MAPPING THE RATE LANDSCAPE
The economic panorama in peripheral economies has evolved remarkably over the past six months, transforming from a broad, albeit light, economic expansion, the focus now has narrowed down to select pockets of growth. Europe’s peripheral countries, especially those with tourism-driven service sectors, are under the limelight. In contrast, countries grappling with industry-driven growth models might struggle to adapt their economies to the energy cost mix, with Germany, the Eurozone’s powerhouse, in the spotlight. Despite current excess supply conditions, possibly due to hoarding practices and a mild winter, the energy crisis is not over, and a potential shift in Q4 could further constrain growth and stoke the fires of inflation.
On the front of duration, in light of the apparent turn in the global economic cycle, we favour a neutral stance, with a lean towards going long. This strategy stems from a prolonged downturn in the global manufacturing sector and subdued demand, threatening to seep into the services sector. Meanwhile, inflation looms large. Unprecedented coordination between monetary and fiscal policy has fueled its surge. As the ECB strives to normalise policy amidst continued fiscal expansion, stabilising inflation remains a daunting task. Current inflation expectations sit slightly above 2% across the US curve. In Europe, inflation breakevens are closer to US levels, higher than the historical European trend, making US inflation expectations appear relatively more enticing. Yet, the discrepancy between breakevens and the inflation coupon accrual in Europe suggests potential value, particularly at the shorter end.
THE CREDIT RISK CAROUSEL
The sovereign credit risk landscape is also changing, with rating agencies placing increased emphasis on fiscal sustainability, leading to the initiation of rating revisions in Europe. In anticipation of the ECB’s quantitative tightening cycle end, significant developments are looming, including reduced liquidity from targeted longer-term refinancing operations (TLTRO), another rate hike, and the full cessation of the APP reinvestment program. These changes could exert sustained pressure on financial conditions in the Eurozone, underlining the need for prudent investment decision-making and strategic security selection.
CLIMBING THE STEEP CURVE
A key area that has been grabbing attention lately is the steepening of the interest rate curves, a trend that has been underway since mid-February. This is largely the result of a mix of an anticipated economic turning point and the closing chapter of the monetary policy’s tightening cycle. The implications are twofold: the short end of the curve aligns with stable medium-term policy rates, while the longer end adapts to a ‘higher for longer’ scenario. This presents an opportune moment for investors to board the ‘steepener’ train.
On the flip side, the credit market could prove less forgiving. Our base case scenario highlights credit quality as the guiding light for H2. Companies boasting strong balance sheets are likely to weather the storm better than those on shaky financial ground. The market, grappling with an economic slowdown and looming rate increases, exhibits a preference for investment-grade over high-yield bonds, prompting cautious positioning. Despite the bearish sentiment among credit investors, we anticipate a brighter horizon once the full economic impact of Central Bank tightening unravels and a consensus on terminal rates emerges. Until then, brace for continued volatility with the consolation that current yield to worst offers a buffer against potential market weakness.
THE SUSTAINABILITY-LINKED DILEMMA
The world of sustainable bonds is bifurcated into two main categories: use-of-proceeds bonds and sustainability-linked bonds.
The former refers to bonds whose proceeds are earmarked to finance specific environmentally or socially-focused initiatives, and thus, are often known as green or social bonds. In contrast, sustainability-linked bonds carry an intriguing twist. While the funds raised are not tied to specific projects and may be used for general corporate purposes, the interest rate or “coupon” these bonds pay can increase if the issuer fails to meet certain sustainability Key Performance Indicators. Enel, the Italian energy company, broke ground in this field back in 2019, promising a 15-basis-point hike in their coupon if they fell short of their renewable energy targets.
However, the sustainability-linked bonds sector, despite promising beginnings, has encountered several obstacles. Regulatory issues and ambiguity over their place in banks’ capital structures have posed significant hurdles. Moreover, the model’s effectiveness is being questioned, as there’s concern that the potential coupon increase might not be enough to genuinely spur companies towards sustainable behaviour. Thus, the narrative around sustainability-linked bonds is evolving into a more intricate tale than many had initially predicted.
CENTRAL BANK MANEUVERS IN EMERGING MARKET ECONOMIES
Finally, we observe that emerging market (EM) central banks have effectively created a robust rate buffer, nearing their peak rates. Fiscal policies and the anchoring of long-term inflation expectations will dictate the start of any policy reversal. We anticipate that most EM central banks will pause, awaiting signals from the U.S. Federal Reserve, providing some support for currencies. This prudent stance has us expecting neutral to mildly positive currency returns for the rest of the year.
In the context of yields, they remain appealing in absolute terms and may provide duration gains as global growth is projected to slow down. The yield curve is expected to steepen, suggesting that maintaining current duration but shifting from wings to the belly of the curve (8-12 years maturity) could be advantageous for investors. While the high yield and investment grade spread may seem attractive, investors should be mindful of potential shifts towards quality investments. In the complex global fixed income markets, it pays to remain adaptable and patient, understanding that opportunities exist for those prepared to seize them.
