When will fundamentals matter again?

Camila Astaburuaga, Senior Portfolio Manager

Headlines about a potential recession have been common since the inversion of the curve back in July 2023. Historically a recession occurs 14 to 17 months since that inversion point. If we take that at face value, we should have seen a recession in November 2024, yet most indicators were still healthy and spreads were at their tightest levels since 2007* with the promise of increased growth from Trump’s presidency.

However, the start of the year has been nothing but volatile with Trump fighting many fronts, amongst them tariffs, the Russia-Ukraine conflict, the Department of Government Efficiency, and defence spending. These topics have created animosity in some cases and worries in others, but what is clear is that they have created uncertainty. Uncertainty regarding inflation, uncertainty regarding legislation and uncertainty about growth. Simultaneously, consumer confidence and Purchasing Managers’ Indexes have continued to deteriorate in the US, albeit still above contraction levels. Will Trump’s actions continue to negatively impact sentiment and growth?

In periods of economic slowdown a country's fiscal stability and capacity to service debt come under scrutiny. Slower growth can lead to reduced tax revenues, increasing budget deficits and public debt levels, which in turn could trigger downgrades and spread widening. Political uncertainty further exacerbates these challenges, as unpredictable policy environments can hinder effective fiscal planning and implementation. This combination of factors may elevate the risk premiums demanded by investors, raising borrowing costs and potentially leading to a negative feedback loop of increasing debt and fiscal strain.

Having robust fiscal and debt fundamentals are essential to enhance resilience against economic downturns and political uncertainties. Countries with strong Net Foreign Asset (NFA) positions are better positioned to navigate these challenges, maintaining fiscal stability and debt-servicing capacity.

Calling a recession might still be too hasty, but what is clear to us is that several of the recent events add doubt about the future with a range of potential negative outcomes. Sovereign bond spreads, particularly for countries with weaker economic fundamentals, tend to widen with uncertainty well before growth actually starts to deteriorate. If spreads were at attractive levels, then we might argue there is reason to participate. But when spreads are relatively and absolutely tight, then the compensation for risk is too low and chasing that extra 1% yield may cost too much.

In simple terms, uncertainty is high, an increased range of negative scenarios have surfaced, and spreads have not adjusted yet. We believe this is a perfect time to pivot to fundamentals and move to countries with strong balance sheets that can sustain periods of lower growth. Several emerging market sovereigns provide these qualities with a spread that remains attractive in our view, providing some defensive value. When times are uncertain, we think that it is wise to stick to fundamentals.

* Using OAS spread in the ICE BofA Eurodollar Index

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