'As AI grows so does demand for energy, so does demand for electricity': Young

Key Concepts

• Credit Spreads: The difference in yield between a corporate bond and a comparable government bond, indicating the risk premium investors demand for holding the corporate debt.
• AI Disruption: The impact of Artificial Intelligence on various sectors, leading to shifts in business models, productivity, and investment patterns.
• Basis Points: A unit of measurement used for interest rates and yields, where 1 basis point equals 0.01%.
• Dispersion (in Credit Spreads): The degree of difference or variation in credit spreads across different sectors or issuers.
• Foreign Direct Investment (FDI): Investment made by a foreign company in the business interests of an enterprise in another country.
• Koozma Negotiations: Likely referring to the ongoing negotiations regarding the Canada-United States trade relationship, potentially related to the US Inflation Reduction Act.

Divergence in Credit Spreads & AI Impact: A Franklin Templeton Perspective

This discussion centers on the emerging divergence in credit spreads, particularly in the United States, driven by the disruptive influence of Artificial Intelligence (AI). Adrien Young, SVP and Director at Franklin Templeton, outlines the current state of credit markets and anticipates a spillover effect into the Canadian economy.

US Credit Spread Divergence & Sector Impacts

Currently, the divergence in credit spreads is most pronounced in the United States. Specifically, insurance brokers experienced widening spreads of 10-12 basis points in the previous week, signaling increased perceived risk. This widening is attributed to headlines surrounding AI disruption and is creating a much-needed “dispersion” – a variation in risk assessment across different credit instruments.

Young anticipates this trend will extend to more industrial sectors within both the US and, eventually, Canada. While Canada lacks a significant tech sector for direct credit investment, impacts will be felt across retail, banking, and insurance.

Canadian Economic Outlook & AI Effects

The Canadian economic landscape differs significantly from the US, lacking the same level of aggressive investment in the tech sector. This difference is expected to result in the US outperforming Canada in terms of GDP growth. Several factors contribute to this outlook:

• Productivity: Canada’s productivity numbers are lagging behind the US.
• Infrastructure Projects: National priority projects in Canada haven’t yet broken ground.
• Foreign Direct Investment: FDI into Canada is currently subdued due to uncertainty surrounding the upcoming Koozma negotiations (likely related to the US Inflation Reduction Act and its impact on Canadian industries). Investors are adopting a “wait and see” approach.

Within Canada, the impact of AI is expected to be sector-specific:

• Banks: AI could lead to lower expenses, particularly in back-office operations.
• Insurance Companies: Some movement is anticipated, though the extent is unclear.
• Real Physical Assets (Pipelines, Oil & Gas, Utilities): Less immediate exposure is expected, but utilities may see positive movement due to increased energy and electricity demand driven by AI growth. This will involve both increased issuance of debt and shifts in supply-demand dynamics.

Investment Strategy & Credit Analysis

Given the current environment of tight credit spreads and limited dispersion, Franklin Templeton is adopting a cautious and selective investment approach. The focus is on:

• Thorough Credit Work: Conducting in-depth analysis of individual credit names.
• Quality Credits: Prioritizing investments in the highest quality credits.
• Pickiness & Choosiness: Exercising careful selection criteria.

The firm is also closely monitoring the economic divergence between Canada and the US, seeking opportunities within the US credit universe. Specifically, engineering and construction remain areas of interest, as previously highlighted.

US vs. Canadian Banks

Young predicts that US banks are likely to outperform Canadian banks, not due to concerns about the solidity of Canadian banks, but because of a healthier consumer base in the US. This translates to:

• Lower Write-Offs: US banks are expected to experience fewer loan defaults.
• Better Provisioning: They will require less capital set aside for potential losses.
• Stronger Earnings: This will lead to improved earnings and capital generation.

Data & Statistics

• Credit Spread Widening: US insurance brokers saw spreads widen by 10-12 basis points in the last week.
• GDP Outlook: The US is anticipated to outperform Canada in GDP growth.

Synthesis & Main Takeaways

The core message is that AI disruption is creating a divergence in credit spreads, initially in the US and expected to spread to Canada. This divergence necessitates a cautious and selective investment approach, prioritizing quality credits and closely monitoring the differing economic trajectories of the US and Canada. The US, with its aggressive investment in technology, is poised for stronger growth, potentially leading to outperformance in sectors like banking and construction. The uncertainty surrounding trade negotiations (Koozma) is a significant headwind for Canadian FDI and overall economic performance.