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While emerging markets (EM) debt was negatively impacted by the April 2 maximalist tariff announcements, after the delay in implementation and some backtracking, the asset class was able to bounce back.
Of note, there was differentiation between sectors, with hedged local rates and EM foreign exchange outperforming other fixed income assets.
Notably, the decline in the US dollar, as the broader market adjusted its outlook on US economic dominance, created opportunities in both emerging and developed markets.
While there’s been no major shift away from the US dollar and US assets yet, early signs suggest future investments could increasingly flow toward non- US developed and emerging markets.
Recent events in the Middle East highlight how the market has compartmentalised geopolitical and other global macro uncertainties. While a worst-case scenario did not materialise, the markets did not sell off, even before the “cease-fire”.
That is not to say that we should not incorporate tail risks, but to recognise that the current market context favors bottom-up carry opportunities. There will be performance differences across sectors and issuers, depending on how each is fundamentally impacted or able to adapt.
The attractiveness of EM debt is currently underpinned by meaningful structural and cyclical shifts emanating from policy and growth dynamics in both the US and across emerging markets.
Global growth appears to be moving from US-led dominance to a more balanced global landscape.
While the US continues a phase of meaningful fiscal profligacy, trade protectionism and monetary policies, inflation in the market remains sticker than the rest of the world.
In contrast, EMs are benefiting from increasing growth differentials as US policy is producing a larger drag on the US than the rest of the world.
While growth expectations have been lowered across the globe, there are reasons to believe US growth will slow more meaningfully than EM.
Emerging market fundamentals remain relatively resilient
EM fundamentals have remained relatively resilient, outperforming developed market counterparts recently. While fiscal deficits remain negative, 12-month rolling fiscal deficits are showing improvement in many countries, keeping public debt trajectories stable and driving credit upgrades across numerous EM sovereigns.
A weaker US dollar would naturally reduce debt-GDP ratios across EM sovereigns and create a more favorable external environment. EM central bank policy trajectory also remains supportive as EM central banks, having front-loaded rate hikes post-Covid, are making gains in inflation and have less concerns for their currencies — with room to ease — supporting domestic demand.
EM spreads are at the tighter end of the range, with broad dispersion persisting between credit rating categories. The attraction of hard currency EM assets is the attractive yield/carry opportunities and relative value compared to other credit markets, as well as the ability to identify winners and losers given the global macro context and country specific fundamentals. Even in the second quarter, EM high yield sovereigns did quite well.
In a fragmented global landscape, hard currency EM debt offers a rare combination of yield, diversification and macro resilience.
With US policy uncertainty rising and global capital flows shifting, the potential for EM outperformance should make this an opportune time to reassess strategic allocations and consider increasing exposure to this under-owned asset class.
EM rates have scope to do well amid slowing growth, reasonably behaved FX and balance of power, though a spike in oil prices could curtail rate cuts in the short term.
During the second quarter, nearly every EM currency strengthened against the US dollar, despite higher US yields driven by increasing real yields.
Looking ahead, a weaker but mixed dollar trend could offer plenty of relative value opportunities.
Weakening dollar
Why expect a weakening dollar? Despite US President Trump backing off the steepest tariff levels, a minimum of 10 per cent levied on many countries is still net growth negative, which should eventually cause the Fed to cut more than expected, outpacing other central banks.
The EU, led by Germany, may see better relative growth momentum than the US as slow-moving fiscal measures take effect. And finally, China’s economic backdrop appears stable, which should keep volatility low and support higher beta cyclical currencies.
Clear headwinds persist, including uncertainty regarding the timing and impact of the trade war, US-China trade relations and a possible re-escalation of events in the Middle East. However, the re-mapping of the world order also presents opportunities.
Technicals remain relatively supportive for the asset class as dedicated investors are “light-risk” in general, and crossover investors may be attracted to the appeal of the yield and diversification.
The writer is the head of PGIM’s fixed income emerging markets debt team.
These materials represent the views, opinions and recommendations of the author(s) regarding the economic conditions, asset classes, securities, issuers or financial instruments referenced herein, and are subject to change without notice. Certain information contained herein has been obtained from sources that PGIM believes to be reliable; however, PGIM cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed.
