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key points
- While the uncertainty that emerged in Q4 2024 continues to weigh on risk assets, we believe the significant differentiation that exists across emerging markets should provide ample opportunities for managers who focus on fundamentals.
- Broadly, U.S. trade policy and dollar strength may act as headwinds in 2025, but cautious monetary management, fiscal discipline and economic reform are likely to matter more to the investment outcomes of individual emerging markets.
- In our view, research-driven, flexible investment approaches are best placed to capitalize on the wealth of idiosyncratic opportunities that exist across this broad and deep asset class.
Q4 review: Macro headwinds blow from the U.S.
When inflection points occur in financial markets, the driving forces are often event-driven, highly conspicuous and always well documented. Such was the case for emerging markets (EM) debt in Q4 2024, following a surge in global volatility on the U.S. election outcome and reset of rate expectations.
In what was a largely positive year for performance, the victory of Donald Trump and the Republican Party at the U.S. elections in November, coupled with the U.S. Federal Reserve’s shift to a more restrictive tone in December, created performance headwinds for of all three EM debt segments.
For hard currency sovereign and corporate EM debt, a sharp rise in U.S. Treasury yields dragged on quarterly returns, causing index-level declines. Still, both sectors ended the year in positive territory with returns of 6.54% and 7.63%, respectively (Display 1). The significant strengthening of the U.S. dollar, meanwhile, acted as an even larger detractor for returns on the local currency sovereign debt index, resulting in a 2.38% fall for full-year 2024.
Technicals were also challenging. After a short period of recovery in inflows to dedicated EM debt funds in 2024, the trend reversed with outflows totalling $29.9 billion by December amid peaking uncertainty and a rise in risk-off sentiment.1
Difficult Q4 dents stronger performance in 2024
Difficult Q4 dents stronger performance in 2024
DISPLAY 1
2025 preview: Local rates attractive
Early into 2025, that uncertainty still looms – foremost, with respect to U.S. policy. Uncertainty also dominated markets when Donald Trump first came to office. And yet, inflows to EM debt were strong in three of his four years in office (i.e., 2016, 2017, 2019), indicating that diminishing investor appetite for the asset class under Trump 2.0 is not a foregone conclusion.
In fact, the outlook for EM debt remains distinctly nuanced. Uncertainty is an issue, to be sure, but the overarching economic picture for emerging markets is far from bad. Growth forecasts have improved in the majority of EM economies, while inflation appears to have peaked in many countries as well.
EM FX faces headwinds from prospects for a stronger U.S. dollar and the potential impact of restrictive trade policies from Washington on certain countries in 2025. However, EM central banks will be watching Fed policy closely and are expected to only cut rates selectively, as the latter maintains a tighter for longer stance.
Notably, real yield differentials between emerging and developed markets already sit at wide levels (having widened further in Q4), which could bolster local EM rates as a return driver in 2025.
Discovering value in differentiation
While it is difficult to speculate on the precise impact of U.S. policy change, history tells us that blanket outcomes are not inevitable – for instance, some countries were impacted more by U.S. policy during Trump 1.0, and others less so. Moreover, broad generalizations about EM countries elide the significant differentiation that exists across the whole of the investment universe.
And that differentiation is critical for discovering value in EM debt, particularly as it relates to economic policy. Fiscal laxity in Brazil, for example, caused market confidence to plummet and the currency to hit an all-time low against the U.S. dollar in December. In contrast, the Nigerian naira gained against the greenback in the month, as the central bank’s launch of a new FX trading platform instilled greater investor confidence.
Active advantage
Investors with significant research and analytical heft are best placed to understand how policy and institutional reform at the individual country level can drive fundamentals. This may prove particularly important at a time when economic reform, monetary policy and fiscal management are likely to matter more to investment outcomes.
Flexibility and market access are also likely to play a greater role, as they allow managers to execute on their country views. Investors able to take advantage of idiosyncratic opportunities, whether that be positioning in off-index credits or taking long or short positions in the currency, rates or spreads of a given market are best placed for investment success. This is especially true for investors who have optimised their trading infrastructure to access smaller, off-index markets that are often under-invested by the broader market and, therefore, less impacted by macro trends.
Lastly, strategies that hedge out U.S. Treasury duration for a purer EM debt exposure may find themselves better insulated from this potential source of yield volatility, which has been more pronounced into early 2025.
Bottom line – When the macro environment for EM debt appears uncertain or weak, investors should find strength in fundamentals. No two countries or credits are the same and significant variation exists across this broad and deep asset class, which has long-term investment potential that extends beyond any one quarter, or year, for that matter.
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