Q3 Credit Research Outlook The Election Year

Elections in the UK, Europe and the US will have implications for credit markets. Market scrutiny of governments’ fiscal policies could have the most significant impact on global bond markets in the aftermath of this election cycle.

In December 2023, Time magazine said about 2024: It “is not just an election year. It’s perhaps the election year.” By the time the year is over, countries whose populations represent approximately 49% of the global population will have participated in national elections.¹ Further, the run up to some of the most globally consequential elections is proving quite dramatic.

In May, Prime Minister Rishi Sunak set an earlier-than-expected election date of 4 July for the United Kingdom. French President Macron called for snap French parliamentary elections at the end of June after his governing party materially underperformed the far-right National Rally (RN) party in June’s European Parliament election. The results of these elections do not necessarily clarify the near-term outlook from the perspective of the financial markets. And then, of course, we have the contentious US presidential election in November.

The elections in the UK, Europe and US will have implications for major global economies and credit markets. Heightened geopolitical tensions, the potential reversal of global trade liberalization, and fundamental changes in the West’s economic relationship with China are all factors to consider. Market scrutiny of governments’ fiscal policies could have the most significant impact on global bond markets in the aftermath of this election cycle. Outcomes could challenge the delicate balance between bond investors and governments, and potentially reprice risk premiums across credit markets.

We saw an example of this reaction in French government bonds since 7 June. During this time, the spread between French and German government bonds widened to levels not seen since the peak of the European Debt Crisis in 2011–12. This was after snap parliamentary elections were called in France and the two groups leading in the opinion polls – the National Rally (RN) and New Popular Front (NFP) – both advocated for fiscal expansions. The results of the 7 July election indicate the likelihood of an extended period of gridlock, with no party securing a majority. France has been on a deteriorating fiscal path, as evidenced by S&P’s sovereign rating downgrade on 31 May, and bond markets are opining that the deterioration will continue, given the political situation.

The fiscal situation in France is hardly unique. Budget deficits across the G7 have widened by an average of over 3% of gross domestic product (GDP) per year compared to 2019.

In our view, such worsening of sovereign fiscal profiles support higher interest rates and the repricing of risk premiums. Furthermore, political parties – both on the right and the left in various G7 countries – continue to have unrealistic (in our view) fiscal plans that are inconsistent with future consolidation. In the absence of fiscal consolidation, sovereign debt burdens will continue to grow and higher debt servicing costs on government and private debt could alter economic growth rates.

In addition to fiscal considerations, there is much debate among competing parties in several countries with regard to trade policy and immigration. Any policy enacted post elections that restrict trade (i.e., via tariffs) or result in additional labor supply constraints (i.e., immigration curbs) could add further impulse to higher interest rates and, in a worst-case scenario, result in stagflationary conditions – the combination of higher inflation and lower growth.
Putting this all together, and using the US as an example, we would point to a recent study published by the US Congressional Budget Office (CBO).

The study demonstrates that, if all interest rates were just 0.1 percentage point higher each year than they are in CBO’s current economic forecast (and holding all other variables constant), higher-than-forecast interest rates would cause deficits to exceed the agency’s baseline projections by $50 billion in 2034 and by $324 billion over the 2025–34 period.²

Interest rates appear to be settling at higher levels, yet certain policy choices could pressure them further. In fact, in our view, there is an absence of serious policy proposals in the global political landscape that would do the opposite.

Implications for Credit Markets and the Global Cash Investment Universe

Rising debt servicing costs, alongside further increases in government debt issuance, can add to the pressure on higher rates. In extreme scenarios, these factors could result in indirect crowding out of private investment, which would have negative impact on credit markets and credit conditions.

To be clear, we do not expect such conditions to develop imminently. Indeed, in many developed market economies, over the last few years, higher rates have existed alongside reasonably strong economic growth and low unemployment levels.

We continue to believe that the “reasons for higher rates” (i.e., strong economy vs. stagflation) is important when considering outcomes for credit conditions and credit performance. Stronger economies can support a much broader universe of bank and capital market borrowers, even with nominally higher interest rates.

To date, credit conditions have remained accommodative for most types of borrowers. Loan-loss levels on bank balance sheets, and default rates in the corporate bond market, are at levels that indicate a healthy credit backdrop. While sovereign yields are higher, most types of credit spreads are at, or near, their tightest levels since central banks started raising interest rates in 2022.

Still, interest rates impact the economy and the credit markets on a lag, and there is historical evidence that suggests higher interest rates will eventually lead to higher default rates.

A recent default study published by Deutsche Bank Research demonstrated that, while median CCC-rated credits default at similar rates in high- and low-interest-rate regimes (~30%–35%), B2 & B3-rated credits’ default rates are materially higher when shifting to a high-rate paradigm. Median B2 defaults rise from 0.2% to 4.7% and median B3 defaults rise from 1.3% to 8.8% in the historical study.³

The likelihood of material default rate increases will grow if nominal interest rates do not fall over the next few years, as refinancing needs in some of the most leveraged segments of the credit markets (high yield corporates, commercial real estate) increase with building maturity walls. Conditions that could prevent interest rates from falling sufficiently enough to support broad credit conditions are continuously growing fiscal deficits, shrinking central bank balance sheets, and higher inflation expectations. Government policy decisions could materially influence the path of each of these factors.

In our investment universe, we prefer resilient and less cyclical bank credits relative to many previous credit cycles, due to historically high capital levels, improved pre-provision profit margins (a benefit of higher interest rates) and less risky loan books.

As an example, the US Federal Reserve (Fed) announced the results of its annual stress test exercise on 26 June, which demonstrated that the largest US banks are well positioned to weather a substantial credit cycle, while continuing to lend to households and businesses. All 31 banks “passed,” which means that they maintained adequate capital levels despite a significant gross domestic product (GDP) decline (–8.5% peak-to-trough), unemployment rise (10%), stock price decline (–55%), home price decline (–36%), and commercial real estate decline (–40%).⁴

Sector Outlook