Bond Voyage

Read this article to understand:

• How the US election results might affect emerging markets depending on the winner
• Why it’s back to being all about the economy for high yield
• How Spain might be inching towards core EU issuers while France is sliding
• The complexities of sustainable investing in Asia… And local investors’ considered approach to it

Welcome to our October edition of Bond Voyage. September has been rich in news on the political and economic fronts and has fed some fascinating debates across our investment desks. US elections next month, the US Federal Reserve’s (Fed’s) first rate cut, France’s fiscal woes and Asia’s complex relationship to environmental, social and governance (ESG) investment approaches have given our teams plenty to think about… Here are the results of our discussions, which we hope you will enjoy!

Feedback is important to us, so please send any thoughts on what you like, don’t like and suggestions on what we might cover in future blogs to: gcs.creditinvestmentspecialists@avivainvestors.com.

Emerging market debt: Respected, selected, I wanna be elected…

This month, we reflect on what US elections might mean for emerging markets, which countries may struggle if US growth slows more sharply and why Asian currencies have been strong performers. As usual, we have picked a soundtrack. If Trump or Harris had a personal theme tune right now, Alice Cooper’s 1973 hit “Elected” may fit the bill: “Respected, selected … I wanna be elected, elected.”

With Harris and Trump running neck-and-neck in the polls, we see little value in trying to predict who will win. Rather, our focus is on assessing whether electoral uncertainty is priced in; we don’t think so. A bout of election-related volatility could provide an interesting entry point into emerging market debt (EMD). If you share our view that a US “soft landing” is more likely than not, all-in yields still look attractive.

A Harris presidency would likely mean continuity and few major policy changes. Post-election, the market’s focus would probably shift back quickly to growth/inflation dynamics, which have preoccupied investors for much of this year.

Judging by his last term in office, a Trump presidency would likely come with higher tariffs and looser fiscal policy, which should be positive for the dollar and put upward pressure on US Treasuries. A stronger dollar and higher borrowing costs risk weighing on the more vulnerable names in the EMD universe, particularly those like Nigeria and Egypt that will need to come to market over the next twelve months.

Exposure of emerging markets (EM) to trade is likely to be a differentiating factor. Most dependent on exports to the US are Mexico and some smaller Central American countries. However, a major hike in US tariffs is likely to reverberate through global supply chains, so the exposure to global trade matters as much as exposure to the US economy itself. The EM sovereign issuers currently most dependent on exports are Hungary, South Korea and Chile.

But if history provides any guide, reality often proves much less dramatic than market fears suggest. For most in this category, including Mexico, exports to the US as a percentage of gross domestic product (GDP) are the same today as in 2016. For China, they are a bit smaller (three per cent versus four per cent), but they are higher for Vietnam, Thailand and Korea. While much was written on the impact of trade wars under the last Trump administration, spreads quickly moved to price out fears.

A debate we’ve been having around the EMD desk in the past few weeks is whether the Fed’s next cutting cycle will be good for EM. Lower US rates and a weaker dollar are good for EM assets insofar as they drive capital flows into emerging economies. However, the reason for softer external conditions matters for those flows. If lower US rates and dollar are driven by a moderation of US growth relative to otherwise resilient growth in emerging markets, then EM assets can outperform. If, however, a “hard” landing is what prompts the weaker dollar and lower rates, the result for EM is a different set of winners and some losers.

We set out to investigate the likely scenarios ahead. Our starting point filters our EM sample based on countries’ degree of exposure to US growth, mostly through trade linkages. The usual suspects include Mexico and most of Asia, along with Chile and Hungary, which have indirect exposure through their trade connections to China and Germany respectively. Those more insulated from a US growth slowdown are mostly economies with higher domestic demand like India, Indonesia or Poland.

