KEY POINTS
1. The performance for local and hard-currency emerging markets (EM) debt was bolstered in Q3 2024 on support from an improved macro backdrop.
2. We expect strengthening EM currencies, attractive real yields and improving prospects for net inflows to continue as tailwinds for the asset class ahead.
3. Considerable differentiation at the individual issuer level requires a judicious approach to credit selection, especially in an asset class as broad and diverse as EM debt.
The initiation of rate cutting by the U.S. Federal Reserve (the Fed) in September helped lift the performance of EM debt across the local currency sovereign, hard currency sovereign and corporate EM debt segments in Q3 2024. While the overall performance was strong for each bond sector index, we continued to see meaningful variation at the individual country and corporate credit level across the broad-based and diverse EM debt asset class.
Importantly, easing by the Fed and other developed market (DM) central banks is still in its early stages. We believe this factor combined with the potential for further strengthening of EM FX, high real yields and prospects for improving net inflows to the asset class will provide tailwinds for EM debt ahead.
Firing on all cylinders
All performance contributors were additive to returns in the third quarter, with the highest gains coming from FX and rates on the local currency side, and U.S. treasury yields on the hard-currency sovereign and corporate side. The Fed's dovish policy shift acted as the underlying driver. On the FX side, the shift led to a general strengthening of EM local currencies against a weakening U.S. dollar. At the same time, the fall in U.S. Treasury yields also supported price gains on hard-currency EM sovereign and corporate bonds.
Monetary easing by EM central banks, which hiked early and aggressively to combat the post-pandemic inflation surge, also delivered a notable contribution from rates to local currency debt. Notably, concurrent rate cutting by many DM central banks helped sustain the wide EM-DM differential in real yields. Combined with falling price pressures in emerging economies, this dynamic should provide scope for EM central banks to pursue further easing. This scenario would support returns on local EM rates and FX, with currencies also benefitting from healthy growth and strong current account positions in some markets.
EM Debt rallies in Q3 2024
Source: J.P. Morgan, Morgan Stanley Investment Management calculations. Corporate Credit Spread and Sovereign Credit Spread return attributions are modeled by decomposing the overall spread return to its two components: the sovereign spread and the corporate spread over the sovereign. It is not possible to invest directly in an index. Data provided is for informational use only. Past performance is no guarantee of future results.
Five things to watch
In addition to the trend of rate-lowering by many global central banks, we see a number of key areas that may affect the investment environment for EM debt ahead.
Global elections. All policy change matters, good or bad. And while the upcoming U.S. elections are not directly related to emerging markets, U.S. policies can have meaningful spillover effects into EM. Within emerging markets themselves, many of the 2024 elections have already taken place. With the results now starting to play out, we are closely scrutinizing incoming reforms to gauge their potential impact on individual EM countries.
China's stimulus. Beijing announced a raft of measures in late September, including rate cuts, bank recapitalizations, facilities to boost the stock market and fiscal spending. Despite an initial positive response, market skepticism remains. Additional policies may be on the horizon. In our view, stimulus alone, absent any meaningful institutional reform, is unlikely to deliver the government's aim of economic revival.
Regional Conflict. Conflict in the Middle East continues to escalate, as it expands beyond Israel and Hamas. Geopolitical risks could increase, as tensions with Iran intensify and western nations increase their involvement. As with the U.S. elections, economic spillover effects from this conflict or others emerging elsewhere cannot be ruled out.
Technicals turn positive. Following a long period of outflows from dedicated EM debt funds globally, the third quarter ended with positive net inflows in September. We believe this trend will continue, as the search for yield amid a dovish monetary backdrop in developed markets increases investor appetite for the asset class.
Country differentiation. Growth, inflation and policy vary widely across the EM investment universe. As such, we expect markets to continue placing an emphasis on differentiation amongst countries and credits, rewarding outperformers and punishing issuers that fail to deliver.
Bottom line: We expect the improved macro backdrop that began in Q3 2024 to continue ahead, with high real yields driving positive net inflows to EM assets. We are particularly bullish on local currency EM debt, as lower-trending DM yields should support FX and rates. As ever, a discriminating approach to credit selection remains key to this asset class, with wide variation at the individual issuer level and some downside global risks remaining.
Index definitions:
J.P. Morgan Government Bond Index-Emerging Markets (GBI-EM) Global Diversified is an emerging market debt benchmark that tracks local currency bonds issued by emerging market governments.
J.P. Morgan Emerging Markets Bond Index (EMBI) Global Diversified is an unmanaged index of USD-denominated bonds with maturities of more than one year issued by emerging markets governments.
J.P. Morgan Corporate Emerging Market Bond Index (CEMBI) Broad Diversified is an unmanaged index of USD-denominated emerging market corporate bonds.
