think the private equity firms will deal with this and deal with this appropriately? I there's no doubt in my mind. But I think for most investors, they have to ask a fundamental question about private credit. And that is, are you comfortable with illiquid securities in a structure that is priced minute by minute or day by day? And that you have limits on the amount of liquidity that you can get out of that structure. And you have to ask yourself the single question of am I being fairly paid for that illiquidity and for capturing that capital? Um, I can't answer that question for every investor. All I know is it's a risk factor that you have to consider.

Ryan 42:23

Yeah, it's uh it's interesting. It all comes back to uh risk compensation. And you've talked about that a couple times in uh our conversation today. So uh I think that's that's a good place to uh maybe wrap things up. I do have one more question for you. You know, I'd like to throw a curveball at the end of the uh the podcast. Um, and uh so here's my curve ball for you today, Gibson. Um, and and uh, you know, there's a couple different ways I can go with this. Um I'm gonna I'm gonna ask you um as you think about, you know, you're you're a portfolio manager, you've been very successful, you've built this this big business. Let's say that early on you decided to go into a different industry or a different type of business. Where would Gibson Smith be? What what what would you be doing if you were not in the financial industry?

Gibson 43:16

Gosh, it's such a great question. I wish you could ask my team and do a survey on that and see the results. I uh I I I think when when all is said and done, it would be something in serving or helping people. Um I uh spend a lot of time in the leadership uh kind of studies and culture studies and people studies and personality studies. And I don't I don't know what the exact role is, but it would be something that was really working closely with particularly high performing people and helping them achieve even better results and kind of build businesses or build better lives and so on and so forth. I uh I I'd be ridiculous to say I'd wanna be a Tony Robbins because I just don't want to be in that segment of the marketplace, but Boy, if I could find a way to help people in a more broad-based way and help people be more successful and more content and more happy, that's probably what I would be doing besides managing money. But don't read anything into this. I love what I'm doing. I I am obsessed with the bond market. I said probably my second or third favorite thing in my life away from my wife and my kids. But uh I love what I do and I get I'm very fortunate in running a company that I get the ability to do what I love from a career standpoint and being engaged in asset management, investment management, and I get to work really closely with my team and building both their personal and professional skill set so they can advance in their careers. And so I get a I get a little taste of both of them in my in my role at Smith Capital. So it's a great question, Ryan. I uh again, I wish I could survey my team and get the response from them. Be interested to see what they say.

Ryan 44:51

Well, it rings true, and and uh, you know, maybe I should I should tell you in advance when I'm gonna ask you these questions, but uh, you know, it's kind of fun to do it the other way as well. One of the one of the purposes in a question like that is that it does kind of reveal um how you think about what you do. Um even though I'm asking you what you know what what it is that you would do different if you weren't in this industry, I think it reveals some of what you enjoy doing most in your current role. And in you know, you're you're managing money, but at the same time, I think you're you're trying to achieve, help, help your team um, you know, function at a higher level and and kind of acting as uh you know as you're lending capital to businesses, you're helping them to uh hopefully um be able to level up what they're doing. Um so, anyways, um enough of my philosophical meandering. Um I I do a pa I do appreciate you uh coming on the podcast. Um, you know, usually we try to do this in person, but um, you know, there's a lot going on in the world, and it wasn't possible for us to be in the same place. But I'm hoping next time either I can make it to Denver and spend some time with you and your team, or uh maybe you can make it out to Chicago or somewhere else. But um once again, uh appreciate you coming on. Thank you for all of your insight and all your comments.

Gibson 46:13

Well, I appreciate you and thank you for accommodating this uh, shall we say, online interview, allowing me to stay in Denver and be focused on markets and focused on my team and uh our investors and everything else. I can't wait to see you face to face. All right, whether it's in Denver or it's in Chicago or someplace else. Uh thank you for the grace. Thank you for having me. And uh I hope, I hope that markets calm down here a little bit. And uh next time we're talking, we're talking about exciting things in the fixed income market. But again, thank you for having me. I really appreciate it.

Ryan 46:43

All right, thanks, Gibson. Uh, and thanks to all of you for joining us on this episode of the First Trust ROI podcast. We'll see you next time.