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Following the maximalist tariff announcements on April 2 that adversely affected emerging markets (EM) debt, the asset class managed to recover after delays in implementation and some retraction of those measures.
It’s important to note that there was a variance among sectors, with hedged local rates and EM currencies outperforming other fixed income instruments.
The depreciation of the US dollar, which coincided with the market adjusting its expectations regarding US economic supremacy, provided prospects for both emerging and developed markets.
Although there have not been significant shifts away from the US dollar and US assets, early indicators suggest that investments may gradually gravitate towards non-US developed and emerging economies.
Recent developments in the Middle East illustrate how the market has compartmentalized geopolitical and macroeconomic uncertainties. Despite the absence of a worst-case scenario, markets remained stable even prior to the cease-fire announcements.
This reflects the need to be aware of tail risks, as current market conditions seem to favor bottom-up carry opportunities. There will be performance discrepancies among sectors and issuers, which will depend on how they are fundamentally affected or adjust to the ongoing situation.
The allure of EM debt is bolstered by significant structural and cyclical changes stemming from policy and growth dynamics both in the US and within emerging markets.
The trend in global growth appears to be transitioning from US-led dominance toward a more balanced global economic framework.
While the US continues on a path of considerable fiscal expenditure, trade protectionism, and unique monetary policies, inflation remains more persistent in the US compared to other global regions.
Conversely, emerging markets are experiencing increased growth differentials, as US policies impose a heavier burden on the US economy than elsewhere.
Global growth expectations have been revised downward, yet there are indications that US growth may decelerate more significantly compared to emerging markets.
Resilience of Emerging Market Fundamentals
Emerging market fundamentals have shown notable resilience, recently surpassing the performance of developed market equivalents. Although fiscal deficits continue to persist, many countries are reporting improved 12-month rolling fiscal deficits, which helps stabilize public debt trajectories and leads to credit upgrades for various EM sovereigns.
A weaker US dollar is expected to naturally decrease debt-to-GDP ratios across EM sovereigns, fostering a more advantageous external environment. Furthermore, central bank policies in EMs remain supportive; having previously implemented rate hikes post-COVID, these banks are now making progress in controlling inflation and have fewer concerns regarding their currencies, providing them with room to ease policies and boost domestic demand.
Spreads in EM markets are currently on the tighter end of the spectrum, while notable disparity persists among different credit ratings. The appeal of hard currency EM assets lies in attractive yield opportunities, relative values compared to other credit markets, and the ability to distinguish successful and underperforming entities based on global macro conditions and specific country fundamentals. Even during the second quarter, EM high yield sovereigns demonstrated strong performance.
In a fragmented global setting, hard currency EM debt offers an exceptional mix of yield, diversification, and macro resilience.
With rising uncertainty in US policies and an accompanying shift in global capital flows, now might be an ideal moment to reassess strategic asset allocations and potentially increase investments in this relatively underappreciated asset class.
EM rates have significant potential to perform well in light of slowing growth, moderate foreign exchange behaviors, and a balanced power dynamic, although a sudden spike in oil prices could hinder rate reductions temporarily.
During the second quarter, nearly all EM currencies appreciated against the US dollar, despite rising US yields driven by increasing real yields.
Looking forward, a trend of a somewhat weaker yet mixed dollar may present numerous opportunities for relative value.
Anticipating a Weaker Dollar
Reasons to anticipate a weakening dollar stem from the fact that despite US President Trump’s withdrawal from severe tariff levels, a baseline tariff of 10 percent on numerous countries remains growth-negative, which could eventually prompt the Federal Reserve to enact deeper cuts than anticipated, surpassing the actions of other central banks.
Europe, particularly Germany, may exhibit stronger relative growth momentum than the US as more gradual fiscal policies are implemented. Additionally, China’s economic environment seems stable, which may help maintain low volatility and support cyclical currencies with higher betas.
Challenges still exist, such as uncertainty surrounding the timing and effects of the trade war, US-China trade relations, and the potential for renewed tensions in the Middle East. Nonetheless, the restructuring of the global order also brings opportunities.
Market technicals remain generally supportive, as targeted investors are exhibiting a “light-risk” approach, and crossover investors may be drawn to the attractive yield and diversification this asset class offers.
Author: Head of PGIM’s Emerging Markets Debt Team
The viewpoints, opinions, and recommendations expressed herein reflect the author’s insights on economic conditions and financial instruments, subject to change without prior notice. Information utilized within this document has been sourced from what purportedly are reliable channels; however, the author does not guarantee the accuracy or completeness of said information, nor can it assure that the information will remain unchanged.