Positive economic dynamics are a plus for emerging market debt, but headwinds in strong USD
Higher volatility from political noise and bombastic rhetoric could create opportunities for long-term investors
AFTER a strong 2023, emerging market (EM) debt performance slowed in 2024 due to robust US economic growth and persistent inflation.
Despite tightening EM credit spreads, higher US Treasury yields and a strong US dollar created headwinds, leading to higher EM bond yields and weaker currencies.
However, EM debt fundamentals remain supportive. Resilient economic conditions, favourable fiscal, debt, and external dynamics, and disinflation present opportunities for monetary easing.
We project EM gross domestic product growth to stay above potential at 3.9 per cent in 2025, with inflation decreasing to 4.2 per cent in 2025, from 5.9 per cent in 2024.
We expect stable fiscal and debt dynamics, with fiscal deficits at around 5.7 per cent of GDP and government debt-to-GDP at 60 per cent.
We anticipate solid external accounts, with the aggregate basic balance at 2 per cent of EM GDP. The region’s financial sector fundamentals remain positive, with limited impact from rising interest rates on asset quality. We expect this supportive backdrop to continue to bolster EM assets.
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However, risks persist. The Donald Trump presidency introduces uncertainty, particularly regarding international trade. Trump’s proposed tariffs on imports, especially from China, could disrupt global trade. Countries with large US trade surpluses, such as China and Europe, may face significant economic impacts, prompting fiscal and monetary responses.
While US tariffs could affect global trade, EM countries may be less exposed due to growing intra-EM trade. We expect China to implement fiscal and monetary measures and shift exports from developed economies; EM countries now comprise nearly half of Chinese exports.
Opportunities in hard currency EM debt
In 2024, EM hard currency sovereign and corporate credit spreads compressed significantly, reflecting a positive fundamental backdrop, low default rates, and an improved credit-rating cycle.
This compression was notable in higher-yielding segments with attractive valuations, leading EM debt to outperform developed-market credit.
Currently, we believe EM credit spreads suggest fair valuations. High-grade spreads are below long-term averages, while high-yield spreads remain slightly above. The spread between high-yield and high-grade EM debt and US corporate high-yield credit are above long-term averages.
Despite less appealing spreads than in 2023, yield levels remain attractive, in our opinion, due to higher US Treasury yields. Therefore, we expect EM hard currency debt returns in 2025 to be driven predominantly by lower US Treasury yields and carry, and less by credit-spread compression.
Our positive outlook for the 10-year US Treasury yield remains unchanged post-US election. We see attractive opportunities for investors to increase exposure to long-duration securities, locking in favourable real and nominal yields.
We find better value in high-yield, high-beta credit and anticipate further high-yield/investment-grade credit spread compression.
However, we expect fewer opportunities in distressed/defaulted securities, with no EM sovereign credit defaults anticipated in the next year.
Opportunities in local currency EM debt
We believe the greenback will remain strong due to a robust US economy and a cautious US Federal Reserve, creating headwinds for EM local markets.
Currency depreciation may offset tariff costs, which may be applied unevenly across EM countries, leading to varied returns and opportunities for active investors.
The Trump administration’s response to a strong US dollar and its impact on growth remains uncertain. Local rates should be supported by prudent EM central banks, benign inflation and stable economic activity.
The frontier markets are a bright spot, with local currency bonds playing a key role. These countries are opening their capital markets to diversify financing and reduce reliance on foreign currency debt.
The measures to achieve this include strong reform momentum, often supported by multilateral organisations; the reduction or removal of capital controls; additional liquidity measures provided by central banks.
Many frontier market currencies offer investment opportunities at or below our fair-value estimates, supported by high real and nominal local interest rates. These currencies can provide an attractive combination of lower beta to the strong US dollar trend, and higher carry than larger EM counterparts.
We expect several markets to benefit from official sector support due to their geopolitical importance, enjoying strong multilateral and bilateral backing.
Many frontier markets are on International Monetary Fund programmes, benefiting from cheap financing and strong economic reforms designed to ensure higher and more consistent growth.
This ample and diversified funding has been evident in recent years, providing strong financial support. The evolution of funding convinces us that the asset class now has the diversification necessary to be relevant as a standalone asset class.
EM debt outlook for 2025
While EM debt lost some of its positive momentum in 2024, economic conditions are still resilient; fiscal, debt, and external dynamics are supportive; and disinflation creates opportunity for monetary policy easing.
While a key risk is higher tariffs (which could negatively affect trade), we believe EM countries should be less directly exposed, given the significant growth in intra-EM trade observed over the past few years.
Overall, we expect a favourable market environment for EM debt in 2025 and believe that higher volatility, induced by political noise and bombastic rhetoric, could create opportunities for long-term investors.
The writer is partner, portfolio manager and head of emerging markets debt team at William Blair, an investment bank and financial services company
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