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This is Winnie Cesar, Global Head of Strategy at Credit Sites. And today, we are going to be taking a little bit of a trip around the world to try to figure out what the heck is going to happen in Q2 2025 and beyond. Joining me today, I have Zach Griffiths, my right hand man, and our head of US macro strategy and investment grade strategy. And then we also have Regis Chautelier, who is our head of eM Sovereign Strategy.
Gentlemen, thank you so much for joining me today. Thanks, Winnie. Looking forward to a great discussion. Yeah.
Regis, you have very little words right now. I know you have a lot to say. Yes, yes. So I opened the sound a bit late.
Anyway, yeah, exciting. Delayed reaction just like the market. So Zach, let's start with the old elephant in the room. We've had some recent economic data that have definitely painted a more mixed picture of US momentum.
A lot of people have started to call into question the concept of US exceptionalism, which was very much the base case expectation heading into this year. And we've had a bit of a revival of its stagflationary or even recessionary concerns. How are you thinking about the shift in both hard and soft data prints? And what is your current base case for growth inflation?
Labor markets in 2025, should I be continuing to buy equities on down days? Well, I'd say my answer to those several questions are not exactly consistent. I guess I'd say Winnie, to start this year, things are at least now that we're through the first quarter and thinking about it. And I forget playing out the way we had anticipated.
So in terms of the economic growth, inflation, and labor market landscape, we had come into the year expecting a below potential type growth rate after a couple of years of very strong growth. And that's what we are looking at. I think when you look at both the hard and soft data, of course we don't have Q1 GDP just yet. I know the Atlanta Feds, GDP now forecast, if you adjust for some oddities with how they account for, I think, gold imports or something like that, it's looking like negative 0.5% for the first quarter.
And so I know the first quarter historically has seemingly had some residual seasonality, but clearly we're seeing signs of weakness. You see that in the personal spending data, not only in January, but the first quarter of the February print confirmed more weakness there. And then you have survey data pointing to really stagflationary concerns with sentiment, dropping and inflation expectations rising fairly significantly. And so when I think about our outlook as a whole and what we put together at the end of 2024 for our base case for 2025, we had effectively combined our prior base case and stagflation scenarios into one that kind of became our stagflation light.
It's complicated scenario. And so I think so far things are playing out pretty well the way we had anticipated in terms of growth coming down to something below potential inflation, looking sticky with core PCE still around 2.8% and labor markets starting to show signs of weakness, but not rolling over. The one area where I think sequencing has been important and maybe not playing out exactly as we had anticipated is the treasury yield backdrop. We had anticipated and still anticipate higher yields this year.
We got that very early on in January as expectations for the Fed were a little more aligned with our expectation for a hold throughout 2025. It seemed like there were more fiscal concerns about the deficit likely to remain around 2 trillion for the foreseeable future. I think early in this year, economic growth prospects and optimism about the current administration were elevated all pushing yield higher. Now what we're seeing, and I think this is the big risk to our forecast right now, is risk has shifted to certainly on shakier footing and on these risk off days where you have equities falling, credits perhaps widening a bit, treasury yields are falling as well.
And I think that relationship has been very tenuous for the past couple of years. Historically, you think of if equities are falling, yields are falling or bonds are rallying. And that hasn't exactly been the case since we've had this big inflationary period. So yields have come down quite a bit and it does seem like the treasury market is pricing in more the stagnation concern of stagflation, whereas we're still focused on the inflation concern of stagflation.
That's a super helpful backdrop. And I'd like to dig into the concept of stagnation versus stagflation versus stagflation light. I know that we've debated a lot about our call for higher treasury yields and the Fed being on hold up for the foreseeable future. We've had some brief glimpses of taking a little victory when we've seen yields move higher, even amid a pair of headlines and some popular economic data.
But as of today, it seems like things are moving the other way pretty decisively. How are you feeling about the call for higher treasury yields and the Fed being on hold for the foreseeable future? Is there still a Fed put or is that off the table? Yeah, I think you can tell from my prior remarks, feeling a little bit like the risks are clearly skewed to the downside, at least if the current market dynamics and just looking at, you can do 20-day correlations in betas of the S&P 500 in the 10-year or 13-week if you like to look at weekly.