The next step is to map growth vulnerabilities to fiscal sensitivities and debt-sustainability metrics. Our analyses point to two sets of countries to keep on close watch. First are those with already weak fiscal metrics, which cannot afford a material growth slowdown, like Mexico, Brazil, South Africa and Colombia. The second set consists of countries on the cusp, which will find themselves facing a higher interest-rate burden if growth slows materially (Hungary, Peru) or where fiscal consolidation efforts will have to be ramped up if growth disappoints (Thailand, Poland, Romania).

With US rates easing and the Dollar Index (DXY) weakening, Asian currencies are starting to flex their muscles. The Malaysian ringgit has been on a roll thanks to stable interest rates and a little encouragement by the authorities to bring home investment. The Taiwanese dollar might get a boost if life insurers ramp up their hedging, and the Indonesian rupiah could see a flood of bond-market money due to its underweight status. All three are also riding high on foreign-exchange deposits that may continue to unwind as the Fed cuts rates, too. On the flip side, the Thai baht is looking a bit stretched with its weak fundamentals and political mess and, while we are positive on Korea, the Korean won is not set to break any records right now.

High yield:  It’s the economy, stupid

James Carville, a strategist for Bill Clinton during the 1992 US presidential campaign, coined the phrase “It’s the economy, stupid”. It was meant to remind campaign workers to focus on the economic issues that were most important to voters at the time.

Well, as Richard Thompson once sang, “Mr. Stupid’s back in town”. With the Fed finally firing the starting gun on the latest cutting cycle, high yield (HY) investors (along with almost everyone else) have been considering what this will mean for the performance of the asset class.

History gives ample opportunity for both bulls and bears to draw comparisons to previous cutting cycles, and we provide a summary of the main schools of thought below.

For the bulls

• Positive returns in non-recessionary cuts: Comparisons to previous pre-emptive or “insurance” rate cuts, where the Fed reduced rates to prevent a recession or address specific economic concerns. During the rate cuts in 1984, 1987, 1995, and 1998, HY bonds performed well as economic growth remained positive.
• Lower borrowing costs: Rate cuts reduce interest expenses for issuers, particularly those with floating-rate debt. Lower quality issuers (CCCs and Bs) stand to benefit the most, as they typically have higher floating-rate exposure.

For the bears

• Mixed performance in pre-recession cuts: HY bonds often underperformed during rate cuts that preceded recessions, as in 2001 and 2007-2008. This underperformance is typically due to increased default risks and economic uncertainty during recessionary periods.
• Lower starting yields: Compared to previous cycles, starting yields for HY bonds are currently lower. This could limit the potential upside, even if economic conditions remained stable.
• Economic uncertainty: Despite some positive indicators, there are ongoing concerns about inflation and labour market weaknesses. That could undermine the performance of HY bonds if economic conditions deteriorated.

Ultimately, the impact on HY bonds will depend on… "the economy, stupid” and whether the Fed can orchestrate a safe landing for it. As of October 1^st, the macroeconomic data continues to look healthy, leading many to compare this environment to 1995.

However, we need to keep in mind that starting yields today are significantly lower than in 1995. While historical data provides insights, we need to consider the unique conditions of the current economic landscape carefully. Investors should stay informed – and active – and prepared to adjust their strategies as economic indicators evolve.

Global sovereign debt: How to get into the club

Being part of an exclusive club is very desirable. The opportunities that come with such membership can bring many advantages, from networking opportunities with influential individuals, to access to resources that are not available to most, and unique experiences. Sounds great, right?

Being part of the European periphery, however, is quite the opposite. Historically, it has been reserved for the likes of Italy, Portugal, Spain and Greece who, as the MisterWives song goes, were “Watching from the sidelines, wishing [they were] on the other side”. Instead of advantages, the unfortunate members of this club faced higher borrowing costs than the likes of Germany and France, and an uphill struggle to bring higher prosperity to their citizens.

However, following France’s large fiscal slippage and new government, Spanish ten-year bonds recently traded at a lower yield than their French equivalent for the first time since 2007. That feels like a century ago given how many once-in-a-lifetime economic events have occurred since.

