Welcome to No More Risk Better, a Credit Sites Podcast. Across the global strategy team, we aim to make sense of the macro and the micro, highlighting opportunities and the risks facing the fixed income markets. As the macro makes headlines, we leverage our network of experts across fictions to better understand economic trends, rates, gyrations, geopolitical events, and how these factors impact corporates. At Credit Sites, we understand that credit investing comes down to picking winners to generate alpha and avoiding losers.
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Today, I am joined by Andy Beltan, who is the head of basics and infrastructure here at Credit Sites in Europe. And my name is Logan Miller. I am the head of European Strategy here at Credit Sites. So happy to be joined by my co-worker, who covers a wide range of sectors.
His team is responsible for a very long list of sectors and a number of credits that are highly sensitive to the cyclicality of today's global economy, and particularly as it relates to the potential for renewed tariffs by the US, these are sectors that are certainly going to feel some impact. Today, we'll dive into how we're thinking about the sector from an investment positioning standpoint, our recommendations across sub-sectors within the basic industry segment, as well as dive into the potential impact of tariffs, like I mentioned. So Andy, welcome to today's podcast. Thanks very much, Logan.
It's certainly a very interesting time to be a basics analyst. Mr. Trump is keeping us very busy at the moment. Yeah, there's no doubt about that.
And I think that certainly fits into some of the risks that we had mentioned in our 2025 outlook coming into this year. And I think for those of you who follow our research and saw our outlook from December, would have known that we came into 2025 with a rather defensive outlook for the broader European credit markets. We had come in with an underweight on the European IG side, and neutral weights on European high yield. And really, one of the key risks here is that we flag as the potential impact of renewed tariffs and what that would mean for broader risk sentiment, as well as obviously the fundamental impact from an earning standpoint and as well as margin.
So with that said, we are still continuing to strike that more defensive tone. Obviously, this year has been actually starting off on a pretty strong note with spreads continuing to grind tighter. But we do think we're nearing an inflection point where sector positioning and really analyzing the impact of potential tariffs is going to be a key theme to really drive performance for the rest of this year. So let's start off with diving into our underweight on basics.
Andy, I mentioned we have a more defensive approach this year on a sector basis. So how does this fit in with our recommendation on the basic industry sector? Yeah, that's a good point, Logan. I think from a defensive standpoint, I think you have to recognize that European basics is an incredibly economically sensitive and a very cyclical sector.
And it's those two issues that really drive our underweight recommendation combined with the fact that basics on average trades well inside the index and will be maybe less so at the moment than certainly we saw during parts of 2024. However, the underweight is also driven by, I guess you'll call it a sum of the parts approach because it reflects the underweights that we have on three of the constituent sub-sectors. That's underweights on building materials on chemicals and on metals and mining. And these three sectors account for about 3.6% of the BAMLIG index when measuring by market value and that compares to about 4.3% for the whole of basics.
So whichever way you look at it, whether it's from a top down standpoint or from a bottom up or some of the parts, I think we end up saying this is a very cyclical sector. And really we don't think that the compensation investors are getting at the moment is sufficient to offset the risks. Yeah, that's really helpful. So I guess in terms of the sum of the parts approach that you mentioned, can you kind of go through some of the key themes and sub-sector recommendations for 2025?
Like you mentioned, there's a whole host of kind of sub-industries within the broader basic sector. So how are we thinking about that from a sub-sector level? Yeah, absolutely. I think for European basics, the macro economy is the most important driver.
And we think that the macro situation is definitely going to dominate the headlines for the rest of this year, whether we're talking about the tariff debate itself, whether we're talking about the rate path, whether we're looking at the risks of inflation getting out of control and we end up with low growth and therefore speculation. And on top of that, I probably added Cherry in the form of China. Now I always go back to our head of metals and mining in the States when Lee and he has a catch rate, which I think illustrates the importance of China to his sector. And he has, as saying that when China sneezes, the metal sector catches a cold.
And I think that's a very apt illustration of the importance of China to that particular sector. And in the background, we have a risk of a sector allocation strategy across European basics. For my sector in building materials, Europe remains somewhat challenging from a construction macro perspective. We're only really expecting a growth of about 60 basis points in total construction activity this year.
