Investors who have avoided EM debt based on past assumptions may want to reconsider. Years of policy adjustment, stronger institutions and improved fiscal discipline have left many emerging market debt issuers on a firmer footing than previous cycles would suggest.
Amid an increasingly uncertain global backdrop, many EM economies have strengthened their fiscal positions, built reserve buffers and improved debt dynamics. Lower-rated countries have made particularly meaningful progress, supported by record-high IMF lending, and, importantly, strong implementation of programme reforms. Among the countries currently in IMF programmes, such as Ecuador, Egypt, El Salvador and Argentina, primary balances are nearly three percentage points of GDP stronger than their long-term averages. Debt restructurings in Ghana and Sri Lanka have motivated sovereigns towards more reforms to lock in gains in macro stability. Should countries continue to meet their programme objectives, fiscal positions are likely to strengthen further and debt-to-GDP ratios should decline meaningfully, even accounting for higher borrowing costs.
Many EM central banks have strengthened their credibility, in part by tightening monetary policy ahead of DM central banks in 2022. South Africa has lowered its inflation target to a DM-like 3%, with fiscal and structural reform adding credibility to this revised target. Meanwhile, governance changes post elections mean that fiscal laggards such as Hungary and Colombia are likely to pursue meaningful fiscal consolidations, providing space for additional monetary easing.
The resilience of the global economy is notable and helps EMs. Despite policy rates remaining above long-term averages, global growth has remained close to trend and global trade has reached record highs. Stronger banking systems following the 2008 global financial crisis, healthier household and corporate balance sheets, and continued expansion in global trade have all contributed to a more stable macroeconomic backdrop.
Many EMs are also benefiting from a changing geopolitical landscape. Their commodity endowment, in particular metals needed for semiconductors and artificial intelligence, boosts export growth while also encouraging both China and the US to deepen economic engagement. The US’s desire to strengthen relations in Latin America has generated financial aid for Argentina, regime change in Venezuela and reinforced Mexico’s role as a manufacturing hub for the US. At the same time, China continues to recycle part of its savings surplus into EMs while acting as a key export destination for EM.
In recent years, credit rating upgrades to EM sovereigns have significantly outnumbered downgrades. Absent a deterioration in policy, we expect that to continue even as fiscal sustainability becomes a growing challenge across much of the developed world. In the US, twin deficits and limited appetite for fiscal adjustment raise concerns about the long-term debt trajectory. In the UK, political and fiscal uncertainties persist, while in Europe, rising defence and energy spending is increasing fiscal pressures as adherence to fiscal rules weakens. As EM fundamentals continue to improve and fiscal challenges mount across much of the developed world, the line between EM and DM is becoming increasingly blurred.
In select countries, work remains to achieve the targets agreed upon under IMF programmes and establish a more sustainable fiscal footing. Senegal, for example, continues to struggle to deliver on a comprehensive reform plan. From a broader perspective, the US fiscal outlook remains troubling and could place upward pressure on government financing costs globally. The US is at risk of persistent inflation amid large AI investments and could force some Fed tightening. China’s large current account surplus is also a potential source of longer-term instability. Even so, the broader trend across EM remains one of continued reform, providing greater resilience against a more volatile global backdrop.
EM fundamentals are stronger than they have been in a decade. Multiyear reform efforts across countries of varying credit quality have driven sustained ratings upgrades, greater resilience and limited defaults. The result is an asset class that has evolved considerably, yet one that many investors continue to view through the lens of previous cycles. We believe that perception no longer reflects today’s reality.
For investors, the implication is clear: EM debt deserves a fresh look. Stronger fundamentals, attractive yield potential and diversification from DM risks suggest the asset class may be better positioned than legacy assumptions imply. While rigorous risk management and selectivity remain essential, investors should reassess whether current EM debt allocations reflect today’s improved opportunity set.
Fixed Income Portfolio Manager Gillian Edgeworth and Equity Portfolio Manager Bo Meunier explore whether emerging markets are at a turning point in our Active Views webcast.
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Emerging markets: Cyclical recovery or secular opportunity?
The views expressed are those of the author at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional or accredited investors only.
