Against a challenging global macroeconomic and geopolitical backdrop, emerging market debt has shown remarkable resilience and delivered steady positive returns. Local currency sovereign debt has returned almost 13% year-to-date, while hard currency sovereign debt has outperformed US Treasuries by generating around 2% additional spread returns, delivering a total return of 6%.1 Emerging market high yield corporates have also outperformed developed market equivalents, based on ICE BofA global high yield index.
There are several reasons supporting the solid returns year-to-date, which are asset allocation shift, weak USD performance and strong EM fundamentals. Looking ahead, we believe these factors will continue to act as a tailwind for emerging market debt.
An asset allocation shift we have seen this year is that investors now seek more diversification to hedge against the US exceptionalism, reducing asset allocation into the US and increasing allocation in places such as Europe and emerging markets. As a result of the main source of volatility coming from the US, a previously considered “safe haven”, a substantial portion of Inflows into global strategies are now being deployed in EM. We believe this shift in asset allocation is more profound and could be longer lasting than markets currently expect.
The chart below shows that foreign investors’ exposure to US securities have risen significantly, tripling from $10 trillion to $30 trillion in less than two decades. This historical heavy positioning has resulted in an observed reduction in asset allocation into the US.
Sources: U.S. Department of the Treasury
USD weakness typically leads to strong returns for EM debt in general, especially so for local currency debt. EM return data were relatively weak for some time and USD appreciation was one of the main drivers for the underperformance. Now the tide has turned. The last USD bear cycle lasted almost seven years from 2002 to 2008. This time if USD weakness turns out to be structural, combined with current tight valuations of US risk assets, we believe EM can continue to outperform.
The chart below shows that the US Dollar Index (DXY) has declined by 10.7% from beginning the year to the end of Q2 this year, making it the largest decline for any given year since 2003. If we assume the USD continues along its current trajectory, this would lead to a decline of around 20% for 2025, which would be the largest decline on record for any given year since the inception of the DXY index.
Source: Bloomberg
Finally, solid EM fundamentals have led to resilience of the asset class and a structural change in the ownership of the asset class. Improving fundamentals and credit ratings have made EM much more attractive to global and crossover investors. Now the average EM debt credit rating is BBB-.2 Furthermore, EM currency risks have been reduced because of prudent inflation targeting regimes and better balance of payments in most EM countries. EM corporates, for both Investment Grade and High Yield segments, have lower leverage ratios than DM peers.
Heading into Q3 2025, markets, and the Fed, are waiting for Trump’s policies to be fully reflected in the inflation and growth data. Continuous inflows to the asset class and light investor positioning could provide a relatively calm summer period of carry returns. For EM hard currency sovereigns, the positive credit rating momentum continues, with upgrades outnumbering downgrades. Furthermore, higher prices of commodities can be a positive performance catalyst for selective high yield sovereigns. For EM local currency sovereigns, steady EM-DM growth differential and a weaker USD should support EM FX performance. For EM rates, if US headline risk continues, EM low yielding countries’ rates can drift tighter due to US de-risking. In high yielding space, we like Turkey. We believe the summer months could provide an opportunity for the Central Bank to cement confidence in Turkey’s disinflation process, paving the way for gradual rate cuts and increasing resilience against shocks. For EM corporates, we start to see better risk reward in some cyclical sectors than defensive sectors.
Events we are keeping a close eye on include the conflicts in the Middle East and between Russia and Ukraine. Markets could be under-pricing the geopolitical and fiscal risks if the conflicts turn out to be more prolonged than expected. The eventual US trade- weighted tariff rate on US imports is yet to be determined, where the uncertainty remains high and markets can surprise on both the upside and downside.
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