Of note, there was differentiation between sectors, with hedged local rates and emerging markets (EM) foreign exchange outperforming other fixed income assets. EM credit also did well, in particular the higher yielding segment.
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 towards non-US developed and emerging markets.
Recent events in the Middle East and elsewhere 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 and the market looked for opportunities. That is not to say that we should not incorporate tail risks, but to recognise that the current market context favours 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 stickier 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.
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-gross domestic product ratios across EM sovereigns and create a more favourable external environment. EM central bank policy trajectory also remains supportive as EM central banks, having front-loaded rate hikes post-COVID-19, 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.
Why expect a weakening dollar? Despite President Donald 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 improved growth momentum 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 remapping 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.
Cathy Hepworth, head of PGIM’s fixed income emerging markets debt team
