It's clear that Real Madrid should be the most likely to defend their trophy. But, as you said, it's weird they got second, not first. Prob Pep's factor is the reason why we're still seeing City at the first place. Also, the funny thing is that Arsenal is more favored. They have smaller odds than Munich, which beat them last season. But the only acceptable reason is probably due to the new coach of Bayern Munich. Still, this looks so strange.
Bookmakers overestimate City every year and this is not news, although of course this year it is extremely strange against the backdrop of how Real has strengthened.
As for Arsenal, I think the odds are fair - Arsenal has been progressing for 5 years in a row and has actually become the strongest team in the Premier League (if you don't take into account the cheating club), while Bayern is deteriorating, Barcelona is in crisis, PSG has lost Mbappe.