Bond Voyage

Read this article to understand:

• What factors are helping the US outperform Europe
• How rate volatility and the uncertainties ahead of the US election are impacting bonds 
• Why fiscal concerns and uncertainty created a sombre mood at the IMF Annual Meeting

Welcome to the November Bond Voyage newsletter! Next month, we’ll focus on the US election outcome and its implications for bonds.

In the meantime, our investment desks have plenty to consider. With the high-yield competition between Europe and the US, investment-grade’s journey into the unknown ahead of the US election results, the emerging market team going “on the road again”, our sovereign debt team assessing whether to go the distance on gilts, and cash management strategies for declining rates, this letter is aptly named. We hope you enjoy this month’s journey.

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.

The Ryder Cup of highyield

As the clocks change and the nights draw in, we are reminded that the colder, darker months are upon us. This seasonal shift often makes us long for the excitement and warmth of summer sports. One event to look forward to next year is the Ryder Cup, which will take place in September 2025. This biennial golf tournament will see Europe’s best golfers take on their US counterparts.

In this episode of Bond Voyage, we produce our very own Ryder cup of high-yield (HY) markets, by analysing the factors that can lead to out- and underperformance between the two regions.

Economic and policy divergence

Economic growth

• US: The US economy has shown more resilience and stronger growth than Europe, reflected in better performance in the HY market.
• Europe: European growth has been persistently slower, particularly in the manufacturing sector. Germany, Europe’s largest economy, has struggled due to its reliance on exports and close economic ties with China. France has also faced economic challenges, contributing to the overall weaker performance in the region.

Central bank policies

• US Federal Reserve (Fed): The Fed’s larger-than-expected rate cut is seen as a proactive measure to support the economy, positively impacting the HY market. The market views this as a move towards a “soft landing” scenario, where the economy avoids a recession while maintaining low growth and controlled inflation.
• European Central Bank (ECB): The ECB started its rate-cutting cycle before the Fed and delivered its second consecutive monthly rate cut in October. However, the market perceives the ECB as being behind the curve due to subdued demand in the region, limiting the positive impact on the European HY market.

Sectoral performance

Manufacturing versus services

• US: The US HY market has benefited from a more balanced economic performance across sectors, with both manufacturing and services contributing to growth.
• Europe: The underperformance in Europe is mainly driven by the manufacturing sector, particularly in Germany. The services sector has not been able to compensate for the weakness in manufacturing, leading to overall slower growth.

Regional disparities

• Core versus peripheral economies: Interestingly, while core economies like Germany and France are struggling, southern European countries such as Italy and Spain have shown stronger growth. This two-speed growth within Europe highlights the varied economic conditions across the region.

Market sentiment and investor expectations

• US: Investors in the US HY market are optimistic about the potential for positive returns, driven by the Fed’s rate cut and the expectation of a soft landing. The larger rate cut has reinforced this sentiment, making financing conditions less restrictive and supporting credit markets.

• Europe: In contrast, the European HY market has not benefited as much from the ECB’s rate cuts. The slower economic growth and the perception that the ECB needs to do more to spur demand have dampened investor sentiment. As a result, European HY has underperformed its US counterpart.

These differences highlight the varying economic landscapes and central bank policies in the US and Europe, with significant implications for the performance of HY markets in each region. Although it won’t affect the outcome of next year’s tournament, it should at least keep our HY team entertained during the long winter nights.

Investment grade: Journey into the unknown

As we approach one of the most closely contested US elections in living memory, the investment-grade (IG) team has been reflecting on what has changed since 2016.

In early November 2016, US IG credit was trading at a spread of 135 basis points and European IG at 110, with ten-year US Treasuries at 1.6 per cent, marking the start of a hiking cycle. Fast forward eight years, and the US 10-year is around 4.25 per cent. The Fed has begun its cutting cycle, with US IG trading at a spread of 83 and European IG at 105.

One topic remains similar: the path of growth. Growth was the question back in 2016, and it is still the unknown in 2024.

Two observations

1. Reversal of credit metrics

The US hopes for a soft landing, while Europe is gradually moving towards regional recessions, with weaker corporate profits, soft GDP growth, and rising unemployment. In 2016, the US saw economic growth and the start of the rate hiking cycle, while Europe remained in easing territory, with dominant industries keeping spreads tight. By 2024, the macro backdrop has changed.