As a founding member of the EU, France has so far been closer to core membership and lower borrowing costs than periphery countries. But concerns about its deficit continue to push the spread of French government bonds higher compared to German bunds, and a possible rating downgrade could lead to France being shown the door of the core members’ club.

Meanwhile, Spain has seen a tremendous improvement in its debt-to-GDP ratio and its deficit, whereas France has higher debt to GDP, and France’s new prime minister Michel Barnier has postponed the goal of bringing the French deficit back to the three per cent EU limit from 2027 to 2029. The European Commission has also placed France under the excessive deficit procedure, and market sentiment doesn’t look supportive for French assets.

What’s more, forecasters predict Spain will grow at a rate of two per cent in 2025 and 1.7 per cent in 2026, compared with 1.1 per cent and 1.4 per cent respectively for France. Over the next year, the unemployment rate is also forecast to go down in Spain and up in France.

We could keep going but, wherever you look, the prospects look rosy for Spain and less so for France, so we remain positive on Spain relative to France and Germany.

Spain’s 2024 GDP continues to be revised higher and its 2024 deficit has been recently revised lower. Net issuance will turn negative in the fourth quarter, and we continue to see strong demand in the market. We also continue to favour the long end of Spanish government bonds, where we think the credit curve remains too steep relative to peers. While there are always risks, we believe the current positive backdrop for duration globally could drive an extension in demand for yield further out on the curve.

But going back to our original question of how to get into the exclusive club you’ve always wanted to be a part of; how to get an invite to all the elite events full of interesting and influential people; and how to gain access to the exclusive content shared among members… Sometimes, the idea of a club is better than the reality. Be careful which club you end up in.

Investment grade: Musings from the East – ESG in transition

Once again, we return from our travels highly impressed with the quality of the conversations in the Asia-Pacific (APAC) region. This time, our focus was on Singapore and the private wealth sector. As wealth progresses down the generations, core fixed income is becoming more of a focus, particularly investment-grade (IG) offerings that provide a reasonable spread of return over already attractive rates markets.

What was particularly interesting to note was investors’ approach to sustainable investing. Asia is at the centre of the transition, and there are some complicated interplays between the region’s benefits from fossil-fuel usage and the lens through which investments are viewed. Broad ESG investing without traditional credit returns still feels like an unpalatable place to start. However, if the returns are in line with conventional peers and managers can articulate a focus on supporting real-world transition, rather than purely exclusions, there is a good conversation to be had.

ESG investing in Asia presents unique challenges due to the region’s diverse economic, regulatory, and cultural landscape. Here are some of the key ones:

• Divergent standards and regulations: Unlike regions with more uniform regulations like the EU, Asia’s ESG landscape is highly fragmented. Different countries tend to have varying levels of regulatory maturity and standards, making it difficult to create a cohesive ESG strategy.
• Data availability and standardisation: There is a significant lack of consistent and reliable ESG data across the region. That makes it challenging for investors to assess and compare ESG performance accurately.
• Transition financing: Asia’s heavy reliance on fossil fuels complicates the transition to sustainable energy sources. Balancing economic growth with sustainability goals requires innovative financing solutions that can support a gradual transition.
• Cultural and social factors: ESG priorities can vary widely due to cultural differences. For instance, social issues like labour practices and community impact can be viewed differently across countries, affecting how investors implement and value ESG criteria.
• Market maturity: The ESG market in Asia is still developing, with varying levels of awareness and adoption among investors and companies. It can lead to challenges in finding suitable benchmarks and measuring fund performance.

Despite the above, the climate transition was pre-eminent in every meeting we had and was the first question asked. Subsequent discussions of how we view and support the transition showed investors are taking an extremely considered approach to sustainable investing that is up there with the best conversations we’ve had globally.

This is a growth region with significant capital to deploy, and that capital can be a meaningful contributor to driving real-world change. We are looking forward to the next visit, and not just for the satay!