Maybe that kind of cuts through a little bit of the noise, but you're seeing rising correlations and rising betas. And so I think that's kind of the clearest risk, especially with our call for wider spreads, at least an IG, I think we're already through our high-yield spread target. And I know we'll get into that in a little bit more detail. I'm feeling a little more comfortable with the idea of the Fed staying on hold as long as economic data and in particular, the labor market doesn't roll over.
I think the sticky inflation narrative is clear. Market pricing is focusing more on growth concerns from tariffs and the uncertainty how that's weighing on business leaders' ability to plan and make decisions and all the while we've been highlighting for quite some time now that the consumer seems to be on a bit shake your footing. So all those things together are certainly concerning for growth, but when we put our forecasts together, we certainly don't have a recession as our base case. I think we'll be notching up the probability of recession at the expense of the probability of our bull case scenario, which was more of the immaculate disinflation where the Fed is able to ease.
The economy is still solid. Really, the perfect scenario I'd say for picks and come broadly. And so I think the risk to our treasury call are skewed to the downside. We still have a lot to learn about the Fed's reaction function, but the thing that really stuck out to me at the March meeting is you had a big down draft in growth expectations and uptick in inflation expectations.
And in terms of the Fed's reaction function, while the median dot for any of the forecast years did not move up the average, so just looking at the mean did shift a little bit higher. And that indicates unbalanced. Policymakers want to respond to the inflation concerns, not as much the growth concerns at least in that last data point. So I think there's a lot of cross currents to consider maybe risk to the downside in terms of our treasury call, but I think in terms of what the data is telling us and what we learned from policymakers, we're feeling pretty good about our view coming into this year.
That's super helpful. And while Logan Miller, our head of Euro strategy is out on holiday, celebrating a much anticipated wedding, I do want to just kind of mention the Euro side of the equation because there have been an awful lot of headlines, especially coming out of Germany. You have this very mixed economic backdrop of kind of industrial stagnation going on within the Eurozone. And like I mentioned, heading into this year, people were still pretty optimistic about the America outperformance and kind of exceptionalism on the economic narrative.
And that seems to have shifted pretty dramatically, which is also now reflected in boondeals and expectations for where the ECB and the Bank of England are probably going to go over the near term. It seems like we are running into a point where the ECB is more likely to be on pause, waiting to see how the impact of tariffs flow into the European economy, while at the same time you've had a pretty significant move on the German fiscal side of things with a commitment to some significant, at least for Europe spending. And so it has been very interesting to see how credit markets have reacted to that with European spreads trading inside of US spreads for the first time in really quite some time. This was much more typical of some of the post GFC era when we had energy in the US being kind of front and center as the problematic sector and much less exposure to that within the European market.
Now Regis, I want to bring you into the conversation because you have definitely expressed some concern about the economic fundamentals given the potential impact of Trump policies on a wide range of the sovereigns that you cover. Where do you see the greatest risk to growth and other countries or regions that you think are in a bit better shape? Yeah, Winnie, definitely. I would start to say that imagine markets have been quite resilient to the economic slowdown in developed markets in the first place.
I mean, arguably you have some pockets or weaknesses, you know, growth losing momentum, especially Mexico. We can probably understand why, given the context, but also Brazil, some CE countries like Hungary, Romania for a specific reason than Turkey. But overall, growth and momentum have been quite good. Starting with China, I would say last quarter was printed at 5.4% year on year with a stimulus.
Growth improving quite a lot in Middle East as well, Saudi Arabia, Egypt, a lot of Atlantic America countries, Argentina, Chile, Peru, Colombia, and growth remain quite strong in Southeast Asia and namely Indonesia, Philippines, Malaysia, this country. So, unbalanced actually, growth has been quite decent. You have some pockets of weakness, but overall it's quite decent. Growth was expected to be close to 4% this year, 4.2% if you include China, but definitely improving from last year, which was at 3.6%.
So fundamentals were going the right direction and doing much better than developing economies. Now, clearly we have clouds accumulating now and basically with the long-term policy is likely to have a meaningful impact on global trade and EM economic activity. So obviously, tariffs, US tariffs are going to have a big impact. Mexico, China, I mean, we all know that, given the big exposure of these two economies, but you have also other EM that should be or likely very significantly impacted given the high share of the exports to the US market.
