Read this article to understand:
- How much further EU and US policy can diverge and what it means for government bonds
- What the EMD team learned at the IMF/World Bank Spring Meeting
- What higher rates for longer mean for global high yield
Welcome to the May Bond Voyage newsletter! This month, our emerging-market debt (EMD) team has been talking about what they learned at the IMF/World Bank Spring meetings. Divergence has been high on the agenda for the sovereign bonds desk and higher for longer for our high-yield colleagues.
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: Asking the right questions
This month, we report back on our recent trip to Washington to participate in the IMF/World Bank meetings. This bi-annual event sometimes resembles a “speed dating” event for EM investors and policymakers, with a mad rush to meet as many decision-makers as possible. It got us thinking about the kinds of questions you can ask people to get a sense of compatibility.
If you were an animal, what kind do you think you’d be? A leopard
They say a leopard never changes its spots. While this may be true for some people, it is certainly not true for many EM countries. What we found very striking, across numerous meetings we went to, was just how many policymakers acknowledged the need for reform. Politicians even recognise that fiscal prudence can help their re-election prospects.
Policymakers acknowledged the need for reform
This shift was notable in Ecuador, which has just signed an IMF programme. President Naboa and his advisors tacitly acknowledge IMF support and reforms could benefit their re-election prospects. Turkey’s finance minister, Mehmet Simsek, continued to highlight President Erdogan’s commitment to economic orthodoxy, which is needed to restore macro stability.
The IMF was complimentary about Argentina President Milei’s commitment to fiscal prudence, while the country’s finance minister highlighted that Argentina had no other option than to live within its means. Only four weeks into his job, Pakistan’s new finance minister also spoke eloquently at the summit about the need for an IMF programme and the importance of raising revenue.
If you could have a superpower, what would it be? Predict the future
The failure to make more progress on debt restructurings is leaving market participants, the IMF and sovereigns scratching their heads. While a Zambia debt restructuring is largely done, deals on restructuring debt in Sri Lanka and Ghana still appear some way off. The point of contention seems to be VRI (value recovery instruments).
The IMF do not want to saddle vulnerable countries with an uncertain re-payment profile
Very simply, some bondholders believe the IMF is being too conservative in the assumptions that underpin its Debt Sustainability Analyses, and are pushing for a way they can benefit from a better-than-expected macro outcome. On the other side, the IMF (and official creditors) do not want to saddle vulnerable countries with an uncertain re-payment profile.
Ukraine remains a clear focus, with its debt restructuring, which the IMF expects to be completed by the end of June – a very ambitious timeline. Meanwhile, Ukraine clearly wants to pay coupons to bondholders, in part to keep markets on-side, and to regain market access as quickly as possible. Our discussions with both the IMF and the US Treasury suggest that paying coupons is politically a very contentious issue, particularly given the extent of the support the country has received from the G7.
If your life was a movie, what song would be on the soundtrack? Stronger (What Doesn’t Kill You)
The IMF’s latest WEO (World Economic Outlook) showed global growth remains remarkably resilient, helped by a positive surprise on the supply side, largely due to stronger employment growth in developed countries. The “scarring” effect from the COVID-19 period was not as bad as expected and there was a surge in immigration across developed markets. That contributed to the steady growth of 3.2 per cent in the short term. But medium-term global growth of 3.1 per cent is not too impressive, as total factor productivity growth decelerates and labour input declines.1
While headline inflation trends are encouraging, services inflation remains high
Despite the good growth news, challenges remain. While headline inflation trends are encouraging, largely driven by lower energy prices and easing in supply-chain frictions, services inflation remains high – and in some countries stubbornly high – which could put disinflation at risk. Headline global growth masks strong dispersion across countries.
US growth remains extremely resilient, in part driven by loose fiscal policy. It can be argued the US’s fiscal laxity is complicating EM countries’ fiscal position, both in terms of high interest costs and ease of market access. This is due to the US government’s need to borrow more and the inflationary impact of its spending, which puts upward pressure on treasuries and leads to higher US rates for an extended period. Larger EMs like South Africa, Brazil and Mexico continue to stagnate and see deficits widen again. By contrast, frontier markets continue to consolidate public finances and should see debt edge down.
If animals could talk, which would you have a conversation with? A fly
When, and by how much, the US Federal Reserve (Fed) will cut rates has become a highly contentious issue. The market has shifted from expecting a cut as early as June at the start of the year, to current speculation the Fed might need to hike rates if the disinflation path proves stickier or inflation picks up again. Oh, to be a fly on the wall in Jerome Powell’s office.
