New Year, New Dynamics?

The EM (emerging market) debt asset class enjoyed another stellar year in 2024, with hard currency sovereigns generating a total return of 6.54%. Spread returns of +6.69% more than compensated for the –0.14% drag from US Treasuries. Within EM sovereigns, it was the year of high yield (HY), with the segment posting +13.0% returns. The distressed debt segment continued to drive the bulk of the return, generating more than half of the returns of the EM sovereign asset class.

The story was similar for EM corporate debt markets, which generated a total return of +7.63% during 2024, due to a significant +5.54% contribution from spread return as spreads tightened by more than 60 bps during the year. The high yield sector of the EMD (EM debt) corporate universe significantly outperformed investment grade, with a +11.67% return for HY and a +4.93% return for IG (investment grade) Distressed credits were by far the best performers, with triple-Cs a significant contributor.
The new Trump administration in the US poses a potential source of volatility, with the likely resumption of tariffs and confrontational trade tactics. The EM hard currency market ended 2024 with both historically high yields and tight spreads. While the balance of risks remains notably uneven due to these rich spreads, the fundamentally sound picture across many EM countries and a very low expected default rate gives us reason for optimism. 

US Rates and the Dollar

The global macro environment will likely favour further dollar strength, despite the strong appreciation since the US elections in early November. Under President Trump’s second administration, we may even test the dollar highs seen during Paul Volcker’s Federal Reserve chairmanship in the 1980s. The prospect of widespread and significant US tariffs weakens the outlook for global economic growth, especially in those EM markets which may be most impacted by Trump’s trade policy
changes. We expect a reduction of portfolio and direct investments into EM, and even more capital moving into dollar-denominated assets. The continued strength of the US economy will likely leave the Fed somewhat more cautious in how quickly it is willing to ease monetary policy – and potentially further strengthen the dollar. The
current growth trajectory, as well as the decent labour market data, which imply stickier inflation, support a view for this potentially slower decline in rates. The path depends heavily on Trump policies, such as promises of income tax cuts and deregulation, which could further boost the economy as well as inflation. If tariffs were to lead to increased prices of imports, this Trump promise could also generate higher inflation. These elements could lead in turn to a higher US terminal policy rate – possibly 3.75 or 4.00% -- resulting in a stronger dollar than was seen in the pre-Covid policy cycle. These higher interest rates make the US a relatively more attractive fixed income
investment destination. 

EM Interest Rates and Exchange Rates

Dollar strength is ultimately a headwind for EM currency performance. The most important precondition for the local currency asset class performance is for the Fed to meaningfully reduce the monetary policy rate – that is, to reduce it beyond current market expectations. We should only see this if the central bank is confident that inflation remains anchored around its target, quite an assumption in the complex risk landscape of geopolitics, higher tariffs, poor fiscal discipline in the
US, and strong US growth. With 2025 almost sure to bring uncertainty on these issues, EM local currency investors will need to be nimble and to adjust their positions as the story develops. Idiosyncratic currency situations such as the Turkish lira, Egyptian pound, Nigerian naira or Dominican peso may prove valuable for investors in this environment. The argument for buying EM rates is at least somewhat clearer, even if volatility continues. Foreign positioning in EM rates markets is low, real yields are high, and we think most central banks are likely to cut rates further, albeit gradually. We think markets such as Brazil, Colombia, the Czech Republic, and the Philippines offer attractive EM rates risk premia at present. 

Rising Deficits 

Fiscal indiscipline is arguably underappreciated by the markets, especially structural fiscal risks stemming from developed countries. Most importantly, the US is running an exceptionally large deficit, even more noteworthy given the current economic growth. If the second Trump administration follows through on promises of cutting income and other taxes, these actions should further increase the fiscal gap. Admittedly, deregulation and a promised downsizing of the US government bureaucracy could partly offset the expected reduction in revenues, but in reality spending cuts are often harder to implement than tax cuts. The largest expenditures in the US budget – entitlements including Medicare, Medicaid, and Social Security, and the military budget – are difficult to reform, and especially so by only one side of the legislative aisle. Without cross-party consensus, any fallout from reform would disproportionately impact the party in power and thus we are unlikely to see the Republican election sweep translate into meaningful spending cuts. US and global debt levels are likely to rise further, with the proportion of government revenues consumed by debt-service payments rising in tandem. While this may be relatively less problematic in periods of economic growth and easing monetary policy conditions, markets may be less willing to provide affordable financing to the US and other countries once another economic downturn hits.
Many EM economies face fiscal challenges, although there are exceptions and idiosyncrasies. Latin American sovereigns – such as Brazil, Mexico, and Colombia – are subject to some of the most intense market scrutiny for their loose and somewhat populist fiscal policies. Some sovereign issuers in this region are facing weaker currencies, higher local rates, and significant impacts on credit spreads. The recent sell-off in the Brazilian real and its local-currency government bonds is a good
case in point, illustrating how unforgiving markets can be of sustained fiscal profligacy. The resulting inflation concerns have led the Brazilian central bank to raise policy rates, while most nations are easing monetary policy.

In Asia, we see relatively better fiscal discipline, though even here governments are occasionally caving to socio-political pressures for increased spending. In Europe, populist demands have resulted in some very worrying fiscal spending in countries such as Romania and Poland, but markets have given the benefit of the doubt to countries where political stability and reform appetite are stronger. On a positive note, South Africa’s National Treasury appears to have stabilized debt levels after many years of deterioration, while in Turkey a more orthodox economic policymaking team is now in charge --developments which have increased investor appetite for those credits.

Inflation

Apart from the possible impact of fiscal looseness and US tariffs, geopolitical pressures may also revive inflation. In addition, global central banks are still grappling with what appears to be somewhat sticky services inflation in many markets, while labour markets remain relatively strong, especially in the US. The main deflationary impulse may emerge from China. If US tariffs are increased significantly, Chinese economic growth could struggle even further, and the impact may not be fully offset by
China’s economic stimulus program. This dynamic has important implications for emerging markets, as China accounts for a large share of global demand for metals and other commodities. EM commodity exporters are at risk of a slowdown, and so could ‘import’ some of China’s lower inflation levels. For instance, this may impact copper exporters such as Chile and Zambia. Separately, lower Chinese exports to the US would likely result in a re-channelling of cheaper imports into other markets, especially those in nearby Asian countries. Europe – already struggling with weak economic growth – may also import some of China’s deflationary dynamics.
The combination of these factors could result in an acceleration of the trends seen so far – subdued inflation for tradeable goods, but sticky inflation for services. This could present a dilemma for global central banks and could result in a higher potential for policy errors. 

Commodities – China and Beyond

These vulnerabilities in the Chinese economy and their deflationary effects also make us cautious on oil prices as we enter 2025. The decline in Chinese oil imports in 2024 has already placed downward pressure on the global oil price, and we expect that this trend might continue or even accelerate. While transportation accounts for the largest share of oil demand, for the last several years the growth in demand has come mainly from petrochemicals – which could be affected by US tariffs. At the same time, deregulation and the clear intent of the Trump administration to encourage higher oil and gas investment will likely result in greater US supply, while OPEC+ is likely to have limited ability to accommodate further production cuts. Disruptions in global trade could dent Chinese demand for industrial metals, where China is the main buyer. We expect further tariffs on Chinese steel and consumer products not only from the US, but other countries as well, pressuring Chinese manufacturing as well as global steel and copper prices.