A credit investor’s perspective on inflation, fiscal policy, and AI

In this wide-ranging discussion, Investment Director Paul Skinner sits down with Fixed Income Portfolio Manager Connor Fitzgerald. Together, they explore the forces shaping the economic landscape today, from the inflation outlook and the evolving role of fiscal policy to the transformative impact of artificial intelligence on markets and corporate behavior. Connor shares his perspective on where opportunities and risks are emerging across fixed income and what it all means for investors positioning their portfolios in an uncertain environment.

What is driving inflation right now, and what does it mean for investors?

Heading into this year, inflation had been gradually cooling while the jobs market showed signs of stabilizing. Then the situation with Iran pushed oil prices higher, putting inflation back in the spotlight.

The good news? Today’s inflation levels are nowhere near the 4% – 6% we experienced in 2022. We still believe the broader forces in the economy are pulling inflation lower over time, but higher energy prices are creating a near-term headwind. For the US Federal Reserve, this likely means staying on hold for now, waiting for more clarity before making any moves on interest rates. Markets are already pricing in much of this uncertainty.

How strong is the US economy right now?

We see what we would describe as a two-speed economy. On one side, the artificial intelligence buildout is powering a remarkable wave of investment that should support growth for some time. On the other, years of cumulative price increases and a softer jobs market are weighing on everyday consumers, particularly those in lower-income brackets.

The bottom line: Growth should remain solid for now, supported by AI-related spending and the tail end of government stimulus. But the picture is uneven, and that unevenness matters.

Government spending has been a big topic. Where do things stand?

Government spending has been an unusually powerful driver of economic growth over the past few years, even at a time when the economy was already running near full capacity. We believe this fiscal boost has been the key factor pushing both growth and inflation above their longer-term trends.

That boost is peaking right now. The maximum impact is being felt in the first half of this year, turning neutral in the second half, and potentially becoming a drag on growth early next year, unless new spending measures are passed. Given the current political landscape, passing additional stimulus could prove difficult. History offers a useful parallel: After the 2010 midterms, a shift in Congressional power significantly curtailed government spending, and the deficit shrank quickly.

We are not predicting any specific political outcome, but the direction of fiscal policy is something every investor should be watching closely.

What about housing and population trends?

Put simply, housing is unaffordable for many. Home prices are still rising at the top end of the market, but for most buyers, prices are starting to soften. Rents are following a similar path.

Why does this matter? Housing-related costs make up roughly a third of the Consumer Price Index, the main measure of inflation. If rent and home price growth continue trending toward zero, that alone could reduce inflation by 80 – 100 basis points, a meaningful shift.

On the demographic front, population growth has slowed sharply, from its fastest pace in 25 years to one of its slowest. Since economic growth is essentially population growth plus productivity growth, this is a headwind for the economy and a further force pulling inflation lower. We expect this dynamic to persist for at least the next two years, which should also help bring housing supply and demand into better balance over time.

Everyone is talking about AI. How is it really affecting the economy?

This is one of the most fascinating debates we are having at Wellington. Economists point out that technological revolutions have historically created more jobs than they have destroyed. But when we speak directly with large companies, the message is remarkably consistent: They want to grow profits by 30% – 40% over the next five years while keeping their workforce the same size.

That is a telling statement. It suggests that even in a good economy, companies are unlikely to hire aggressively, and if conditions worsen, reducing headcount will be their first move.

Over the medium term, we believe AI will be a powerful source of productivity gains, enabling businesses to do more with less. While the current buildout phase carries some inflationary elements, think of all the physical infrastructure being built, the longer-term effect should be disinflationary. The pace of change continues to surprise even the most optimistic forecasters, and we expect that to continue.

With all of this in mind, how should investors think about bonds versus equities?

The story we have laid out is, in many ways, supportive for equities. A better productivity outlook translates into healthier profit margins for large companies.

But here is what has changed: The income available in bonds is meaningfully higher than it was for most of the past decade. Investors can now build a portfolio yielding 4% – 6% with a sensible level of risk, something that simply was not possible during the era of ultralow interest rates.

We still believe strongly that government bonds can protect portfolios in a downturn, provided growth and inflation move below trend. Rather than reducing equity exposure, our view is that investors should consider shifting some cash into intermediate-duration bonds to add both income and resilience. Think of it as building a more balanced portfolio, not choosing one over the other.

There has been massive borrowing by big tech companies. What does that mean for bond markets?

The scale is significant. We expect the large technology companies, often called hyperscalers, to raise anywhere from half a trillion to a trillion dollars in the bond market to fund their AI infrastructure. Most of this borrowing will be in longer-dated bonds.

For the past few years, the investment-grade bond market has seen very little new borrowing, which has been one reason credit spreads, the extra yield investors earn above government bonds, have stayed tight. That is now changing. We do not expect a dramatic blowout in spreads, but we do anticipate that excess returns on longer-dated bonds will be eroded as the market absorbs this wave of supply.

This is the largest corporate investment cycle we have seen in our careers. For investors, it means being thoughtful about where you take credit risk and favoring shorter-duration positions while the market adjusts.

What is your view on private credit?

Private credit has grown enormously over the past decade, stepping in as the primary lender to small and midsized businesses as traditional banks pulled back after the global financial crisis. It has become a significant part of the lending landscape.

However, the sheer volume of capital flowing into the space has compressed returns and, in our view, modestly lowered lending standards. We do not see private credit as a systemic risk; the structure of these funds does not lend itself to the kind of sudden withdrawals that can destabilize banks. But we do think returns going forward may not be as attractive relative to public bonds as they have been over the past five to 10 years.

Private credit remains a sound asset class, but investors should temper their return expectations and weigh the trade-offs carefully.