And it's really only in 26 where we see a return to meaningful growth, which will be into the tune of about 1.8%. Now, the US looks a little bit more sanguine from a construction perspective, but that US kicker is not really big enough to move the needle at the level of the building material sector, although it does have an influence on our single name credit views. And this somewhat challenging macro act outlook is combined with a mid to high single digit spread discount to the wider index and that justifies the underweight. If we switch to chemicals and negative stances really dictated again by tight spreads, but also by a very challenging backdrop that includes a number of risks like weak global demand, high energy costs in Europe, geopolitical uncertainties, and of course, coming back, the potential risks of intensifying trade wars.
Switching to metals and mining, we actually dialed down our sector stance to underperform from outperform in December of 24. And that was really driven by the fact that valuations for what is a very high beta China centric sector are too tight to balance out the risk profile. Now, at that time, we were cautiously optimistic about industry fundamentals, but we did recognise that Trump's policies and the potential for higher US tariffs could have a negative impact on Chinese exports and of course, broader metals demand. Now, of course, events have moved on quite sharply since then, but more of that, I guess, in the moment.
Yeah, there's no doubt about that. I mean, it seems like every day or every hour waking up to new headlines and new situations to really unpack here. But I think that's a really good overview of how we're thinking about, you know, sub-initiaries within basics, but let's kind of dive into more. Now, what we're seeing in terms of the state of the sector as it stands today, particularly from a fundamental standpoint, so what are some of the key themes and performance drivers that we saw in 2024?
Let's start with that. Yeah, of course. I think last year was what we would call the year of elections across basics. Although we were still talking about inflation and the lack of progress in terms of getting rate drops for most of the year, it was really politics and the election cycle that was dominating the headlines for most of last year.
That said, chemicals did see some restocking issues after a long de-stocking phase that took place between the second half of 2022 and during the course of 2023. But certainly there wasn't as much as we had perhaps expected. And that was partly due to China worries, which of course also impacted on the metal space. Yeah, no doubt.
It seems like elections were obviously a key theme. And they're actually going to still probably remain a key theme. We obviously have the upcoming elections across Germany coming up on the 23rd of February, so just shorter than two weeks away. Certainly going to be a lot to watch out for there.
But turning back to basics. How are we, you know, obviously the credit cycle in basics is sometimes different than the economic cycle. You mentioned it's a very cyclical sector. So how are we kind of marrying up the credit cycle within your sector with what we're seeing in terms of the economic cycle, particularly where we're seeing pretty continued weak, persistent weakness across the industrial complex versus no continued resiliency within the consumer space?
Yes. And the way I look at the basics grouping, it's really essentially a materials processing group sectors. What we essentially do is we extract basic materials, for example, like metals, like pulp, like petroleum and rock. And we process them into materials like steel, petric, m's, paper and cement, and mostly for use by other manufacturing industries.
So as a grouping therefore, basics tends to be somewhat far from the consumer and much more aligned to the industrial complex, which is essentially its customer base. So the current weakness that we're seeing in manufacturing remains quite a significant issue. And as an example of that, we can look at the impact that we construction, but also more recently, a weak auto demand has had not just on chemicals in general, but also specific names like BASF and Covestra. Yeah.
So I guess with that weakness, are we seeing most companies continuing to kind of focus on boundary preservation? Or are we starting to see some animal spirits emerge and companies shift towards more growth and consolidation phase? I don't think there is a clear trend across basics as a whole. I think the answer very much varies by subsector.
Going back to building materials, which is Myspace sector balance sheets are in pretty good shape overall. And the larger stronger credits are seeking to improve strategic positioning through M&A whilst keeping shareholders very happy. That said, the modus operandi in Myspace is very much what I call portfolio churning. And essentially what this means is they're selling off non-sto-chiti parts of their portfolio at typically high multiples whilst reinvesting the proceeds in more attractive parts of the sector at lower multiples.
And CRH, the Irish building materials major which recently switched is primary listing to New York is the epitome of this approach. At the same time, and this is CRH is also a good example of this, the US remains very much in focus. And that's really driven by partly better growth prospects as I talked about in the previous answer for the US versus Europe, but also more attractive e-bit down multiples. And it's that kind of valuation premium which is prompting names like wholesome to reshape their businesses.
