EM Debt Q&A: Exploring a more constructive outlook

Fast view

• While not immune to the recent sell-off in global bond markets, EM Debt has shown resilience in the face of multiple headwinds. This speaks to the fundamental strength of EM economies now compared with other sell-offs seen over the past 25 years.
• Structural improvements in EM include lower levels of dollar debt, free-floating exchange rates and proactive central banks. Stronger balance of payments positions on the back of higher terms of trade should also help EMs cope with a lower growth environment.
• That said, a ‘tail’ of EM frontier markets appear to have over-borrowed in hard currency and they will face challenges if yields remain elevated and the new issue market closed. While market pricing has already largely reflected some these risks, selectivity is vital.
• Inflation in EM is showing signs of moderation (with a few notable exceptions) thanks to proactive rate-hiking by EM central banks who began tightening policy much earlier than their developed markets peers and are significantly further through their hiking cycles.
• Historically, as interest rate-hiking cycles progress to their later stages, investors have underestimated this progress, reflected in undervalued bonds. Bonds then tend to outperform as expectations catch up with reality. Many EMs are now well-placed in this regard.
• Now at levels not seen since the GFC, EM hard currency yields provide a cushion against volatility. Furthermore, history shows that yield is the dominant driver of bond-market returns, painting a positive picture for return prospects.