Quantitative tightening (QT) has removed the backstop. IG companies borrowed long and low post-COVID. The period from 2012 to 2020 also created “zombie companies” in defensive sectors like utilities, autos, and industrials, which are now struggling against a backdrop of higher rates and lower profits.

2. Rates volatility

Volatility is driving all markets. US rate volatility is high and increasing, while European rate volatility is lower and more stable due to recent ECB easing. The upcoming election and potential deficit expansions could further increase US rate volatility, widening US IG spreads and, by extension, European IG spreads. Tariff fears also contribute to rate volatility, with more tariffs potentially leading to wider spreads due to reduced growth and increased easing needs.

On the flipside, reduced fears of tariffs, an easing ECB, and muted growth would still see wider European IG spreads, but not by as much.

Downside Risks for European IG

Growth is fragile, and profit margins are weak. The potential of US tariffs could significantly impact European trade, particularly in the auto sector, which has underperformed this year. The transition to electric vehicles (EVs) has been costly, and competition from China adds pressure. European auto bonds may not yet reflect the potential negative impact of tariffs. Banks, however, are faring better and many are anticipating easing their own rates for client borrowing, benefiting European consumers.

Indeed, there are numerous uncertainties as we approach November 5. Despite these “what ifs,” IG spreads remain tight, with low dispersion in both US and European markets (see Figures 1 and 2). These spreads are tight against various metrics, including growth, Purchasing Managers Indices (PMIs), and equity market volatility.

Spreads are being kept tight due to strong technical factors, including significant inflows into credit and relatively low supply amid earnings and election uncertainty. And the rise of fixed-maturity funds contributes to a stickier buyer base. But the tightness may also indicate a degree of complacency, particularly in European sectors vulnerable to tariffs, such as autos and consumer goods.

IG credit is vulnerable to a combination of higher yields and higher spreads, which could result from stickier inflation due to central bank easing, geopolitical energy shocks, fiscal mismanagement, and longer-term structural trends.

Emerging market debt: On the road again

The Emerging Markets Debt (EMD) Team has been traveling extensively this month. The sovereign team attended the International Monetary Fund (IMF) meetings in Washington, D.C., while the corporate team explored the sunflower fields and factories of Romania and Moldova. Much like Willie Nelson’s famous tune, “we just can’t wait to get on the road again”; these adventures are crucial for meeting issuers face-to-face and asking the tough questions.

The mood in Washington contrasted with the bright sunny skies. Whereas previous meetings focused on the immediate dangers of needing to tame inflation, the focus has visibly shifted, with fiscal concerns now front and centre.

Both emerging and developed countries find themselves with much higher debt levels than in the pre-COVID period, and high debt-servicing costs are increasingly constraining the fiscal space needed to face the challenges of the period ahead, from climate transition to social protection to the investment needs of new and large industrial policies. Whether that ultimately leads to higher interest rates than currently assumed remains to be seen.

Immediate concerns

Policymakers are currently worried about potential tariffs under a Trump administration, geopolitical tensions, and the higher costs of a fragmented global economy. This creates different trade-offs for emerging markets. Those exposed to a growth slowdown may need to push harder on fiscal measures, while those with high external financing needs could be at risk due to a stronger US dollar. Our upcoming focus will be sifting through these potential winners and losers among the various moving parts.

The IMF is navigating a delicate balancing act to maintain global stability. It must advocate for structural reforms to stimulate growth and fiscal consolidation to bridge funding gaps. This is coming at a time when both governments and populations are suffering from reform fatigue and, in some cases, a lack of trust in governments.

Concerns about corruption or inefficient government spending are making populations more resistant to reform, particularly those that squeeze incomes. As a result, we note an increasingly lenient tone from the IMF. For example, the IMF’s Managing Director Kristalina Georgieva said, “We have been very open to adjust the Egyptian programme or any other programme to what is best to serve the people.” While this may help keep countries engaged with the IMF, it does risk fiscal consolidation being slower—a risk that will increase if growth slows more than the IMF anticipates.