While the market has tied itself into a knot over rates during the past week, we are still of the view that the Fed will cut rates this year – although the path to get there may prove a little choppier than we had expected.
Global sovereigns: “Bye bye bye” divergence?
A key theme for us this year is the divergence of monetary policy expectations especially between the US and Europe. Developed markets largely tightened *NSYNC to respond to the global inflation shock, but we’ve always been sceptical that every central bank would raise rates to the same level and then normalise back to a neutral level without any problems. So, while many have called 2024 “the year for bonds”, we think it’s the slightly less catchy “year for greater divergence”.
The “Atlantic spread” between the EU and US ten-year bonds currently sits at around 200bps
The “Atlantic spread” between the EU and US ten-year bonds currently sits at around 200bps and close to multi-year highs. We think there’s limited potential for further widening.2
The European Central Bank (ECB) has clearly signalled that it is independent from the Fed; is focused on its inflation mandate; and that staff forecasts continue to point to inflation gradually returning to target. As a result, we expect the ECB to cut several times before the Fed does, but the market has now priced this in.
There are signs the EU economy is recovering, with survey PMIs rising and Q1 GDP beating forecasts. However, with US inflation rebounding in Q1 (see Figure 1), a crucial question for the rest of the year is how much the US inflation surprises are specific to the US market, and how much they come from global financial conditions easing again.
For 2025 and beyond, we think further US economic resilience will matter for the terminal rate of policy in Europe and will limit how far EU policy can diverge.
Figure 1: US core inflation has picked up this year; Eurozone keeps moderating; UK core has dropped substantially since mid-2023 (per cent)
Note: Inflation is represented by the 6-month core CPI seasonally adjusted annual rate.
Source: Aviva Investors, Macrobond. Data as of March 31, 2024.
When we look at whether US rates can continue to drive the divergence, we come to the same conclusion. US resilience has been a strong theme over the last six months, but this is now a consensus view. The market has priced out the excess cuts in the US and we now sit with just one cut priced for 2024 and around four cuts in total.
US resilience has been a strong theme over the last six months, but this is now a consensus view
If there is anywhere that neutral rates are significantly higher than before 2022, it’s most likely in the US. The market is not pricing for policy rates to move materially below four per cent over the next few years. But we see that as the upper band of nominal neutral rate expectations, and the Fed’s long-run dot plot is only slightly above 2.5 per cent.
There is a risk the Fed could hike rates again, but we think it’s around the same level as the risk of seeing fewer cuts in Europe, so it doesn’t impact our view on the EU versus US spread.
We continue to expect more disinflation despite resilient growth, eventually allowing for more easing than what’s currently priced in most developed markets. But recent data trends have pushed this back, so Q2 data will be extremely important in shaping the rest of the year.
Global high yield: A macro month
The key topic for the global high yield team – and all high yield investors – this month was the path of US rates. Following a hot March GDP print, investors hoped for data that could support rate cuts by the Fed, as that would help alleviate refinancing risk.
At the beginning of April, they had priced in an 84.9 per cent probability of at least two cuts and only a two per cent probability of no rate cuts by the end of the year. But as April CPI came in higher than expected, any hopes of several rate cuts in 2024 were dashed. That caused the high yield index to return -0.94 per cent over April and ten-year US Treasuries to sell-off to November levels.3 As April ended, markets priced in just a 42.9 per cent probability of two cuts, while the probability of zero cuts increased to 27.1 per cent. And the US economy now appears to be holding up enough to maintain current rates for the foreseeable future.
The US economy now appears to be holding up enough to maintain current rates for the foreseeable future
Due to this strong macro data, lower rated CCC and CC companies have led a sell-off, returning -0.99 per cent and -2.38 per cent respectively in April. While the ten-year Treasury sits around 4.6 per cent, investors are continuing to lose interest in many distressed names, demanding more secured paper or higher quality buckets to allocate capital to.4
With no rate cuts in sight and the formation of several co-op groups, it might seem like the lower quality end of the high-yield market is becoming increasingly stressed. But CCCs and below have been proactive at refinancing and extending their runway: they own only 13.8 per cent of the $55 billion of debt that matures in 2024, and just 12.8 per cent of the $132 billion maturing in 2025.5
Only time and macro data will tell whether rates will be cut. In the meantime, many lower-rated companies will continue evaluating alternative options to reduce their cost of capital, whether through distressed exchanges or other liability management exercises.