That's the case, for example, like Vietnam, Thailand, Malaysia, or country like in Latin America, like Colombia. We heard a lot about the older sector is going to be impacted quite strongly. Mexico, again, being a target or the victim here, South Korea. But even in Europe countries you wouldn't imagine wouldn't be so exposed.
CE countries would be indirectly exposed because Germany is exposed and Eastern Europe is actually exporting a lot to Germany, especially in the older sector. So indirectly, you're going to have countries like Slovakia, Hungary, being significantly impacted. You have also the steel sector and aside from China, you're going to have India, Turkey, Brazil affected quite a lot. Another interesting point and side point in the way is they also the impact of the deportation of migrants and the impact on remittances in Central America.
In a lot of countries you have remittances representing 20 to 25% of GDP, so it's massive. So as you deport a lot of these people, obviously they don't send money anymore to their countries and that's going to have a meaningful impact. Now in this kind of a pretty gloomy picture, you have some positive news, especially coming from Europe with an increase in the military spending and fiscal expansion. And then I have an impact on CE countries, but this is going to take time.
And the adverse impact of that is going to have public deficit widening. So in a nutshell, I would say in the end, no one in safe is safe in EM. It's a pretty broad-based impact of the long-term policy. EM growth will remain stronger than in developed economies, that's probably sure, but it's going to be much weaker than expected, essentially because of tariffs.
That's a really helpful overview. And I think that the China kind of outperforming so far has been interesting. Is there really an honor team who looks at Asia's strategy has definitely been mentioning that clients are taking another look at China, including the property sector, which I think is really interesting. But we're just thinking more about kind of the Fed and Treasury yields and the broader potential for a re-inflation narrative.
If the Fed is on hold and Treasury yields do start to rise, how are you thinking about the potential impact on EM severance? Do we just have spreads stand still because all in yields still look good? Or is there something more concerning out there? So this definitely a concern on this side.
I mean, it's definitely a game changer for the other side of the picture. The tariffs and the other side is the Fed. What's the impact of this policy on inflation and how it is going to impact the Fed's policy? And in the end, if you have Fed keeping high interest rates, then obviously that means high funding costs are in much in markets.
What does it mean? The first impact is obviously on central banks. Real rates are pretty high still, but it's going to be difficult to cut interest rates if the Fed doesn't do anything. I would say it's a shame because if you look at core inflation across EM, it's been the trend is still downward, right?
Apart from few countries, especially Brazil or some countries, but overall, the inflation picture is still oriented in the right direction. But obviously the Fed doesn't cut. It's going to be more difficult. And especially if you have a big risk of, then you have pressure on EM currencies and then typically central banks tend to maintain rates or even hike to defend the currencies.
And that's going to be an adverse impact for EM growth. Now purely on the starting credit side, higher US Treasury yields would have significant impact on EM-IG bonds. Because of two reasons. The first is the impact duration.
The duration impact. The average duration in EM-IG is close to eight. And that's quite much higher than the US corporate IG. For example, it's 6.8 if I remember well.
So you have a higher duration impact on EM-sauvering IG. But also, spreads would probably widen. They're still relatively tight by historical standards. And if you have deteriorating financial conditions, then you would likely to see wider spreads on their side.
But my main concern is EM-high yield. EM-high yields are still trading pretty tight. They have improved a lot in terms of credit fundamentals. We had a massive rally last year.
They recovered from the inflationary shock. But obviously, if you increase funding costs now and whereas valuations are very tight, you take the risk of having or we could see a significant repurising for EM-high yield. And that's why I'm quite defensive on this. That all makes a very good sense.
And Zach speaking of defensive, we came into the year with an underweight allocation to US investment grade. Since we went more cautious on risk, spreads have widened out, hitting a recent wide of 97 basis points. That's about 20 basis points wider than the post election fights, which is when we downgraded. So kudos to you on that.
This is definitely a big move, 20% plus. But spreads are still objectively quite tight at 700 basis points. And all in yields are in that 5 to 5.5% area, which a lot of people say is kind of the sweet spot for yield buyers. How are you thinking about the direction of US investment grade spreads in the near and medium term?
