Strong Earnings, Crisis Fatigue Led to Market Rally: Q2 2026 Strategic Income Webinar

Mark Schug: Good morning everyone. My name is Mark Schug and I'm a Regional Investment Consultant here at Osterweis. Today I'll be moderating a panel discussion with Carl Kaufman, Brad Kane, Craig Manchuck, and John Sheehan. Carl, Brad, Craig, John, it's great to be with you today. Carl, as usual, I'd like to start by getting your big picture thoughts on what's happening in markets. As you point out in your latest outlook, market sentiment in the second quarter was much more positive than the first, but the economic fundamentals are broadly the same. Can you talk about that disconnect?

Carl Kaufman: Sure. And thank you for being with us. One thing, a housekeeping item here for those of you who known me for a while, you know I've been Co-CEO and Co-President for almost the last ten years and I have decided to step down from those roles and focus my efforts entirely on managing the Fund, which is what I love to do. And Cathy Halberstadt will be the sole CEO of the firm going forward.

So clearly investor sentiment in the second quarter was significantly more bullish than during the first quarter. And the uncertainties really don't seem to have changed much, but the results were striking. In the first quarter, the S&P lost 4% and the second quarter gained 15%. That's a huge swing. High yield also had a nice quarter rising 2.4% after losing half a percent in the first quarter.

So there was indeed a positive shift in investor sentiment.

Mark Schug: So what happened?

Carl Kaufman: Well, our opinion is that investors really stopped worrying about the headwinds that had been bothering them. And the reason they did that, things like the Iran war, which was a huge concern all throughout March as the price of oil spiked roughly 75% and global commodities like fertilizer stopped flowing through the strait of Hormuz, or as we like to call it, Schrodinger Strait. You never know whether it's open or closed, can be both at the same time. It's not surprising that unnerved markets initially. But in the second quarter, what we saw was that earnings were very strong for most companies. And I think that was what was contributing to the market strength is that despite what's going on in the world, earnings are still okay. AI, we had some weakness in semiconductor stocks and software stocks particularly in the first quarter, but in the second quarter we saw huge rallies in semiconductor stocks as people realized that these commodities are in short supply and prices are going up and there seems to be an insatiable appetite for them.

So AI went from being a headwind with software stocks in the first quarter to a tailwind with mostly semiconductor and other supplier stocks, memory, et cetera, in the second quarter.

The other thing that people will stop worrying about with equities anyway is the private credit market. We have had troubles in that market for a while. It continues. You're starting to still seeing large redemption requests above and beyond what the gates allow. And we are seeing a few more larger bankruptcies. But I think this is all part of the growing pains of private credit and it's not systemic. So people have realized that that can be compartmentalized and focus on your controllable, which is your earnings. As long as earnings are good, equities and by proxy, corporate bonds are going to do pretty well. I think that a lot of the things have abated, things like the DOJ investigation of Chairman Powell, the Ukraine-Russia conflict in its fourth year. That shows no signs of abatement, but I've had this theory that the market gets fatigued by bad news.

If it lasts long enough, it goes in the back of the mind. So as long as earnings stay strong, as long as the economy keeps bubbling along, I think we're going to be okay.

Mark Schug: Interesting. Any theories about why the market's perspective has shifted so much?

Carl Kaufman: I'm going to hand this one over to John Sheehan on our team.

John Sheehan: Sure, thank you, Carl. Good to be with everyone today. We do have a couple thoughts on why the sentiment shifted. We focused on the two primary themes of the quarter, the conflict in Iran and the evolution of AI. So first specifically just around the conflict. As time went on, I think that people got comfortable with the fact that this was or hopeful that this was not going to be a prolonged war. The Strait seems to be open and closed every day as Carl mentioned, but people have started to realize that the impact on the price of oil and ultimately gasoline is likely to have a smaller impact than initially feared or maybe would've happened last time we had significant disruption in that region. If you look at how the price of gasoline has changed over say the last 30 years, it's really only moderately outpaced inflation while other expenses that are front and center with consumers such as health care, higher education, et cetera, have significantly outpaced inflation.

So the net result of that is that consumer spending that is attributed to energy as a much smaller percentage now than it did say 30 years ago. So the net result of that is that the economy is much less exposed to an increase in the price of gasoline and that as the

Mark Schug: Thanks, John. And what about AI? Why did the market flip-flop so much on that?

John Sheehan: Yeah, I'd say a similar theme. As Carl also mentioned, the market can only stay concerned and/or in crisis for so long. So it seems to us that the fears of AI, which were focused in the first quarter around its disruptive capabilities and how that would impact the labor market, really shifted towards just the incredible amount of CapEx that is being deployed in investing around AI. So much of this investment has come from hyperscalers. That's cash that was largely sitting on their balance sheets that's now being deployed into building data centers and investing and also through tremendous amount of funding that we've seen in the capital markets, both debt and equity. So this is putting a tremendous amount of cash to work in the CapEx in the investment sector. And you've seen it in the form of tremendous positive cash flows among the chip companies and the memory companies.

