The World said NO to fossil fuels

Hi all,

It's the last week before Christmas, signaling a likely slowdown in sovereign activities for a week or two—or will it?

• Final week of COP28 in Dubai leads to a 'historic, landmark, game-changing agreement

• Ethiopia faces an official default

• Many sovereign debt issuers neglect emission reduction targets

• The Fed is poised for rate cuts next year

• Markets embrace full dovish mode

Let’s dissect.

Markets Snapshot

Federal Reserve

• US Treasury Secretary Yellen is optimistic about successfully navigating the "last mile" to bring inflation down. Last week, she expressed confidence that inflation would reach the Federal Reserve's 2% target by the end of next year.

• Meanwhile, The Federal Reserve maintained interest rates at a 22-year high at 5.25 - 5.5% last week with officials entertaining sharper cuts next year. They project a decline in the policy rate by 0.75 percentage points in 2024, an additional full percentage point in 2025, and stabilization between 2.75% and 3% in 2026. Chair of the Federal Reserve Jerome Powell emphasized that these projections are flexible and not a fixed plan.

• Nonetheless, right after the meeting the two-year Treasury yield fell to 4.45% as of market close on Friday, marking the most substantial daily drop since March.

• This all comes after pubslihed inflation data on Tueday showed a slight increase in US consumer prices in November, with overall consumer price index (CPI) up 3.1% YoY and core CPI at 4.0%. It is a substantial drop from the peak CPI of 9.1 percent recorded in June 2022! Encouragingly, recent labor market data also revealed a stronger-than-expected performance, marked by a drop in the unemployment rate to 3.7% and an increase in wage growth.

European Central Bank

• On Thursday, The European Central Bank (ECB) also maintained interest rates unchanged for the second consecutive meeting in a row. Simultaneously, it adjusted its growth projections downward and revealed intentions to accelerate the reduction of its balance sheet.

• The main refinancing rate stays at 4.5%, and the deposit facility rate at 4.0%. Inflation has already declined to 2.4% annually in the most recent reading in November with further decreases anticipated next year.

• ECB President Lagarde stated that rate cuts were not discussed , and upcoming decisions would be data dependent.

Equity Markets

• Equity investors have eagerly awaited confirmation of the anticipated rate cuts for a while now. Despite no official signal from central banks yet, a more dovish stance from the Fed and ECB propelled equity prices higher, with S&P, NASDAQ, and DOW all growing around 3% each last week.

Oil Prices

• Interestingly, oil prices dropped over 3% on Tuesday to their lowest point in six months right after US CPI data was released. Although the price has rebounded to $76 per barrel, oversupply concerns and a bearish market sentiment on demand, further exacerbated by Moody's pessimistic credit rating outlook on China that we wrote about last week, are the culprits behind the current price level.

Sovereign Debt and Climate Targets: Findings Revealed

• An investor-led initiative aimed at empowering sovereign bond holders with $5 trillion in assets, known as the Assessing Sovereign Climate-related Opportunities and Risk project (ASCOR), revealed in its inaugural study that the majority of sovereign issuers lack the necessary ambition in their climate pledges. Members of the ASCOR include pension funds and other institutional investors.

• Among 25 analysed countries, only Bangladesh, Barbados, Kenya, and Morocco have emissions reduction targets aligned with a 1.5 degrees pathway. This underscores the challenges in applying sustainable finance and ESG investing metrics to sovereign debt.

• ASCOR also reported that, based on 2020 data, only Japan, Germany, and France allocate at least 0.2% of their GDP to climate finance. Australia, Canada, Italy, the UK, and the US fell short of that threshold.

Our thoughts:

• There is currently no uniform method to assess sovereign debt from a climate change perspective. When examining net-zero targets, investors typically concentrate on companies, despite sovereign debt constituting a significant portion of institutional investors' portfolios.

• ASCOR’s analysis can help investors to determine ‘sustainable’ sovereign bonds and increase their inclusion in their net zero investment strategies.

