Bonds Around the World in Election Days

Matt Soifer: I'm Matt Soifer, head of U.S. Institutional Distribution here at Allspring, and welcome to SpringTalk. I'm joined today by two of our outstanding fixed income portfolio managers. First, we have Lauren van Biljon, who covers FX and rates, and she is joined by Alex Temple, who covers credit on our Global Fixed Income team here at Allspring. Welcome, Alex. Welcome, Lauren.

Lauren van Biljon: Great to be here.

Alex Temple: Great to be here. Thanks, Matt.

Matt: Well, why don't we kick things off with elections? It seems like any time you tune into the news, elections are going to certainly be one of the top three headlines. And I'm here in the U.S., based in New York. We obviously have a very big election coming up toward the end of this year. And it's just suffice to say that it's been an interesting lead-up to this election—never seen anything like it before. But it's not surprising that elections are taking some of these headlines. If you look across the world, we have over 70 different major elections across countries that make up almost half of the world's population. And when you think about bond markets, one of the things I respect the most about bond markets is they always have their fingers on the pulse. And I feel like elections are really no different. Bond markets are going to be super sharp around this risk. So, why don't we start with that? And Lauren, maybe we can begin with you. What's your take on where we are with elections so far this year? And what are you looking for as we get into the back half of 2024?

Lauren: 2024 has certainly been one of the busiest years for elections that I can remember. And that's true whether you look at developed markets, emerging markets, frontier markets. Everyone has gotten involved. I think, generally, there's been more willingness to reprice weaker than stronger. Bond yields have certainly or sovereign bond yields have certainly tended to trend higher in the first half of this year. And it's been a tough election cycle for incumbents in a lot of cases. For example, the snap election in France. So, sovereign bond yields there are moving higher and that spread of France over both the U.S. and Germany is moving wider. Mexico is in the wake of the election there. All things Mexican cheapened materially after the ruling party came. It had a far stronger result than expected. But what has been heartening to see is that markets have generally treated elections as idiosyncratic domestic events. The spillover has been fairly limited, and these large initial reactions have tended to be walked back at least partially over the subsequent weeks and months. Those two factors have created space for active investors to take shorter-term tactical positions as valuations have drifted a decent level away from fundamentals. So that has created a lot of opportunity. There have been some markets where elections have passed with barely a ripple, thinking about the U.K. in particular where the Labour Party's very strong win was very much priced in by the market. And we have something of a summer lull ahead of us. In the next two months, there is almost nothing in the way of major elections scheduled. It will give us a bit of a break, but it does mean that the market has plenty of time to focus on the U.S. election in November, which we know will have ramifications for both the U.S. and the global economy for not just the months ahead, but for the years ahead.

Matt: Thanks, Lauren. Alex, what's your take on that?

Alex: Yeah. So, the French snap elections really have been the big driver of spreads in the euro market—came as a bit of a surprise. The French corporates and banks make up 20% of the index (the ICE BofA Euro Corporate Index). They're actually the largest percentage weight in the index. So, it was always going to be a bit of a spread mover. And then, spreads effectively followed the government bond moves wider in sympathy. As a house, we tend to be underweight credit from France because their trade is quite expensive. They trade rich. One of the reasons is there’s a strong domestic bid and the second is that there's also been a strong bid from the ECB (European Central Bank), who had these active purchase programs and they own a lot of French credit. So, we've tended to underweight French corporates but actually have been very positive on French banks. They're very highly rated and diversified. We use the weakness in spreads to add in the primary market. So, a couple of French corporates, which we wouldn't usually buy into, really traded a lot cheaper in the primary markets. And that gave us an opportunity to get exposure to those high-quality names at a bit of a discount. But we still remain cautious overall because we think the French election volatility is actually here to stay for a little bit longer. So, it was just about adding a little bit of incremental risk, similar to what Lauren was saying earlier.

Matt: So, if we continue on the theme with global governments here, higher for longer has been a theme that's been a little bit sticky, right? I mean, here in the U.S., people have been expecting rate cuts. We haven't got there yet. The Fed (Federal Reserve) has not made any moves, although there's a good number of people that are starting to focus on September for the first possible rate cut. But in other parts of the world, we are starting to see some of these initial cuts. The ECB being one of them, the Bank of Canada being another, and it could be a signal that changes in global trends are coming. It can also suggest that maybe an economic slowdown could potentially be faster in certain international markets. So, Lauren, given your background on rates, I would love to hear your thoughts on this and what you think it means for rates going forward.