For those of you, those are the clients that don't know wholesome is actually going through a full demerge of its North American unit, which we expect to complete by the second half of this year. So that's building materials if we switch across to metals and mining. I think it's fair to say that there's definitely still a chase for consolidation and for what it's when the calls are chased to get green metals, but nonetheless, merges and combinations do tend to be equity funded in the metals and mining space. And I think that's partly because the big caps really do need to maintain a strong financial profile to act as a cushion against the inherent volatility of commodity prices.
If we think about chems, companies generally have remained reasonably prudent in the investment grade space, although we are seeing a lot more opportunism in high yield, both in terms of M&A, but also in terms of CAPX and in the autism very good example of that. At the same time, we have seen reports of potential disposals for names like Cabco, Nobian and Ital much, but I think the jury is out as to whether or not LBO activity is going to pick up again this year. Finally, in paper and packaging, there's definitely been a trend of consolidation since 2024. And of course, the Smurf it West Rock merger in July was a very good example of that as is international paper move in January.
And of course, many others fit that bill. And generally, we think that this industry consolidation will allow some rationalization of capacity as it becomes more evident we really need to take some supply out of the market. Yeah, that's really helpful, Andy. So now that we've kind of talked about the fundamental trends over the course of 2024, a little bit about the potential for some boundary consolidation as well as some sectors preserving their boundary.
So let's talk about what we see changing in 2025. What are some of the main fundamental themes that you're thinking about for this year? Yeah, sure, Logan. I think if we talk about fundamentals, I think it's very difficult to see substantive change from what we were talking about in 24, I guess the biggest change is maybe the scale of the conversation that we're going to be having on the impact of last year's elections.
And by that, I mean, of course, President Trump's election re-election into the US and the theme of 2025 for us is clearly going to be tariffs. And also the direct election risk we think is going to be lower geopolitical risk and the consequences, as I mentioned of last year's decisions in election terms, are going to drive credit risk we think pretty much across the basic space. And in particular, and to quote here a song by a young pop artist called Megan Trainer from about 10 years ago, this year is not so much all about the base, no trouble, as it is more all about the tariffs, much trouble. That's a pretty good one.
I think I may have actually used a title like that back at my previous gig. So kudos to that one. That was good. We always like to be inventive in terms of titles and credit sites.
It's one of the things as well as the content that we pride ourselves on. Of course. Yeah, definitely. Really the big key topic for 2025 beyond what you mentioned about fundamentals, but that is the potential for US tariffs on imported goods, particularly from Europe.
And obviously this has been highly talked about and highly debated over the last few months. Trump campaigned on implementing broad based sweeping tariffs on US imports, really globally kicked off this year with threats to tariff Canada and Mexico, as well as implementing a 10% based tariff on China. Obviously, that has been pushed out, at least in terms of tariffs on Mexico and Canada. Looks like the China tariff is going forward for now.
But nonetheless, I think really we've seen a ton of uncertainty around this, even this past weekend, which probably hits closer to Euro sector, Andy, the 25 base rate tariff on steel and aluminum, certainly the metals and mining complex will be impacted by that. But let's talk about, Andy, you published a recent note about the impact of tariffs, or at least kind of the read through for Euro sector. So why don't you give us a high level overview of your thoughts on tariffs under the Trump 2.0 administration? Absolutely.
Absolutely. And I think it's fair to say that across the European basic space, it's a little bit of a smorgasbord in terms of trying to assess tariff risks. So for example, at first glance, my sector building materials does appear very exposed, particularly if we focus in on what President Trump did in his first sort of go round with tariffs last week, which was the 25% proposed tariffs on Canada and Mexico. Now, obviously, we've got a 30 day postponement, but as far as I understand, as far as the market understands, it's only a postponement, no formal agreements have been made for the longer term.
And in the event that those tariffs actually do come back in, well, there it is, however many days we're left, then we think that could be quite a significant issue in, certainly in European building materials. However, I do draw a distinction between sector level exposure, the industry level, and single name terms. If I drill down into my building materials names, it's really only named two names that spring to my mind. One is Cemex, and the other one is Teetensoment.