And do you have levels in mind that would get you a bit more constructive on the market or some key dates or events? Thanks, Wendy. It's nice to see the call playing out after what had been pretty stubbornly tight spread and a lot of optimism about policy at the end of last year and early this year. So going forward, our spread target for year end 2025 is 110 basis points.
And so if we were to see widening, I'd say into the 125 to 135 level, I think that would be a range that we would look at getting more constructive. But of course, it'll depend on what is driving the spread widening. Right now, I think we're seeing a pricing end of more economic weakness, uncertainty at very elevated levels. And I don't think that we have any true fundamental concerns, but really we're just kind of widening off what we're historically tight levels and perhaps a pricing of credit risk that was not really reflective of the policy mix we had been anticipating and seem to be getting out of Washington right now.
So I think in the near term, looking for spreads to continue widening, obviously we'll get a little bit more clarity on the tariff front with Liberation Day tomorrow. We're recording on April 1st. And so we'll have more of a sense of what reciprocal tariffs look like and perhaps what regulatory measures look like. But in terms of other risk events that are out there and could kind of loom over risk sentiment, you have the debt ceiling that's still out there.
The CBO thinks that Treasury could run out of cash if we don't have another suspension or lifting up the debt ceiling as early as late May. We could get all the way to late August or early September. And then at the same time, the current continuing resolutionally goes through September 30th. So I think if the administration tries to link debt ceiling negotiations with getting one big beautiful bill passed, I think that could be kind of a lingering overhang that if that pushes spreads wider, but ultimately we do get tax cuts extended and the US doesn't default on its debt, of course, and I think spreads in that 125 to 135 range would be probably a good time for us to maybe upgrade the market weight and depending on the overall economic backdrop, maybe even moving back to an overweight recommendation.
All right. Well, we'll look for spreads to get to those levels. And on the leveraged finance side of things in the US markets, we've had some really interesting moves. We've had Lev Finh held in much better than at least I anticipated to start the year, but March represented a bit of a turning point.
And in fact, US high yield spreads widened pretty significantly in March by 68 basis points. This is the biggest one month move since we had since June of 2022, which if you recall was when the Fed had just started hiking and everyone was really worried about the combination of inflation and fed rate hiking, just pulling the broader US economy into a pretty significant recession. Now, the move has still left high yield spreads, I would say objectively tight at 355. Our forecast for this year was actually 350 basis points.
So we've gotten to our target in high yield a bit more quickly than we did in investment grade and yield are now at 7.7%, which is usually a level where people take a look at high yield and say, should I start to get into this trade? We're holding off on that a little bit longer. We have been underweight US high yield and I think that we're kind of happy to sit there for a little bit more. I do think that in all in yield area of maybe closer to 8%, would make some sense when we think about our different forecasts, we have yields going to the 8 to 8.5% area in a range of different, more negative scenarios and I think that I feel pretty good about that still.
Now, one thing that we've also been looking at is the broadly syndicated loan space. We were a bit more constructive on loans and then high yield to start the year on the expectation that the Fed would not be cutting and that inflation would be a bit more of a problem. And just looking at relative value in the loan space, it looked pretty attractive. We are getting a little bit more cautious on loans.
It's taken a bit more time for loans to also react to some of the more negative at market sentiments. We feel like it's a pretty good time to downgrade broadly syndicated loans. There's been a lot of technical demand for loans this year into CLOs, CLO ETFs, separately managed accounts. And when we look at retail fund flows into loans, it's been pretty robust to start the year.
But more recently, we've started to see some outflows, which is generally not a great sign of things to come. And when we think about the relative value prospects of high yield versus loans, they're trading at a pretty similar dollar price at this point. So it's kind of like there's not a lot of incremental loan upside unless you have a massive resumption and very strong economic fundamentals, which makes us a little bit more cautious overall. So in US leverage finance, sticking with our underway on high yield for now, thinking about 8% as that target and loans also starting to get a bit more cautious again.
So reach us on the AMP sovereign side of things. This has been an outlier in terms of performance for the year. It's off to a pretty reasonable start. Can you remind us of your current recommendations for both EAM investment grade and high yield dollar sovereigns and where are you expecting spreads ahead in the next few quarters?
I would say it's been decent performance for your MIG in the first quarter. So that's close to 3% for your date for your MIG. But again, it's essentially due to your estuaries. In fact, it spreads up pretty much flat.