Lauren: 2024 has been almost a textbook example of the cyclicality of market expectations. We started the year with far too much easing priced into both the U.S. and global rate markets. And we then had to endure the rise in sovereign bond yields that came alongside the repricing and the pricing out of all of those rate cuts. I think the good news, though, is that Q2 seems to have marked the peak of bearishness when it comes to global rates. The recent data is looking more supportive, both on the inflation side and on the growth side. And so, we are seeing rate cuts and all the expectations of rate cuts creep back into market pricing. And as you say, developed market central banks are starting to break ranks. We've seen movement out of Europe, we've seen movement out of Canada, and a number of other central banks are signaling that they'd like to be following suit quite soon. And I think there is the potential that the market is underpricing what the Bank of England can do and I think the market is certainly underpricing timing there. I think the Bank of England will move ahead of the Fed by a fair margin. And New Zealand is another name where, for me, the market could be underestimating the size of the 2024 cycle. But I don't think we should get too excited yet about the overall size of this next leg lower in global interest rates. Data currently is suggesting lower rates, yes, but at a more shallow easing cycle. But even so, I think sovereign bond yields, particularly shorter-dated maturities, could respond very well to a broadening pool of more dovish central banks. The one exception to all of this is the Bank of Japan, where rates will need to move higher. And that's somewhere where I'd love to see the bank be more aggressive actually on rate hikes. I think, for a number of reasons, though, including possible institutional inertia, that's unlikely. But that does leave the Bank of Japan as an obvious outlier in the global rates environment.

Matt: So, Alex, if we come back to Europe for a moment, can you just talk us through a little bit about what you're seeing in European credit—what that performance looks like? Relative to some USD counterparts, we are seeing situations where spreads are quite attractive, yields are quite attractive, even after hedging for currency risk. Do you think these opportunities are going to exist as the market goes on here further into 2024?

Alex: Yeah, that's a great question. I do. It hits upon what Lauren said at the start. We didn't expect the number. The market was too aggressive in terms of pricing the number of rate cuts. So, the big surprise this year, or not a surprise so much to us, was that actually these rate cuts haven't materialized. But actually, credit spreads have tightened a lot, even as yields have drifted higher. And that's primarily because it's the all-in yield bias that they’re buying. They're not just looking at the credit spread. They're looking at the overall yield. So, credit spreads have actually traded pretty well. Euro credit spreads year to date are about 30 tighter investment-grade credit spreads. They were about 30 cheap to the U.S. at the start of the year. Now they’re about 15 cheap. So, there's still some value there in Europe versus the U.S., and it's worth reminding viewers and listeners that ultimately the duration in the euro markets is a lot shorter. It's 4.6 years versus 7 years that you get in the U.S. market. So, you're getting more spread for a shorter market. And actually, historically, we're 14 bps (basis points) inside 10-year averages. Actually, U.S. spreads are like 36 bps inside the long-term averages. So, there's still scope, we think, for further compression in Europe. And technicals are just very strong. I think the hedging costs play in our favor as well, as that policy divergence has kicked in. We've had some cuts in the eurozone. One cut so far. We expect two more over the rest of the year and that should drive performance further.

Matt: OK. Let's shift gears a little bit and make sure that we cover the globe and let's talk a little bit about what we're seeing in emerging markets (EM). This has not been the easiest environment for investors in this space. It's been a little bit tough in both equities and in bonds. And we've seen some investors lighten their allocations in emerging markets. We've seen some investors cut it out completely. But one of the things that I find most encouraging is that we're starting to see people come back here. And the interest appears to be peaking, partly because valuations look interesting, certainly look interesting, relative to what we're seeing across the rest of the globe. But I think we're starting to see investors really value that diversification. So, Alex and Lauren, I would love to get both of your thoughts here on emerging markets. Should we stay constructive? What are we expecting here on the back half of 2024?

Lauren: I am a long-term optimist on emerging markets. I think the tag covers such an incredible variety of names in both the sovereign and the corporate space. I think if investors disengage entirely, they lose access to a really rich opportunity set. But having said that, it is an area that benefits from active management with that deep expertise and experience in the asset class. Emerging markets do have wonderful experience with, shall we say, non-negligible inflation, which post-pandemic has been a really important skill set. So, we saw emerging market central banks stepping in to tighten interest rates sooner than in developed markets to fight inflation. And that meant an earlier pivot to easier monetary policy, as well. Interest rates in both Latin America and Eastern Europe are well off their highs. There are certainly some anxieties around trade and tariffs, anti-globalization. And those are all absolutely valid concerns because we are in the midst of a long-term shift in our global supply chains. But again, with those currents and those changes create opportunities for active managers to outperform and to exploit. Some issuers have struggled in the high interest rate environment. But again, it's been dealt with very much on a name-by-name basis. And there hasn't been that general rise in systemic stress. So, it talks about an asset class that is maturing and that can offer long-term value to investors.

Matt: And, Alex, what's your take on emerging markets these days?

Alex: Yeah, I'm kind of in agreement with Lauren. EM markets really feel like they've matured from a credit perspective. The investor base has changed as well, so it's a lot more global. So, it feels like there's a better understanding. And breaking the link with the Fed, I think, was key. So, the fact that they went early, that's definitely been a bit of a game changer. I'd say also a lot of global corporates that we invest in, investment-grade corporates, have global exposures and that's definitely helping investors understand that these markets can act as a diversifier. So, the big corporates, while they might not be doing so well in Europe, they could be doing very well in Central America or they could be doing well in Africa. So, for us, I think it's a positive development that they've matured and I’m definitely a fan of the asset class.

Matt: Well, why don't we wrap it up there? It's always nice to leave things on a constructive, positive view. Lauren, Alex, thank you very much for joining us.

Lauren: Thanks, Matt.

Alex: Thanks, Matt.

Matt: And to our audience, thank you for joining us on SpringTalk.

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