Now Teetensoment is a very small Greek cement producer with quite a substantial, for its own purposes, it has quite a substantial exposure to United States. Cemex is well known for being not only the market leader in the Mexican cement market, but actually a pretty substantial player on its own account in the US. Cemex bonds in particular have traded off as investors have started to really worry about tariffs on Mexico, but we have to remember that exports actually only account for 5% currently of Cemex's Mexican cement production. And in fact, I was on the phone with the company earlier this week where they told me that AIM is to cut that to 2.5% this year in 25.
And that was a target even before tariffs were introduced. And that's partly because at the end of the day, domestic production is a lot more profitable than importing. And we have to remember that Cemex, as with a lot of the major cement companies in the United States, are actually foreign owned. So a lot of the US cement capacity is actually owned by foreign companies.
And what they're doing is they're bringing in cement tonnage to support their own customers. So it's not as if you're seeing imports coming in and kind of threatening domestic US cement prices. They're actually being used to basically serve what is a sold out US cement market. And that is pretty much the case, regardless of the source, whether you're talking about Canada or Turkey, Mexico, or even Greece as a source of US imports.
So essentially, any price hikes that might arise from tariffs on US cement imports would tend to increase domestic US cement prices in any case. So I think it's maybe a lot less of a headwind than you might think when you first start to do the work. Having said that, of course, we are pretty wary of any wider tariff in positions, particularly on things like the European Union, and obviously, they're the resulting risks of any wider trade war. And I think we also have to recognize the indirect impact.
So for example, tariffs on Mexico, not just on cement, but on a wide range of products, that could end up having quite a significant impact on the Mexican domestic economy. And that could have an impact on Cemex. So it's not so much about the exports from Mexico to the US that are important for Cemex. It's more about what may happen to the Mexican economy in general.
If we switch sectors to Cemmes, I think we're much more concerned about the impacts of high tariffs on China. And as I mentioned, we're building materials, any potential tariffs that President Trump may decide to impose on European production. I think it's better to say that US tariffs on Mexico and Canada, the Cemmes look much more manageable. If we get drilled down to single names, we see it's our match and Cabco is potentially the most exposed to the risks of US tariffs on Europe, as well as Sintoma in your group and ScienceCo, which we think are more in the firing line from any retaliatory tariffs that may be put onto US chemical production.
And of course, that would be the fact that in our coverage, most chemicals companies actually have access across regions, meaning that they could capture demand if there's any shifts between regions, although of course, more materials could end up getting more expensive than interrupt that flow. If we focus on paper and packaging, most of our coverage are based in Europe. And so they may not be able to recover the impact of any lower exports to the US with higher domestic sales, for example. All in all, we think that a broader trade war would definitely be quite bad for the economic recovery of China and Europe.
And this has clearly been an issue for the last two years, not just for chemicals, but also for packaging. And then finally, of course, in metals and mining, look, tariffs on Canada and Mexico and even the EU should not materially impact our coverage, primarily because they don't shift significant products from the European Union, Canada or Mexico into the United States. However, of course, as you've already mentioned, Logan, we are very much concerned about higher tariffs on China due to the fact that the European metals sector is very much China-centric. The way to think about it is that if steel imports into the US from China get too expensive and because of tariffs, then what often happens in 2018 is that that tonnage ended up being pushed over into Europe rather than being diverted to the US.
So that acted as a depressing impact on European steel prices. So within our European metals and mining coverage, we see names like BHP, Rio Tinto, Anglo-American and Glencore as being at the most at risk. And one point I should mention, this is not really my space because this is US, but the tariffs that Trump is talking about on aluminium and steel, in contrast to the European companies where it's bad, these are actually pretty good for our US domestic steel companies and my colleague Wenli has published on that a number of times. Outside of those four core sectors within basics, if we think about our construction and transportation infrastructure, we really think that these are reasonably well insulated from the impact of tariffs.
Yeah, that's really interesting. Sounds like there's actually no kind of one size fits all outlook for tariffs, a lot of moving pieces here, which potentially with some of this volatility really can create an opportunity at some point. But I think that's going to be critical, obviously doing your research and doing your work this year, trying to see what's moving under the hood. But obviously as a credit research analyst, you know, you're focused on sometimes more the downside risk than your upside risk as an equity analyst typically would be.
