In hard-currency emerging market debt, there was a positive contribution from spreads, which tightened by 6 basis points (bps) over the month. However, this was more than offset by a negative contribution from US treasury yields, with the US 10-year yield rising by 23bps over the month to 3.65%. Despite already hiking policy interest rates by 500bps in just a little over a year, market expectations are that the Federal Reserve (Fed) will deliver one more rate hike in either June or July. The case for further tightening is supported by continued strong non-farm payrolls and very low unemployment.

In local-currency debt, returns were positive, but this was far outweighed by a negative FX return of -2.28%, reflecting a strengthening US dollar over the course of May. In emerging market corporate debt, spreads widened by 6bps, contributing to the negative return over the month.

May was a weaker month for emerging market debt, primarily due to the move higher in US Treasury yields. There were also concerns that the economic outlook in developed markets could harm emerging market bonds, particularly if spreads move to price in increased recession risks. However, market expectations are that after one more rate hike, the Fed will pause its hiking cycle. This could be followed quite soon (potentially before the end of the year) by a new rate-cutting cycle. As such, the negative impetus from US monetary policy looks like at least ending and potentially even reversing in the near future.

Softer data coming out of China means that the potential upside risk of a China recovery seems less imminent. The ‘Goldilocks’ scenario for emerging market debt would combine the current expected path for US interest rates with a ‘soft landing’, resulting in weaker US growth and a weaker US dollar. On the other hand, the two scenarios that could lead to more risk-off conditions are upwardly revised US policy rate expectations owing to stickier US inflation and markedly increased financial stability risks.

We think the current environment calls for a high degree of selectivity, with a preference for emerging market credits that are less reliant on imminent market access. Likewise, we prefer credits with more resilient balance sheets and largely fixed rate debt obligations. These factors should help limit their exposure to the higher cost of capital that we expect to prevail for many issuers for some time.