It's very much the duration impact. As I mentioned earlier, you know, duration, average duration in solving high IG is longer than other markets. So the asset class has benefited from that. If you look at sovereign high yield, it's been doing okay, I would say plus 1% in the first quarter.
So nothing really fantastic. In fact, it feels that EAM high yield have been running out of steam after an incredible year last year. Last year we had EAM high yield hosting 15% return. And that was following another 15% the previous year.
So that's 30%. So 15% twice. So that was very, very strong. We had last year also very big performance on a few countries like Argentina, Ecuador.
I mean, basically the kind of a very high yield slash, you know, distressed because situation was improving because of the help of the IMF and more funding, funding conditions improving and so forth. So you had very much all the stars aligned last year now. Things are much more complicated. Obviously, violations are very tight.
You have also some political instability in several countries. You probably heard about Turkey recently, some massive protests. So you have clearly some questions. What's next, you know, for Turkey?
Romania also has been run on quite sometimes. The cancellation of the presidential election. You're going to have new elections in May, but it's still quite uncertain what it's going to look like. You still have the Ukraine conflict going on.
Clearly, it's taking more than 24 hours to solve. So in this environment, it's difficult to see an easy kind of run for EAM. Last thing I would like to mention, fiscal deficit is still quite significant. Also true in many developed markets, but you have fiscal deficits at around 4% of GDP on average and it's improving but very, very slowly.
So in this environment, I would say all the good news have been priced in and I would expect the EAM high yield versus IG spreads to go back to the 400 basis points area that compares to 285 basis points now. So we are moving it in this direction, but I would say there's more potential for reprising at this point. In terms of positioning very briefly, I'm quite defensive. I would favor the most robust credit at this point.
Poland, I would have that as an outperform, you know, like the benefit from funding from the EU and growth is pretty robust. Saudi Arabia, it's interesting because it has benefited from several upgrades recently. And actually, this is a credit that's been away from the epicenter of the crisis. Saudi Arabia exports many in Asia to Asia now, not anymore US.
So tariffs wouldn't impact so much. Saudi Arabia at this point. For the negative calls or negative underperform calls, Mexico is very much in trouble with tariffs, but also the financial support to Pemex. Romania, as I mentioned before, I think political noise is going to continue.
Turkey, I still have it as an outperform, but clearly what's going on right now, I put it as sort of a keep it on watch, I would say it's still positive because inflation has been trending down, I would say nicely. But macro fundamentals are improving, but I would say credit fundamentals are improving, but political situation is a bit complicated. So in a nutshell, not shelf quite defensive on the end of this point. Yeah, that makes a good sense.
And the political situation feels complicated globally at this point, including in Europe, where we had it into the year with an underway allocation to European investment grade and a more neutral recommendation on high yield. Europe has massively outperformed a lot of expectations for a whole range of factors, which we've kind of already discussed. And even with the decompression that we saw in March, what spreads widen out a good bit, both in Euro-IG and high yield, Euro-IG spreads are still tighter on the year by six basis points, and Euro-high yield has only widened out by 17 basis points. So presumably there is some downside on spread widening if we do have more of a broader kind of global economic slowdown or stagnation or stipulation type outcome.
Now, I would note that in Europe, the base case expectation really for the past few years has been for not great economic momentum. We've seen some pretty challenged data, and I think that there is a good bit of optimism around a reinvestment on the fiscal side of things, infrastructure spending, military spending. The big question that I have, of course, is what actually happens with tariffs. And presumably we'll know more actually by the time this podcast comes out, given that we are recording it the day before Trump's Liberation Day for whatever that is worth.
But we will have more on the outlook for Euro-IG and high yield out in the next week or so when Logan is back from his holiday. Now, I guess we should wrap it up with some risks to the outlook. Now, we've not necessarily had the most constructive call. We're a bit cautious overall.
But I would say that our messaging is more moderate regarding recession risk, a true hard landing, and really more focused on every calibration, evaluations, and expectations to reflect at least some of the challenges ahead on the growth and policy side of things. Regis, when you think about the EM sovereign space, what are some of your biggest worries that could drive a more significant correction or a hard landing type outcome? Yes, as I said, lower growth are going forward, but again, fundamental work quite positive. Now, what can turn really bad and put EM in really difficult situation?
