After a volatile year, emerging market debt has rallied in recent months. The recovery has not been without turbulence, but there are signs that the skies are brightening as some of the headwinds that pinned back performance have eased. We consider what investors in EM debt might expect through the rest of 2023. Taking a look back at what transpired in 2022, we can see that emerging markets were caught up in the turmoil of a volatile year. However, when we assess what impacted returns in the asset class it becomes clear that underperformance in both hard currency and local currency EM debt was driven by non-EM factors. In hard currency sovereign debt where returns can be broken down into two main drivers — spread return and treasury return — US Treasuries accounted for almost two-thirds of the underperformance, with spread widening accounting for a third. In local currency sovereign debt, the key drivers of return are foreign exchange (FX) and interest rates; FX was responsible for almost half of the underperformance, and EM FX underperformance was largely due to the strength of the US dollar. While 2022 was painful, this leaves us with an improved outlook for the asset class this year. Even though volatility is likely to remain a feature of 2023, albeit with less intensity if one believes that most of the sell-off in US Treasuries has already occurred and most of the US dollar strength narrative has already played out, this removes two of the key headwinds that weighed on the asset class through last year. Furthermore, with COVID-related lockdowns in the rear-view mirror, there could be additional tailwinds from pent-up demand.
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