Five structural shifts supporting EM debt
Emerging markets debt has seen better days but even better days may lie ahead
PRIOR to the pandemic, emerging markets (EM) debt was garnering a lot of interest – offering higher yields and lower correlation to other fixed income asset classes.
While subsequent underperformance has cooled investor sentiment, five structural shifts in the economic environment offer reasons to expect the asset class to heat up once again.
1. Cyclical headwinds turning into tailwinds
When global inflation began to rise in early 2021, emerging market central banks raised interest rates far more aggressively than their counterparts in developed markets. Now, as inflationary pressures ease, these banks have shifted into reverse, which should support emerging markets growth.
Historically, whenever the gap between emerging markets and developed markets growth exceeded 2 per cent, EMD has outperformed US high yield. Despite uncertainties surrounding China’s growth trajectory which is expected to be positive but muted at 4.5 to 5 per cent this year, the consensus view is that emerging markets will regain their growth premium, surpassing and remaining above 2 per cent for the foreseeable future.
2. Maturation of emerging market economies
As many emerging market economies move from maturing to matured, better policy implementation, exports’ boost to growth, and current account surpluses have improved sovereign fundamentals and growth structures. This has led to increased income convergence and high domestic savings, enabling emerging markets to better withstand shocks.
Additionally, disciplined monetary and fiscal policies have shifted debt structures towards domestic and high-quality funding. As domestic demand now plays a larger role in driving growth, emerging local markets are less sensitive to higher rates and US dollar strength, and growth rates have started to stabilise.
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Excluding China, emerging markets’ share of global gross domestic product is growing on pace to overtake developed markets this year. Traditionally, commodity exports have been emerging markets’ most durable growth engine. However, many middle-income countries are moving towards higher value-added or service-oriented industries, and the demand for emerging markets’ exports should continue rising amid tech advancements and the transition to green energy.
Over the past two decades, increasing exports and higher sustainable growth have helped to double reserves as a percentage of GDP. With improved external accounts, many emerging markets now possess vital buffers, which should reduce growth volatility and support convergence towards developed market spreads over the long term.
3. Solid fundamentals – lower debt-to-GDP ratios
A surprising aspect of emerging market fundamentals is that most economies boast lower debt-to-GDP ratios than developed markets. That gap has only widened as fiscal deficits in developed markets remain historically wide – before the pandemic, the US ran the largest peacetime budget deficit outside of a recession at 4.6 per cent of GDP; today, its budget deficit is even larger at 6.8 per cent of GDP.
4. More favourable demographics
While ageing demographics and slower labour force growth weigh on economic growth across developed markets, younger, growing populations in emerging markets could support growth for decades. The rising middle class within emerging markets drives domestic demand for goods, services, and financial assets. This trend creates a captive buyer base for local sovereign debt, fostering a virtuous cycle of improved funding and reduced sensitivity to external shocks.
5. The great power competition
Finally, rivalry between the US and China is creating geopolitical realignment, with both countries vying for influence in emerging markets, particularly the global south. Global supply chains are moving away from a singular focus on efficiency and lowest cost producers, instead forging geopolitical alliances to source critical goods, such as semiconductors, EV batteries, pharmaceuticals and minerals.
Only five years ago, China accounted for almost 20 per cent of US imports. Now, it is below 15 per cent, with Vietnam, South Korea, Taiwan, India and other emerging markets gaining in share. Over time, “nearshoring” plans will likely consolidate more upstream production in non-China trade partners located primarily in emerging markets.
The carry from EM debt alone is enough to generate attractive returns, and mild spread tightening and/or declining core developed markets bond yields could raise total returns to double digits.
The setup is particularly constructive for emerging markets hard currency – especially in a mix of BBB/BB issuers across EM debt sectors and in select sovereign distressed issuers – against a backdrop of moderating growth and inflation. We continue to favour Mexican quasi-sovereigns, Middle Eastern and Indonesian sovereigns and quasi-sovereigns, and Romania. This cohort is fundamentally solid, offers high yields, and should benefit from the tailwinds from infrastructure investment and nearshoring – particularly Mexico. Local market performance will need to see stabilisation in core rates before domestic yields meaningfully decline.
Following years of underperformance, EM debt is poised to outperform other fixed income assets. Headwinds from sharp increases in inflation and interest rates, US dollar strength, and slower growth are now reversing course. Considering the structural shifts, current valuations for EM debt may not fully reflect the upside potential.
The writer is head of emerging markets debt at PGIM Fixed Income
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