Credit, China and AI: Underappreciated resilience

As an investor, it pays to watch for signs of fragility in the economy and markets.

Such vigilance – paired with appropriate action – can help mitigate some of the risks that come with long-term portfolios.

Lately, though, various fragility narratives may have gotten out of hand. 

Private credit is a case in point. The September bankruptcy filings of two US auto-related firms triggered losses for banks and private credit investors. 

The private credit market – where the likes of private funds and asset managers lend directly to companies – has grown rapidly in recent years.

There are now fears lenders may have granted lax terms, with investors not understanding the risks. So, is another credit crisis in store?

We believe not. Despite persistent chatter about cracks in the credit markets, the data tells a steadier story.

Lenders have focused more on stronger borrowers and lent less aggressively than they did ahead of the Global Financial Crisis (GFC). 

Current loan-to-value ratios in private credit are about half what they were in the run-up to the GFC.

We have also heard few signs of systemic stress from company management teams in their third-quarterly earnings calls.

Admittedly, share prices of companies that have considerable private credit portfolios have sold off. However, the correction has been orderly rather than panicked.

Meanwhile, BlackRock and Blackstone, two of the biggest players in private credit globally, have reported strong portfolio performance. This suggests most loans are in good shape, with borrowers able to meet their obligations.

Our colleagues at Citi Credit Strategy think this credit cycle has further to go – i.e., with positive return potential for investors for now.

So, despite all the recent chatter about credit fragility, we don’t believe this is a 2008 or 2020 situation.

The boom in artificial intelligence (AI) is another focus of fragility narratives.

There are suggestions that the massive buildout in AI infrastructure has gone too far, too fast.

What’s more, some believe that lofty valuations in many AI-related equities represent a bubble.

Again, though, we see promising indications of resilience rather than fragility. Productivity gains from AI are more than mere promise – they’re already here and may soon accelerate.

Over the last two years, US tech companies have maintained or reduced their headcounts even as their output and profitability rose.

Jensen Huang, President and CEO of NVIDIA, recently said that all his employees now have their own AI agent.

The beneficiaries aren’t just tech firms. United Airlines expects to trim its workforce by 4% next year thanks to AI efficiency gains. And at insurer Marsh McLennan, GenAI tools are handling over two million queries a month. 

Put simply, we believe the AI revolution is entering the “payback phase.” This is where all the heavy capital expenditure (capex) on chips and data centers starts to provide tangible benefits.

One result is the US is moving further ahead of the other G7 countries: Canada, the UK, France, Germany, Italy, and Japan. That said, we expect progress elsewhere too. 

For example, Japan’s new government looks poised to turbocharge automation and investment in robotics to offset labor shortages – a structural play we are watching closely.

Against this backdrop, we see heavy US capital expenditure (capex) continuing. Corporate intentions support this view.

The National Association for Business Economics tracks the percentages of businesses planning to increase and decrease their tech and communication services capex minus those planning decreases in the coming three months.¹ The gap between the two groups is at its most positive for a decade.

For several years, China’s real estate market has languished. Once a major driver of the country’s growth, housing now represents a significant source of economic fragility.

Many investors remain fixated on this and the country’s anemic consumer activity.

However, we see the Chinese economy as undergoing a major transition from bricks to bytes.

Digital innovation is flourishing in China. The authorities’ stated goal is for the nation to become economically self-reliant and a global “digital powerhouse.”

Optimism here is powering the rally in Chinese equities. Of course, there are still many skeptics, unsurprisingly given the many false dawns since 2021.

We would point out that over 60% of the MSCI China Index is exposed to technology – via Consumer Discretionary (30%), Communication Services (23%), and Technology (8%). 

These sectors are posting the strongest earnings revisions ratios in the region, particularly relative to real economy sectors impacted by deflation and overcapacity.

The Chinese equity rally may thus have staying power, in our view.

With credit, AI and China more resilient than many appreciate, we are positioning portfolios accordingly.

Credit remains a cornerstone for income-seeking portfolios. We remain anchored to up-in-quality exposures. But we also believe that today’s rich valuations in lower-quality credit may not adequately compensate investors for risk.

Given the transformative potential of AI and the likelihood of continuing heavy capex, we remain keen on the equities of AI-linked companies that offer high quality, secular growth. This means the more profitable, cash-generative players with stronger business models. 

In addition to high-quality US assets, we favor Chinese equities for AI-driven growth and regional diversification.

At the same time, we seek portfolio diversification via gold. We do not think its recent selloff reflects worsening fundamentals. Instead, we see this as a technical pullback after exceptionally strong gains in the first nine months, with October having been a seasonally weaker month for the metal over time.

In the medium term, we expect global central banks to keep shifting their reserves into gold and reducing US dollar holdings. Likewise, many governments’ persistent deficits also boost gold’s appeal.

Amid misplaced fears of fragility across these spheres, we therefore seek opportunities to build more robust allocations.