2 months after the US triggered the worst global tariff hit in a century, followed by a spectacular climb down on US-China tariffs in early May, and an ensuing market questioning of US long term fiscal sustainability as US debt lost its last AAA rating in May, some themes are becoming much clearer for EMD assets.
EM debt assets offer 3 clear advantages:
- Under-owned: EMD ownership is now at a 20-year low. Global allocations have remained at rock-bottom levels as investors ignored EMD assets post Covid, obsessed by DM credits / private debt.
- Diversifying: For all the drama over tariffs and geopolitics, we find that most EMD assets which matter for performance, are farthest from US concerns and greatly benefit from a weaker USD environment.
- Value for Money:
- EM corporate USD credits all-in yields still exceed US credits, at each rating level, despite often stronger debt metrics, lower leverage and smoother debt structures. They represent a unique source of yield , diversification for lower refinancing and macro risks than their DM counterparts.
- EM ex-Asia local government bonds and interest rates still trade near 20-year high yields, when inflation has been defeated, and the net impact of US tariffs should be deflationary. This gives their central banks flexibility to ease to cushion growth, making local duration “great again”.
- EM currencies whether EUR-related Eastern European ones, Asian ones, or high yielding Latin currencies, are boosted by a weaker USD environment, given cheap valuations and high yields.
- EM Sovereign USD credits are a hunting ground for differentiation, where all-in yields remain high despite tighter spreads for some, but where ongoing IMF/multilateral support for the weakest ones, significant reforms in others, potentially offer great risk-adjusted USD returns.
Which concerns should we dismiss?
- EMs ex-China as a whole appear more distant geopolitically, less directly exposed to trade with the US, than China and other G10 countries. Sporadic broadsides against Ukraine, South Africa look like one-offs, with only short-term direct impact on credits FX or local assets
- Inflation is now a non-issue across EMs, and this may be compounded by stronger EMFX, cheaper imported food prices, all that at a time where EM central banks retain a lot of flexibility to cut rates from high levels, should a growth issue materialize . A weaker USD greatly improves EMDs fortunes.
- In high yielding frontier countries, beyond a number of impressive reform turnaround stories (Argentina, Egypt, Nigeria, Turkey) and after key debt restructurings were enacted in 2024 (Sri Lanka, Zambia, Ghana), we see the IMF continuing to act as a lender of last resort, if only to avoid more geopolitical uncertainty in several places (Pakistan, Egypt, Ukraine, Sub-Saharan Africa, Ecuador).
Where are the real risks to be monitored?
- Growth risks exist, but mostly for South-East Asia, which no longer represents a major source of performance for EMD investors. Growth and deflationary risks can be monetized by receiving rates there and possibly entering short FX positions Vs the USD or EUR when justified, although not in the short term.
- Lower oil prices remain a headwind for weaker producers with higher breakeven prices like Angola and, to a lower degree, some Middle Eastern producers, (although the later have lots of financing options). But this greatly helps importers in Asia, Turkey or India from an inflation and growth standpoint..
- Other key commodities like Iron ore, copper or agricultural staples have remained very stable in USD terms, which improves EMs’ inflation outlook. Brazil benefits from high cocoa, coffee, orange juice prices.
- The main point of attention remains fiscal stability amidst potential growth slowdown or political pressure to win elections : Hungary, Romania, Brazil, Colombia, Mexico, Indonesia must be watched.
Written by Damien Buchet, Chief Investment Officer at Finisterre, Principal Asset Management