Well, and in fact, it's purely the escalating tariffs, kind of narratives. So if you start having, obviously, Europe, but China and also other EM countries somehow retaliate, then you start having some really big pressure on growth and inflation. So the overall environment would be very complicated to maneuver for EM. You would still have some pockets of resilience, probably South East Asia or something, but the rest could be affected as well.
The other impact and that's probably the consequence of what I said before would be a sharp fall in commodity prices. If you have commodity prices falling too sharply, then it's going to be a problem for EM exports, most of a lot of EM export commodities, and would have an impact on their fiscal account as well. If you think about it, especially in the EMI-G sector, 60% of the EMI-G index is basically commodity exporter. So if you have oil falling too, I don't know, 40 or even 50, it's going to start looking complicated for EM.
And obviously, if you have intensification of threats from the Trump administration, targeting, let's say, Panama, you have some form of intimidation, like military action there. I think a lot of EM is going to start looking quite concerned about these kind of environments. So with this regard, this is the kind of last option just yet, but I would say the first two scolating tariffs and falling commodity prices could be a more trigger for reprising. Another trigger for reprising.
Yeah, Regis, I'm glad you brought up the prospect of falling commodity prices, because even as there's been some expectations for slower growth and economic stagnation, it doesn't seem like commodity prices, especially on the energy side of things, have really dropped all that significantly so far. And we do know that part of the Trump administration's plans or perspective plans is to drill baby drill, produce more energy in the US, which presumably would weigh on oil prices overall. And clearly, a lot of markets with the upsoffrons and also the US markets have some significant exposure to commodity producers and potential downside if oil prices, or natural gas prices, decline significantly. So Zach, beyond the potential for lower commodity prices, being a potential headwind to some of our key issuers within the US markets, although it would be a good thing for consumers, what are you thinking about in terms of risks to the outlook?
So I think for at least our treasury yield call, I really hammered on the risks earlier. I'd say the one reason we think that we could get higher yields in the second half of this year is if inflation remains sticky and there's a little bit more of that fiscal concern priced in, which we saw fairly briefly earlier this year, I think, as you saw, economic growth surprising to the downside, but yields continuing to rise somewhat somewhat to what we saw in August 2023. I think a big risk to our more defensive positioning recommendation on IG is there is still a ton of cash out there on the sidelines. I think the logic had been if yield are coming down to the front end, maybe you extend duration, extend out credit curves so that you can lock in better yields.
And we've had great performance across corporate credit over the past year, but haven't seen cash materially come out of money market funds. And so it's interesting. It's not a risk to market. It's a risk to our call that perhaps we are too defensive positioning.
And I think the other one that's just become clearer, at least in terms of market pricing, and I think to a lesser extent in the data is recession or hard landing that people had been very fearful of in late 2022 going into 2023. We've had policy rates elevated for longer, perhaps the long and variable lags are longer and more variable than previously anticipated. And so I think that's kind of the other big risk that could push spreads quite a bit wider than our base case forecast. Those are really great ones.
And I would just add a few things. Clearly, the US consumer has been outperforming expectations for the past few years. And now we are facing a slew of more mixed consumer data, especially on the sentiment side of things. I realize that the sentiment surveys have not been a particularly strong indicator of forward consumer behavior for the past few years.
And also, there are some political leanings that tend to influence consumer expectations. But I think it's definitely worth taking note of consumer expectations and consumer confidence. And also just broadening that out to broader confidence in the economy from decision makers at corporations and the investment community. Sometimes you get this kind of fulfilling vicious cycle where people are expecting things to go a bit sideways or be more negative.
And that results in fund outflows and redemptions and spreads go wider and then you need more selling. And that can be quite problematic overall. And given the mix of policy uncertainty and economic data having not been as strong as people anticipated, I could see us setting up for a bit more of a vicious cycle. So and that very positive note, I guess we should wrap up our Q2 outlook podcast.
I want to thank Zach and Regis for joining me today to walk through the world of US and EM Sovereign Credit in our expectations for the next quarter and really the rest of the year. If you have any follow up questions for Zach or Regis or myself, you can always find us on the credit sites dot com website using the ask and analyst function or reach out to your credit sites sales representative. Thank you gentlemen for joining me today. Thanks, Wendy.
Good to see you.