So I'd say the market has shifted from worrying about job destruction to focusing on just the tremendous wave of investment that is coming as a result of AI.

Mark Schug: Great. That's a perfect segue to my next question. Craig, can you talk about how AI has impacted the debt markets? I know there's been obviously quite a bit of issuance for the hyperscalers as they build out their infrastructure capabilities. Can you talk about that a bit?

Craig Manchuck: Sure. Thanks, Mark. We've seen a lot of issuance come from hyperscalers, from the neo-clouds, the data center infrastructure companies, both in the IG and the high yield markets. From what we see, the hyperscalers are budgeted to spend about 700 to $750 million, excuse me, billion dollars just this year on CapEx for AI products and services going forward. So we think probably $300 billion of that is going to have to come from the debt markets, which is a pretty large number. They use cash on the balance sheet, but Google recently came to market with a large $80 billion equity offering as well. So I would expect that we'll continue to see more of the selling of equity have to come from some of these hyberscalers, which is something that we haven't seen for many years. But right now, the debt markets are pretty much being dominated, I would say, by issuance coming from AI-related companies.

It went from being 0% of the market to call it right now in terms of issuance, it's probably in the 15 to 20% area and just continuing to grow. So every day there's a new issue from some of the same issuers on a serial basis, or we're seeing either newer companies come to market as well.

Craig Manchuck: Fascinating. The big thing with that is longer term, where do we get to? And I think there's a JP Morgan piece that suggested totaled CapEx for the build-out of the whole AI ecosystem will require something in the area of five to five and a half trillion dollars in order to successfully complete the build-out. Now as a reference point, the high yield market is a billion, excuse me, a trillion seven in total. So still remains to be seen where all this money's going to come from. They're going to have to continue to generate free cash flow, pump everything into AI in order to keep the ball rolling. But we still have some questions about how sustainable it will be, how big a piece of everyone's portfolios they want AI and AI-related stuff to be within the fixed income world.

Mark Schug: Yeah, thanks. It's been a remarkable transformation of these hyperscalers from capital-light businesses throwing off tons of free cash to now tapping the markets and using all their operating cash. It seems like a huge risk to take. Will it be worth it? I mean, it's hard to say obviously, but what are your thoughts on that?

Craig Manchuck: It's a good question. It's part of the reason why we've decided to really avoid most of these issues. But up to this point, other than the IG issues that are coming from the hyperscalers, all the other issues are really coming from bankruptcy remote-type structures or from companies that are really just project finance with no current free cash flow. And for us, we're not seeing a great opportunity when we're only getting paid fixed income returns for taking equity risk. That just doesn't really make a lot of sense. If we were getting paid equity returns, we would consider maybe deploying some capital into the space selectively. In fact, we did once in the past and it was a convertible bond and it worked out quite well for us, but we learned a lot from that as well. Volatility, it just swings daily. So it's still very, very early in the game, very early in the process.

For fixed income investors, we just don't necessarily think that they're getting compensated for the wave of future issuance that will be coming. They'll have to be hundreds of billions, if not trillions of dollars more of capital that's got to be raised in the debt markets. And there's no advantage being the first mover in debt like there is in the equity world. We're not getting a big payoff. All we're looking to do is collect our coupon and get paid back. So it's still difficult to see where this all goes, how effective it's going to be. It's still not clear what the ROIs are going to look like for these companies in one, two, three, or five years. So for the time being, we're content to continue to hit our singles and doubles in other areas and watch as this whole investment landscape plays out, because we think that there will be an opportunity for us if the cash flow becomes a little bit clearer and the investment case becomes clearer to continue to deploy capital in this space.

Mark Schug: Got it. Makes sense. Brad, can you talk about the portfolio positioning at the moment? Seems like there's so much going on in markets in the economy.

Brad Kane: Yeah. And I hope you guys can hear me. I apologize, my camera just went down as soon as the call started, but there's definitely a lot going on right now, but our approach hasn't really changed. As you might expect, we still think high yield's kind of the sweet spot for fixed income. The quality of the high yield index has steadily improved. In fact, it's now nearly 60% rated Double B versus about 40% back in 07. And the lowest rating category Triple Cs are now only 8.5% of the index versus around 18% in 2007. So what you see is the credit risk metrics are as good as they've ever been in our market, but we are still cautious, especially as Carl talked about the returns in the quarter. Trees don't always grow to the sky and you need to keep an eye on that.