In October, members of the corporate team travelled to Romania and Moldova. One highlight of the trip was a visit to a sunflower oil producer and agricultural commodity trader. This trip was a fact-finding mission aimed at gaining a deeper understanding of the company as it prepares for an upcoming bond refinancing. We went to see their new assets, including a newly built sunflower production facility in Moldova and another one acquired in Romania.

We also observed how the company expanded its grain-trading operations and spent time with management to learn about how things are running and what future growth plans hold. We came back with a renewed sense of optimism and confirmation of our conviction to help the company get through its refinancing hurdle.

Sovereign debt: Going the distance on gilts?

Coming to the end of October, ten-year gilt yields had sold off around 50 basis points (bps) in the space of just six weeks (see Figure 3). This is sizeable to say the least, in both size and speed. It mirrors the magnitude of repricing seen at the start of the year post the December 2023 lows of around 3.45 per cent. 

However, all the while, the widely followed Citi Surprise index for the UK (where economic data actually prints against expectations) has come in consistently weaker and now sits at its lowest point since March (see Figure 4). Therefore, one can certainly argue the recent moves higher in gilt yields cannot be attributed to domestic economic data alone. 

So, what is it then? Fears around the size of any additional government borrowing prior to the UK’s budget announcement had of course grown, but in reality, the move in yields has stemmed from a confluence of variables. Across the pond is the little matter of the US election and, with Trump gaining traction in the polls as of October 29, this has further fuelled the recent rise in global yields. So have both the US and euro zone data, which have printed above consensus expectations over the recent period. 

What now for gilt yields, then? Despite the upcoming event risks both domestically and overseas, value is being created and asymmetries to lower yields have most definitely increased. Terminal rate pricing, at circa 3.8 per cent, is now at the top end of our estimates and as such, we have begun to move into long UK rates positions, be it in outright yields or on a cross-market basis. Our conviction in these will likely grow if there is any further cheapening of gilts post the events ahead. 

Naturally, risks globally still warrant some caution. Any sign of re-acceleration in UK growth, inflation or large fiscal slippage would give the UK’s Monetary Policy Committee (MPC) some cause for concern around how much it would want to persist with interest-rate cuts and, if it did, by just how much. 

Yet given the speed and size of the moves in yields over the last six weeks, plus the outright yield level and the fact we are heading into a seasonally attractive period to be long of gilt duration, asymmetries may well warrant investors employing some of their risk budget to look for lower yields. And given the shape of the yield curve, we think some of our risk budget should be allocated in the longer-dated maturity area, even though performance is never guaranteed.

Cash management: Glide paths

The outlook for interest rates has changed dramatically: a short, sharp increase in rates was followed by a jagged peak and now a fairly sharp decline – a bit like the Andes mountain range.

Cash managers are closely attuned to how things will develop from here. Which brings us back to the Andes and, perhaps more significantly, the gliding world record set by Klaus Ohlmann in Argentina in 2003.¹ Using the “mountain wave” technique, he travelled 3,009km. That’s some distance. 

Mr Ohlmann’s aerodynamic vehicle and mastery of technique were critical to his successful glide. Similarly, form and technique can help cash managers navigate a declining rate environment successfully. 

First: structural form and aerodynamics. Low aspect ratio wings allow for short, high-speed flight; high aspect ratio wings allow for long, slow-speed flight. The analogy in cash management is bank deposits and money market funds. The rates available on the former fall quickly as, and even before, rates fall. The latter can maintain higher market yields for longer. Why? Because money market funds can term-out their assets to some extent, and more importantly, are not beholden to maintaining net interest margins (i.e. the difference between the rates the bank receives and the rates the bank pays on deposits). Instead, money market funds pass on market yields.

Second: the pilot. Experience counts – a money market fund portfolio manager with decades of experience will have seen multiple rates cycles and will be well-equipped to deal with the new environment. Perhaps more pragmatically, although returns are never guaranteed, they will adjust positioning across instruments and banking counterparties to ensure their fund accesses the best yields available in the market. A static allocation to bank deposits, in contrast, will be likely to suffer sub-optimal rates.

The moral of this story is that, with the right form and technique, cash managers can achieve great “distance” with their cash yields in a falling rate environment. Although one might also argue that humans still have much to learn when it comes to flight. After all, the wandering albatross spends the vast majority of its life gliding…²