• On a more practical level, investors can engage more effectively with sovereigns based on these findings, focusing on financing initiatives that will help bridge the gap between climate targets and current outcomes.

Ethiopia Heads for Default

• Ethiopia has informed bondholders of its incapacity to make a $33 million interest payment on its $1 billion Eurobond, which was due on December 11th. The country's finance ministry cited a "fragile external position" as the reason for the non-payment.

• The government attempted last-minute negotiation talks, proposing a restructuring plan that suggested a reduced coupon in exchange for extending the bond's maturity while maintaining its face value at USD 1 billion. However, the proposal was rejected by a committee representing holders of Ethiopian $1 billion bonds.

• If the country does not pay interest payment before the conclusion of a 14-day grace period, Ethiopia will officially join the ranks of Ghana and Zambia , becoming another African nation to default since the beginning of the pandemic. While both Ghana and Zambia managed to secure IMF funding, they have so far struggled to find consensus for debt restructuring among a diverse group of creditors.

• A few days later, Fitch downgraded Ethiopia's foreign-currency issuer default rating from CC to C, citing the non-payment of interest as the initiation of a sovereign default process. If the payment is not made within the 14-day grace period, Fitch will proceed to further downgrade Ethiopia's rating to the ‘restricted default’ (RD). Promptly on Friday, S&P downgraded the foreign-currency rating straight to 'selective default'.

Our thoughts:

• The financial challenges in the developing world are escalating again, with Ethiopia serving as the latest example of how high-interest rates and an unfavorable macroeconomic environment can push nations towards insolvency.

Geopolitics

Cop 28 Historic Agreeement

• On the second of the conference, nations participating in the COP28 climate summit have agreed to a deal aimed at transitioning away from fossil fuels, with the collective goal of achieving global net zero emissions by 2050. It might be quite astonishing to hear, but it is the first time in the history of COP that fossil fuels are cited as a root cause of the climate crisis.

• The document asks countries to establish "ambitious" emissions targets over the next two years, considering their fossil fuel usage, with the goal of limiting global warming to 1.5°C above pre-industrial levels. It also advocates tripling global renewable energy capacity by 2030 and urges countries to expedite the development of low-emission technologies, encompassing nuclear, low-carbon hydrogen, and carbon capture and storage.

• The final agreement emerged on Wednesday after a night of intense consultations with key figures including US climate envoy John Kerry, and Saudi Arabia’s energy minister Prince Abdulaziz bin Salman.

Our thoughts:

• Many rightfully criticized the text for softening the language and replacing "phasing out" of fossil fuels with "transitioning away." In fact, the recent UN findings indicate a concerning trend of rather "phasing up" phenomenon, as petrostates plan for a 460% increase in coal production, 83% more gas, and 29% more oil in 2030 than what is feasible within the internationally agreed-upon 1.5°C temperature rise limit.

• Led by Saudi Arabia, fossil fuel states strongly pushed for the inclusion of carbon capture and storage mechanism in the text, enabling affluent energy-exporters to keep ramping-up production by using the excuse of capturing all emissions from fossil fuel production.

• The agreement also acknowledges that transitional fuels can play a role in facilitating the energy transition, essentially legitimizing the use of gas under the assumption that it is less polluting than coal, despite the fact that the liquefied natural gas (LNG) can be even more environmentally harmful.

• Finally and most importantly, the document fails to specify funding commitments and timelines, despite acknowledging the necessity of trillions of dollars in investment.

• Nonetheless, it is a significant step in the right direction, albeit one that should have been taken years ago. Despite being a compromise that benefits fossil fuel producers, COP28 managed to secure a broad global agreement on a high-level transition plan towards a renewable future.

Thank you for checking out the latest SovereignBeat newsletter! Share your thoughts on the topics covered and let us know if there's anything specific you'd like us to explore.

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• U.S. Increase in Oil Supply and Its Ramifications (FT)