Since 2022, we have been alerting investors to a regime shift in markets. Asset classes traditionally viewed as risk-free, such as the UK Gilt and US Treasury markets (and more recently German Bunds), have seen a remarkable development. Volatility in these markets has shifted gear, resembling the volatility typically seen in Emerging Markets (EM). There is an ever-increasing blurring of lines between the behaviour of Emerging and Developed Markets (DM). Since 2022, returns in DM bonds have been lacklustre, while in EM bonds, returns have followed the historical pattern. At the same time, DM volatility has spiked.
Emerging Market Resilience
Despite headwinds of persistent US dollar strength, and Russia's local currency debt being written down to zero in 2022, EM debt has shown remarkable resilience. Largely thanks to orthodox monetary policy – many EM central banks hiked interest rates at the first sign of inflation post-COVID. In contrast, most DM central bankers deemed the same inflation “transitory” - bond markets suffered from the delayed, and amplified, rate cycles. Moreover, expansionary fiscal surprises have compounded the volatility in DM bond markets – the UK Gilt market, and more recently the German Bund market, offer prime examples. Looking ahead, weaker DM fiscal dynamics, coupled with stickier inflation, suggest this new, more volatile regime will persist: the blurring of lines between EM and DM is likely to endure.
Diverging Fiscal Dynamics
‘Political instability,’ ‘rising populism,’ and ‘unsustainable public finances’ are traditionally EM terms; but now they appear in several large, ‘developed’ economies. While each country’s political backstory is unique, the common theme is a deterioration of macroeconomic fundamentals. There is little sign of the fiscal imbalances in the US and other ‘advanced’ economies materially reversing, turning the traditional economic order on its head. The current tariff uncertainty is too, a symptom of these imbalances.
In contrast, many EM economies have strengthened their fiscal fundamentals over the past decade. Following the 2013 taper tantrum, many EM economies rebalanced, improving their resilience. Even after the COVID-19 pandemic, many EM policymakers chose prudence, returning primary balances to surplus and stabilizing debt-to-GDP. While there are notable exceptions, credible policymaking and fiscal reform are an unmistakable trend in emerging markets.
Figure 1: EM and US debt to GDP, %
Figure 2: EM and US primary balance (% of GDP)
Source: October 24, IMF, Moody's, Ninety One, EM: JPM EMBI weighted scores across 78 EM countries.
Credit Ratings Show the Shift
Recent credit rating actions reflect the shifting fiscal landscape - both France and the US have received negative actions, including downgrades, over the past two years. On the other hand, fundamental improvements in EM economies have spurred a positive trend in ratings. In 2024, upgrades in EM regions clearly outnumbered downgrades, and 39 EM countries are currently on a positive outlook, compared to just 20 on negative outlook.
Market Behaviour Too
The market has also taken note. A useful bellwether is the sovereign asset swap spread: a metric that shows, amongst others, how much credit risk investors associate with a government bond by comparing its yield to the swap market. In recent years, this spread has become more negative in major DM markets, reflecting concerns over the sustainability of public finances.
Another indicator of investor concern is the yield curve. A bear steepening — where long-term yields rise more than short-term yields — is indicative of more premium needed to compensate for debt issuance, inflation, and fiscal instability. This unenviable phenomenon, normally reserved for EM bonds, is now appearing more regularly in DM bonds, as seen in the US Treasury, UK Gilt and German Bund markets in recent years.
Implications for Asset Allocators
The distinction between DM and EM bond markets has become increasingly blurred. The challenge for asset allocators is a “quandary of the denominator.” When evaluating investments, allocators must consider both returns (the numerator) and risks (the denominator). With DM bonds in a new volatility regime, the risk side of the equation has shifted, meaning higher returns are required to replicate past experience.
Today, DM bonds are no longer ‘risk-free,’ and with weaker DM fiscal dynamics, this new regime of volatility is likely to persist. In contrast, many EMs have started to look more ‘developed’ than ‘emerging’ (and vice versa).
Naturally, in an investment universe of more than 70 countries, there will always be some exceptions; selectivity and a robust active approach are still required to ensure investors are rewarded for the risk they take. But the EM debt asset class deserves a closer – and more balanced – assessment. While DM bonds still have much to offer investors as a defensive core allocation, EM debt also warrants a place at the global investment table.
In today’s world of heightened volatility, it is not EM debt that has changed; it is DM.