One area that we are monitoring closely is still inflation. As Carl mentioned, the Schrodinger Strait has significantly reduced global fertilizer supply while it was closed. We saw oil came back a little bit and now oil prices are going back up again as the Strait keeps reopening and closing. And that global fertilizer, it's got to move around the world and get to the farmers. And so the supply that's coming from the higher costs, you could see higher farming costs, higher food prices in the coming months because all that, as we've talked about in the past, all the movement of those products take time. It doesn't happen overnight, just like barrel of oil price coming down, gas prices don't come down immediately. There's time for everything to flow through the systems.

And with the Strait still very fluid, we could see oil prices settling higher here too for a little bit. And also, as Craig mentioned, the combination of all the debt issuance and the hyperscalers and the federal government deficit funding that we've talked about in the past, that all has the potential to continue to push interest rates higher or keep pressure on them to not come down. So with that concern about potential for capital outflows and potential defaults in the private credit markets is stuff that we've got to keep an eye on and makes us a little nervous about different sectors. In fact, as we've talked about in the past, some of this stuff is a long time coming. We just saw another big private credit deal, software company called Medallia defaulted last quarter. The PE (private equity) sponsor, Toma Bravo, just wrote off $5 billion of an investment.

So there's still things that are going to happen and it's going to come through the pipeline. It just takes time. And so for that, we're going to stay defensively positioned. We have plenty of dry powder. As our investors know, we like to keep a fair amount of cash and short-term security. So when we do see market hiccups, we'll be able to put that to work quickly. And at this point, the other thing that helps us is keeping duration low helps lower the volatility in the fund.

Mark Schug: Great. Well said, Brad. Thank you for that. This has been great. Does anyone have anything to add before we open it up to questions?

Carl Kaufman: Not really, but I just want to reiterate that we're just trying to do what we've always done, which was find the areas of the fixed income market where we're getting fairly compensated for the risk we're taking and trying to find the lowest risk way of playing that. It's worked for 24 years. Hopefully it works for another 24 or until they find a stairwell to push me down, one or the other.

Mark Schug: Thank you, Carl. That was my last question. Before we open it up to the audience, we're sharing the fund performance slide and we will follow it up with some key portfolio statistics. Okay. And we'll begin the Q&A. As noted on the slide, please ask a question through the Q&A window or raise your hand to ask a question over computer, audio, or by phone. We did have one question come in prior to the webinar. What is your strategy for weathering a period of high inflation and increasing interest rates?

Carl Kaufman: We would love to see that because given our short-dated portfolio, it's going to be throwing off lots of cash over a short period of time and we would get to reinvest that in high quality companies at much higher rates.

Mark Schug: Got it.

Carl Kaufman: Sounds pretty simple, but you have to have the patience and the cash to be able to do it.

Mark Schug: Sounds pretty elementary. Do you think longer duration is becoming more attractive?

Carl Kaufman: Relative to what it was, but still not in the absolute.

Craig Manchuck: Look, if you look interesting, today we had this very, very weak CPI print. And early in the morning, Treasuries rallied strongly because it throws a little bit of a wet blanket on the hawky stance from the Fed and the possibility of a rate increase. But what we saw was the short end rallied really, really strongly. So we saw maybe 12 to 15 basis point rally in the one, two, three-year part of the curve. But the 10-year really didn't do a whole lot. So I still think that longer term inflation expectations are somewhat anchored and skewed higher. And with that, it doesn't set up for a really good opportunity to buy longer duration paper. Now, if the credit curve changed and we were getting paid a much higher spread for longer paper than we were for shorter paper, that might push us a little bit in that direction, but we're not.

So we have both rate and spread concerns about taking too much duration risk. So if we don't find something that is very well priced, we're going to avoid it and we're not going to just add duration for the sake of adding duration. That doesn't make sense quite yet.

Carl Kaufman: Also, I think the market has come to believe that this inflation print was because the price of oil, which was most of the print, came down as people thought peace was near. And as you've seen, the price of oil has gone back up, so we're probably not going to get a repeat of that for the month of July.

Mark Schug: Got it. We did have a question come through on sectors. What sectors are you most interested in and keeping an eye on?

Carl Kaufman: We don't really invest by picking a sector and investing in it. We build the portfolio one company at a time. And where the sectors fall out determines what the opportunity set was. I would say we're more in the camp of avoiding certain sectors rather than trying to proactively predict what sectors will do well. For example, we don't do biotech. If you don't have drugs that you're selling, you have no revenues and the odds are fifty-fifty that you'll get it approved and be successful. So we don't make those speculative kind of bets. Shipping is another one that Craig has mentioned in the past. Terrible economics, very spiky. Sometimes they do great for a few months and then they do terribly. And most of the assets are already have debt on them that's recourse. So you don't really have a good call on assets. And the other, it's not really a sector, but it's a category, which is private equity-sponsored companies that issue debt in our market. They typically have very high leverage. They have management capital allocation plans that generally don't favor bond holders. They want to suck out as much as they can for equity holders. So they're not in sync with our goals. So that's more of how we approach sector investing.