So I guess in terms of thinking about that potential risk, what sort of assumptions around tariffs are you using as a base case scenario that maybe perhaps investors could be looking to? Yeah, it's funny because I think we've been doing a lot of work on this since President Trump got back in. And to be honest, given the fast changing nature of his tariff playbook, particularly this time as opposed to 2018, it's really hard to kind of work out a base case. I think what we've been trying to do is focus more on, you know, what could be the worst case scenario.
Let's think about the reversals in Canada and Mexico. And although we could of course be back where we started at the beginning of March, assuming that some sort of more longer term agreement is not reached between those two countries and the US. But I think it's suffice to say that our base case is that investors really do need to price in some degree of tariff risks into what they want in terms of compensation from investing in the basic space. And if you look at where spreads have gone across European basics in a year to date, I think it's quite clear that the market does not appear to be pricing in tariff risks to any great degree.
And in relative value terms, this means that we are not changing any of our sector X across European basics. Luckily, our underperform recs on the basics as a whole, on building materials, chems and of course metals already pretty much align well with the risks of tariffs under Trump 2.0. But I think that the tariff situation has done as I guess it's improved our conviction over these sector ratings. Yeah, that's really helpful.
So I guess in terms of sort of thinking about the previous round of tariffs back in 2018 or at least the threat they're of tariffs. So can you draw any kind of parallels about what materialized back then under the first Trump administration to now what we're seeing in 2025? Yeah, it is tempting to try and look back at 2018 for some parallels. It's hard to draw too many though.
Apart from the fact that tariff risk means that that spread discount to the index that I talked about tends to strike a pretty even more discordant note than might have been the case. Remember in 2018, China and Europe were very much in the firing line, whereas in this time Trump appears to have started with his nearest neighbors, Mexico and Canada. That said, of course, the Chinese situation does strike a very much a 2018 called in the metal space and it does reinforce our view that the risk return equation in metals is not really fairly balanced and that in again sort of feeds into our underperform on the space. So we're struggling to find a complete kind of tariff playbook from 2018.
I think where we're trying to learn is the fact that A, the situation is fast changing and that B, we very much need to calibrate the situation on tariffs with what investors should be looking for in terms of spread compensation. Remember that basics as a whole in Europe trades very tight relative to the index. Yeah, definitely. I guess in terms of sort of the analyzing or assessing the impact is it, you know, you think it's going to be more of sort of an equity margin story or do you think we have potential to see some impact on credit metrics if, you know, sort of some of those basis assumptions that we've been talking about, you know, come to play?
Yeah. I mean, we talked, I've already had with that the bond market hasn't really started to price in tariffs to any great degree. I think it's fair to say that across basics equities have definitely felt more of the brunt of the tariff premium if you like. And some might say that the, you know, is the bond market a particular is the bond market in basics being a bit too complacent.
And I think it's fair to say that that argument does have some credibility. If we think about in terms of credit quality for us, M&A and shareholder value at the moment are proving much more important drivers of credit metrics at the moment, certainly than tariffs. We do see some margin impact in the different sectors, potentially much more so in say metals and chems. But really it's capital allocation that is much more a driver of balance sheet strength across basics at the moment.
All right. So let's assume, you know, you know, kind of the flat line tariff broad based across goods that are being imported in the US, I guess, in terms of thinking about what levers European companies might have. I mean, is there anything that investors should be considering there? Yeah, it's interesting.
I mean, we saw in 2018 that the metals credits don't really have much in the way of levels, but I think what the tariff uncertainty does underline is the sector's low leverage burden is appropriate. When you take into account the fact that commodity prices remain incredibly volatile and are likely to be even more so in the wake of any tariff based trade wars. If we think about my spacing building materials, it does benefit from the fact it's essentially an oligopoly. And you have, you know, the fact that cement prices tend to continue to rise, even when we see faltering demand, particularly for things like cement, that in itself is basically driven by the fact that you have two or three companies, or in most cases, four or five companies controlling the market and having, therefore, price setting abilities rather than being price takers.
If we switch to petrochems, the companies already tried to control what they could last time around, primarily for things like cost cutting, and some companies have really lost any financial flexibility that they may have had from the 2018-2019. And you can see that illustrated by the downgrade that we've seen in credit ratings for names like Inios, Synthoma, and of course, Chem 1, which is essentially knocking on the door of distressed territory. All right, so let's assume, you know, sort of the most bullish scenario, or I guess the most non-consensus view right now is that, you know, perhaps tariffs just don't even materialize, get nothing and, you know, continue on with, you know, the current, you know, trade environment. Would you be looking to get more constructive on basics going forward, or are there other considerations or concerns that you're worried about?
