The real economy is starting to show serious signs of weakness, even though financial markets continue to view it as merely a minor hiccup. On both sides of the Atlantic, manufacturing and industrial indicators are losing momentum. In Germany, industrial production fell by more than 4% in August, weighed down by an automotive sector that plummeted by nearly 20% over the month. Across the Atlantic, the Fed is increasingly concerned about the risks to employment, while remaining worried about inflation : it is cutting rates by a quarter of a point but warns that it is “not sure it is done” with price rises...

 

This slowdown, initially concentrated in cyclical sectors—led by the automotive industry—now threatens to expand. In this paradoxical context, equity markets continue to climb, convinced that central banks can only ease further. Equity allocations are rising, while bond allocations are falling to their lowest levels since the end of 2022, as if risk had disappeared by decree. The euphoria is such that investors buying European equities today are betting on already hypothetical growth in 2026, even as production and employment figures deteriorate. The more the economy slows down, the more valuations climb. We can return to the traditional market adage: “bad news is good news” because investors imagine that central banks still have margin to lower rates.

 

This is particularly true in the United States, where the onset of a recession would undoubtedly trigger further significant rate cuts and where every dollar injected into the economy is relatively quickly channeled into consumption and investment. This is somewhat less true in Europe, where inflation is imported, rates are already lower, anticipated rate cuts are already significant, and the weight of debt and budget deficits makes any stimulus policy lackluster. The only ones really benefiting from liquidity injections or rate cuts are over-indebted governments, which can issue bonds without borrowing costs weighing too heavily on their budgets. Real economic actors remain stifled by political, social, and fiscal pressures and by a lack of economic dynamism.

 

And on the ground, cracks are appearing. First Brands, an over-indebted American automotive equipment manufacturer beloved of private debt funds, collapsed amid the usual sudden uproar surrounding opaque structures and “innovative” cash flows. The company filed for bankruptcy at the end of September with more than $10 billion in debt and a $2.3 billion accounting hole. As usual, the most prestigious and supposedly most technically advanced institutions, such as UBS (which seems to have inherited some of Credit Suisse's shortcomings here...), Jefferies, and others got their fingers burned through factored receivables or uninsured loans. The lesson is well known but rarely learned: private debt is not magic, it is just unrated, illiquid bonds, and the bankruptcy of First Brands reminds us that the line between “private credit” and “high yield” is often blurred.

 

While this “old economy” is suffering, the new one is flourishing. It should be noted, however, that some circuits seem to be operating in a vacuum, and that Open AI and others are generating very limited revenue relative to their valuation, but are passing the buck back and forth with multiple announcements, financial arrangements, partnerships, cross-financing, warrants, and promises worth hundreds of billions of dollars. It's like reading the prospectuses of the Internet bubble again, with the same circular integration logic—Nvidia invests in OpenAI, which buys Nvidia chips to build data centers that are supposed to justify Nvidia's valuation! A perfect ecosystem, closed in on itself and financed by ten-year revenue forecasts... When interest rates were close to zero, this kind of bet could be opportune because neither the discount rate nor the cost of debt or opportunity weighed in the balance... Today, it's completely different, and this kind of bet could backfire massively.  The Bank of England and the IMF have sounded the alarm: the valuations of AI-related companies are reaching excessive levels, comparable to those of 1999.

 

The context therefore remains favorable for valuations and performance, whether for equities or bonds. For our part, there has been no change, as we still believe that the additional risk is poorly rewarded and that a cautious positioning, with relatively short duration and close to investment grade (on average) in credit, does not create a significant differential compared to much riskier positions but could prove very rewarding in the event of even slight stress.

 

Matthieu Bailly