Craig Manchuck: I mean, there are a couple sectors that I just want to mention that where we've long held investments. We've always liked the food distributors, for example, because people are always going to need to eat, and that just doesn't change. They supply restaurants, they supply colleges and universities, hospitals.

Carl Kaufman: Those are industries rather than sectors.

Craig Manchuck: And grocery store. Yeah. So that, home builders, and auto dealers. The home builders and auto dealers are interesting because we recognize in 2008 we saw that it's very difficult to drive those businesses under, even in extremely difficult times because of the way they're set up, particularly the asset-light home builders who use options as opposed to owning gigantic tracts of land and getting themselves highly leveraged. But it doesn't mean we're plowing lots of money in. We just happen to be involved in some way in those sectors for long periods of time.

Mark Schug: Got it. And there is a question about whether we own high yield municipals. Do you guys want to just talk about that briefly?

Carl Kaufman: That's an easy one. No.

Mark Schug: Got it. What about convertibles? I know that's been integral to how we generate alpha over the long term. Any thoughts on convertibles at the moment?

Carl Kaufman: Sure. We have been investing recently in very short-dated convertibles, usually under a year, in companies that typically have more cash than debt on the balance sheet. So they're pretty much diffused. And because there aren't as many natural buyers of those, we are getting yields on those that are typically equivalent or higher than what we're seeing in the high yield market for bonds that have much stronger balance sheets. But we're not buying many equity sensitive convertibles now because the equity markets are at our near all-time highs. You do that when the market collapses.

Mark Schug: Right. Imagine we need to see more volatility there for that to be attractive. We did get a question about potential opportunities coming out of the private credit BDC troubles. Anything there?

Carl Kaufman: Too opaque to dive in at this point. I think they still have a ways to go to right the ship, so to speak, in terms of both outflows and credit issues. We're still seeing big credit issues. Brad pointed out Medallia, 5.3 billion in equity written off. That's a pretty big hit and there's probably more to come. So it's going to be a while before that happens, but it's still very opaque and that's probably not going to change.

Brad Kane: I would just add that as some of this stuff starts to go through its troubles and they look at the other side of getting away from them, they refinance the capital structure into what would be more bond-like and with covenants and then we might start taking a look. But at this point, given the way the structures are set up, as Carl said, the BDCs, a lot of it for us would be opaque or a black box. The private credit deals don't have a lot of covenants. There's not a lot of protections. Hard to see us want to step into those existing securities. We'd wait for the next round where you're refinancing all that stuff and you're putting protections back in.

John Sheehan: And most of the borrowers that end up in the private credit space are lower quality than are even in the high yield market. So Brad mentioned about half of the index now is Triple Cs as it was 20 years ago. That's because those borrowers have found their way into the private credit market. So most of the typical borrowers within the private credit market wouldn't meet our underwriting standards.

Mark Schug: Imagine they're much more speculative. So I know it's early in the Kevin Warsch tenure, but any thoughts on so far potential shifts in Fed strategy?

Carl Kaufman: A little too early to tell, but so far the meetings have been rational. I'm happy to see that he hasn't come out with irrational recommendations. He's certainly in the past has been a balance sheet hawk. We'll see how that expresses itself going forward. He's certainly an inflation hawk. Today's number helps him a little bit, but next month's number, probably not so much. So we'll have to see. He's been pretty even-keeled so far, and I think he hasn't seen much pressure from the guy upstairs.

Mark Schug: Got it. Another question just came in. Could you please talk a bit about the strategy of buying paper from "index sensitive" investors who are selling short-dated paper to invest in new issues?

Carl Kaufman: Yeah, that's always been a feature of the fund. As bonds get to be short-term in nature, I'm not saying it's the ETFs per se, but when they fall out of the benchmark, they sell, and it doesn't take much of a move in short-term paper for the yield to get to be pretty attractive. And so that's been a source for us. And even non-benchmark high yield funds, when things lose their beta, their market beta, they're paid to keep up with the benchmark in up years. They also get paid to keep up with it in down years. But that's when we typically see large blocks for sale of short-term paper because they're moving on to the longer paper where you have more market beta.

Mark Schug: Right. Got it. Okay, I don't see any other questions in the queue. Any other final sendoff comments for us?

Carl Kaufman: No, I think we'll have to see how earnings play out going forward and we'll talk to you next quarter.