Just on basics as a whole, but also building materials. However, as long as spread remain as tight as they are compared to the index, it's really hard to get more constructive in terms of our sector stance. We really need, I think, a better balance between risk and reward to consider even moving back to a neutral stance, let alone if we're going long. I think on top of that, I'd probably say that Chem's packaging need a little bit more help outside of spreads.
They really need industrial demand to start to recover, particularly if we look at things like construction and autos, which seems unlikely to happen certainly in the short term. All right. So outside of tariffs, you know, what are some other themes that you're focusing on for 2025? I guess start off with how is, you know, M&A shaking out across the basic space?
Yeah, I think it's better to say that M&A in event risk in general is definitely the new black across basics, although it's not always a negative influence. If we start with metals, the race of consolidation that continues, whilst green metals like copper do remain attractive, although there has been a little bit of a rethink on coal, which whilst it doesn't have strong green credentials, it is actually very cash generative. Nonetheless, metals and mining M&A does, on the whole, tend to be equity funded, and thus that does tend to preserve the solid balance sheets that the sector really needs to offset the volatility of commodity prices. If we switch to building materials, large debt funded M&A has really fallen out of fashion in the last few years, and portfolio optimization, as I discussed earlier, we think will continue.
Names like CRH, Sankaban and Heidelberg are going to continue to make really small to mid-sized add-ons without really attempting to stretch their balance sheets. Semex, which has recently become a risen star, they're going to be a little bit more aggressive on aggregates and add-on businesses in the US this year, but they have a two and a half billion war chest to pay for that. And we don't think the Semex is going to really be willing to jeopardize its hard-line investment rate rating. I guess the one while Carly's wholesome, the proposed merger of its North American operations remains very much on track.
And the moment we're waiting to see not just what the opening balance sheets of wholesome North America and legacy wholesome look like, but also where debt might be issued going forward. In KEMs, the names have really been optimising the portfolios over the last few years. For example, we can expect some potential significant asset disposals from BASF this year. And as I've already said, some PE owners might look to monetise their past investments in names like Cabco.
In packaging, we do expect more consolidation and opportunistic M&A in general. Examples of that would be the French glass packaging producer, Veralia, which was recently targeted by the Mariah Salis family. And we think that that M&A in turn is going to drive primary issuance this year over and above refi. All right.
So let's move on to our final segment of the podcast, which is everyone's favourites. We like to leave investors with some picks and pans and favourite trade ideas. So why don't you kick us off with that, Andy? Sure thing.
And it's nice to say that even in a sector where we have underweight recommendations of the sector level, we do actually have the odd names that we like, more so in IG. Our investment grade picks include flight to quality trades like CRH in building materials and the French construction company, Vansi. But we also have value-driven trades like Semex in Mexico in building materials. Our Caymer in Chems and Anglo-American and Arsenal in Metau in metals and mining.
In the pans in investment grade, we do look at structurally tight names like Sangabani building materials and industrial gases names Linda and Ellicade. We also look at fundamental pans like, for example, Heidelberg materials in building materials. In high yield, it's very much harder for us to find single name value. And at the moment, we don't have any formal picks as such.
We would give an honourable mention to a company called SIG, PLC, which is a building materials distributor. It's currently trading about 10% in yield terms, but it's incredibly risky. On the other hand, we did like SIG on value grounds when they issued in October of last year. And although we've not yet converted that primary view into a formal secondary wreck, the value proposition has not changed since then.
In pans, we have federal gonian paper, we build in construction and Chem1 in Chems. And of course, Chem1 is underperformed majorly since January, very much in line with the sale recommendation that we have. All right, it's been really great, Andy. I know your team and yourself have a lot to cover this year.
I'm sure you'll be on top of it. And hopefully, you'll get you back on for another podcast when we start to learn more about what the potential outlook and the impact of tariffs might actually be once we have some more evidence there. But yeah, it's been great. Thank you so much.
And we'll wrap it up there. And see you guys on the next episode. Thanks, Logan.