Bond Voyage

Read this article to understand:

• How political ructions are impacting emerging-market debt
• Whether European bank credit offers value
• Why industrial action is unlikely to derail Ford’s path back to investment grade

A warm welcome to Bond Voyage, a new series where we – an assorted crew of hardy veterans and more youthful members of our fixed-income teams – put a spotlight on the stories that have sparked debate on the desks. Our commitment is simple: unfiltered thoughts, no fund mentions, no hard sell and certainly no goodbye bonds.

The only thing we have waved goodbye to is the 30-year bull market for bonds.  Although we want to be bullish, sometimes the economic and market backdrop is a challenge for risk assets. Our advice: stay active and stay engaged.

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 to: gcs.creditinvestmentspecialists@avivainvestors.com.

Emerging-market debt: Politics and music meet in Gabon

We start this month with emerging markets, where political risk remains an ever-present factor. 

Have more prophetic words ever been uttered than the above refrain by wannabe funk star-turned-dictator Alain “Ali” Bongo back in 1978? 

The lesson all would-be dictators that like to cook the electoral books should take from this is not to overstay their welcome. After Bongo’s ousting by the army in late August, bringing an end to almost six decades of family rule in Gabon, attention turns to who might be next: no countries in our universe spring to mind as being at such high risk. 

Staying on politics, much of our focus right now is on the upcoming elections in Argentina and Ecuador. Will people vote for orthodoxy or will populism win out? Predicting the outcome in either country is extremely difficult, with the polls proving particularly useless. No-one predicted how well Álvaro Noboa, the country’s richest man, would do in the first round in Ecuador, or Javier Milei’s strong performance in Argentina’s primaries. 

Whilst we can’t predict the outcome, it is unlikely either candidate – Noboa or left-wing rival Luisa Gonzalez – will want Ecuador to default on its external debt, particularly with the oil price at its current levels. In contrast, we don’t think it matters who wins in Argentina given how dire the economic situation is. Our best guess is that Sergio Massa – current economy minister and bookies’ favourite – and Milei, a populist libertarian, whose policy proposals include scrapping the peso and the central bank, will make it through to the second round. 

It’s wise to keep an eye on what’s in front of you: the military if you’re a dictator, the weather if you’re an investor. Summer has come and gone, and with it some of the downside surprises to EM inflation prints we became accustomed to in recent months. Although headline prints continue to come lower – testament to the early and aggressive rate hikes by many EM central banks – the pace of downside surprises has eased. 

Delving into the details, one emerging culprit is food inflation pressure as the impact of El Niño starts to materialise.

While we are still in the early stages of the climate phenomenon, it is a risk worth paying attention to. Headline inflation might not be able to avoid El Niño – indeed, most upside inflation surprises recently resulted from higher food price pressures in India, Philippines, Malaysia, South Korea and Egypt, to name a few. In contrast, there is little evidence yet of knock-on effects on core inflation measures. This is mostly due to tighter monetary policy still making its way through EM economies and domestic demand factors. 

Investment-grade credit: The good, the bad and the ugly

The back-to-school consensus message from the sell side is that banks are still cheap! 

That has been the case on a relative basis for the past few years, particularly in Europe, and we – like many of our peers – have built up positions accordingly. The question now is: if the whole market is long, could we be about to see a reversal?

Banks have experienced a rollercoaster ride in credit and equity markets this year. Expectations coming into 2023 were much improved as earnings for the sector stood to finally benefit from higher interest rates after almost 15 years of low rates and quantitative easing. As we all know, the positive vibes didn’t last for long as higher rates exposed weaknesses at a range of US regional banks and Credit Suisse during the first quarter. 

Credit markets continue to grapple with some of these weaknesses but, leaving aside the widely flagged write-down of Credit Suisse additional tier one securities, the sector has largely escaped unharmed. This is because most global banks hold much higher levels of capital due to the tightening of regulation; in Europe, banks continue to report strong earnings momentum and recession fears are yet to materialise. 

Perhaps the biggest cloud hanging over the sector from a fundamental perspective is the likely increase in provisions and losses as economies slow in response to the tightening of monetary policy. However, for European banks, we feel the earnings and capital benefits from “higher for longer” should more than offset these concerns. 

As for technical factors, there is more uncertainty, largely due to a significant volume of issuance in the sector. This has been driven by changes in central bank liquidity operations and ongoing refinancing needs, resulting in a degree of sector underperformance. A major uncertainty for investors is how much pre-funding for 2024 has been completed. Despite this, we still believe banks continue to look attractive relative to other sectors within credit. We expect strong earnings for European banks in 2024 and improving technicals to drive an upturn in fortunes. 

High yield: Why Ford’s potential return to IG is delayed but not derailed

Industrial strike action has weighed heavily on the "Big Three" US auto companies in recent months. General Motors, Ford and Stellantis continue to negotiate with the United Auto Workers (UAW) labour union on several issues, including wages, benefits, reduced work weeks and the transition to electric-vehicle production. 

The UAW began a targeted strike campaign on September 13. At this stage it is impossible to estimate exactly how long it will last or when an agreement might be reached. Whilst we have been encouraged by signals the differences between the two sides are narrowing, one thing is clear: whatever deal is struck will undoubtedly increase the cost base for the Big Three. 

However, in our view, the impact on Ford’s operations should be manageable.  There is potential for it to become a rising star back to investment grade (IG). The company has ample liquidity and should be able to pass at least a portion of the higher costs on to customers. Ford is currently rated BBB- by Fitch, meaning it only needs an upgrade from one of Moody’s (Ba1) or S&P (BB+) to make its bonds eligible for inclusion in IG indices.  

This is critical because Ford is the largest issuer in the global high-yield (HY) universe with over $60 billion of debt outstanding. A move back to IG-status would continue the rising star trend started in 2021, which has already seen the investible HY universe shrink by over 25 per cent from its peak market value. 

The duration of the strike may determine if and when Ford’s bonds are upgraded; if an upgrade were to occur in the fourth quarter of this year or early next, Ford’s bonds may compress relative to its closest peer GM. This could also have a halo effect on other BB-rated bonds as HY investors may recycle the capital invested in Ford to other higher-quality bonds in that event.

Global sovereigns: Team America streaks ahead (just not on the golf course)

The USA’s team of superstar golfers might have floundered on the fairways of the Marco Simone Golf and Country Club in Rome during the recent Ryder Cup, but out in the real world, it is a very different story. 

When it comes to inflation among G10 countries, we have continued to see a fall from peak levels through the year (although the pace of the falls has varied).  Where we have seen more divergence is around the growth outlook, with China, Europe and the UK showing signs of weakness compared with a more resilient US economy. 

US growth exceptionalism has been the main driver of the move higher in US Treasury yields over the last few months. More recently, the market has started to shift its focus to the increase in term premia (in simple terms, the amount by which the yield on a long-term bond is higher than the yield on a shorter-term bond). This has been driven by concerns around the increase in Treasury supply and uncertainty over what the Federal Reserve will do to monetary policy.  

Although supply will likely have a medium-term impact, cyclical factors are likely to have a bigger effect on bond yields in the short term, with US growth resilience – more specifically the labour market – being the main driver. 

We have maintained an overweight to global markets versus the US this year but, given the extent of the repricing and US growth outlook relative to other developed markets, shorter-dated US Treasuries could benefit.

Figure 1 shows the potential total returns on Treasuries of different maturities, based on a 100 basis-point change in interest rates. Regardless of your views on where rates go over the next 12 months, it suggests the yield on offer at the front end would require almost a 20 per cent move in yields to erase a year’s worth of carry (the income investors receive from coupon payments).