This month, we discuss Spring meetings, the path for rates and sustainability-linked bonds.

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. And our investment-grade team has been thinking about the reasons investors are starting to like sustainability-linked bonds.

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.

References

  1. “World economic outlook – Steady but slow: Resilience amid divergence”, IMF, April 2024.
  2. Bloomberg. Data as of April 30, 2024.
  3. Bloomberg Global high yield index ex CMBS&EMG 2% Cap (USD hedged). Data as of April 30, 2024.
  4. Bloomberg Global high yield index ex CMBS&EMG 2% Cap (USD hedged) CCC and CC index. Data as of April 30, 2024.
  5. Bloomberg. Data as of April 30, 2024.

Subscribe to AIQ

Receive our insights on the big themes influencing financial markets and the global economy, from interest rates and inflation to technology and environmental change. 

Subscribe today

Key risks

Investment risk

The value of an investment and any income from it can go down as well as up and can fluctuate in response to changes in currency and exchange rates. Investors may not get back the original amount invested.

Credit and interest rate risk

Bond values are affected by changes in interest rates and the bond issuer's creditworthiness. Bonds that offer the potential for a higher income typically have a greater risk of default.

Related views

Important information

THIS IS A MARKETING COMMUNICATION

Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (AIGSL). Unless stated otherwise any views and opinions are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Information contained herein has been obtained from sources believed to be reliable but, has not been independently verified by Aviva Investors and is not guaranteed to be accurate. Past performance is not a guide to the future. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested. Nothing in this material, including any references to specific securities, assets classes and financial markets is intended to or should be construed as advice or recommendations of any nature. Some data shown are hypothetical or projected and may not come to pass as stated due to changes in market conditions and are not guarantees of future outcomes. This material is not a recommendation to sell or purchase any investment.

The information contained herein is for general guidance only. It is the responsibility of any person or persons in possession of this information to inform themselves of, and to observe, all applicable laws and regulations of any relevant jurisdiction. The information contained herein does not constitute an offer or solicitation to any person in any jurisdiction in which such offer or solicitation is not authorised or to any person to whom it would be unlawful to make such offer or solicitation.

In Europe this document is issued by Aviva Investors Luxembourg S.A. Registered Office: 2 rue du Fort Bourbon, 1st Floor, 1249 Luxembourg. Supervised by Commission de Surveillance du Secteur Financier. An Aviva company. In the UK Issued by Aviva Investors Global Services Limited. Registered in England No. 1151805. Registered Office: 80 Fenchurch Street, London EC3M 4AE.  Authorised and regulated by the Financial Conduct Authority. Firm Reference No. 119178. In Switzerland, this document is issued by Aviva Investors Schweiz GmbH.

In Singapore, this material is being circulated by way of an arrangement with Aviva Investors Asia Pte. Limited (AIAPL) for distribution to institutional investors only. Please note that AIAPL does not provide any independent research or analysis in the substance or preparation of this material. Recipients of this material are to contact AIAPL in respect of any matters arising from, or in connection with, this material.  AIAPL, a company incorporated under the laws of Singapore with registration number 200813519W, holds a valid Capital Markets Services Licence to carry out fund management activities issued under the Securities and Futures Act 2001 and is an Exempt Financial Adviser for the purposes of the Financial Advisers Act 2001. Registered Office: 138 Market Street, #05-01 CapitaGreen, Singapore 048946. This advertisement or publication has not been reviewed by the Monetary Authority of Singapore.

The name “Aviva Investors” as used in this material refers to the global organisation of affiliated asset management businesses operating under the Aviva Investors name. Each Aviva investors’ affiliate is a subsidiary of Aviva plc, a publicly- traded multi-national financial services company headquartered in the United Kingdom.

Aviva Investors Canada, Inc. (“AIC”) is located in Toronto and is based within the North American region of the global organisation of affiliated asset management businesses operating under the Aviva Investors name. AIC is registered with the Ontario Securities Commission as a commodity trading manager, exempt market dealer, portfolio manager and investment fund manager. AIC is also registered as an exempt market dealer and portfolio manager in each province and territory of Canada and may also be registered as an investment fund manager in certain other applicable provinces.

Aviva Investors Americas LLC is a federally registered investment advisor with the U.S. Securities and Exchange Commission. Aviva Investors Americas is also a commodity trading advisor (“CTA”) registered with the Commodity Futures Trading Commission (“CFTC”) and is a member of the National Futures Association (“NFA”).  AIA’s Form ADV Part 2A, which provides background information about the firm and its business practices, is available upon written request to: Compliance Department, 225 West Wacker Drive, Suite 2250, Chicago, IL 60606