Market Review

In July, hard-currency emerging-market debt (EMD) returned 1.87% [1], while local-currency EMD returned 2.27% [2]. In EM corporate debt, the total return over the month was 1.50% [3].

A handful of downside data surprises in the US helped to drive yields lower, leaving investors optimistic about future cuts to interest rates. Headline inflation was -0.1% month on month (MoM) in June (versus +0.1% expected). Core inflation (which excludes food and energy prices) fell to the lowest rate since January 2021 at +0.1% MoM (versus +0.2% expected). In addition, commodity prices declined across the board, notably for industrial metals, agricultural goods, and energy commodities. The crude oil price fell 6.58% to $80.72 per barrel. This helped to ease inflationary pressures. Optimism about interest-rate cuts was reinforced by Federal Reserve (Fed) Chair Powell’s statement following the Federal Open Market Committee meeting on 31 July. Powell signalled that an interest-rate cut could be on the table in September if inflation continues to moderate as expected.

In local-currency EMD, yields fell 22 basis points (bps) to 6.37%. This generated positive bond return (+1.62%), which was accompanied by a positive currency return (+0.65%). Latin American countries were among the worst performers: Uruguay, Mexico and Brazil were the only three countries in the index to post negative returns.

EM corporate debt returned 1.50% over the month, despite spreads widening by 12bps to 279bps. Investment-grade and high-yield sectors performed broadly in line with each other, returning 1.51% and 1.49%, respectively. Regionally, Asia and Latin America outperformed, while the Middle East and Europe were the worst-performing regions. On a sectoral basis, real estate was the clear outperformer, while financials and consumers lagged.

Outlook

We see value in the high-yield and frontier sectors, where spreads and yields look attractive. But we remain cautious about countries that have challenging amortisation schedules and a significant need for market access, given higher financing costs. Several countries still trade above 1000bps, making market access difficult to justify. But we expect support from multilateral and alternative sources, which reduces default risk and provides ample room for spread compression, as well as a fall in yields.

In EM local markets, we remain overweight in Latin America given the attractive real rates in the region. Lower economic growth and contained domestic wage pressures also provide more room for central banks to cut. For EM corporates, credit fundamentals remain supportive. As global economic growth slows, we are likely to see downward adjustments to operational performance.

However, leverage remains low and interest coverage is healthy. The asset class offers good value compared with developed-market credit, namely in high yield. The ‘Goldilocks’ scenario for EMs combines a more aggressive rate-cutting path for the Fed, with weaker US growth and a weaker US dollar. The two scenarios that could lead to a risk-off environment would be a higher terminal rate (if inflation remains elevated) or markedly lower bond yields (because of financial stability risks).