Emerging market debt (EMD) investors face some unusual dynamics heading into year end. After a period of decoupling between US and emerging market central banks, will the resilience of the US economy mark the return of the data-driven Fed as the dominant driver of EMD returns?
At the start of the year, markets were focused on two macroeconomic themes: the US economy and China’s reopening. However, neither of these panned out in line with consensus expectations.
In the US, although there was a healthy debate around what kind of landing the economy would make, the consensus seemed to be that there would be some sort of landing in the second half of the year. Approaching year end, however, the US economy continues to surprise with its resilience, leading markets to re-evaluate their stance. As a result, we have seen both the dollar and US Treasury yields trend higher.
As for China, high expectations about the country’s move away from its zero-COVID policy gave way to disappointment later in the year as the Chinese economy failed to deliver and the stimulus provided was largely regarded as inadequate.
In addition to the surprising resilience of the US economy and the surprising weakness of China’s economy, there are other aspects that are quite unusual about these late-cycle dynamics that investors should be cognizant of when considering EMD.
Firstly, emerging market (EM) monetary policy has, at least for the time being, decoupled from that of the US Federal Reserve Board (Fed). As we have previously discussed, EM central banks started their hiking cycles ahead of the Fed. As a result, EM inflation already peaked in the fourth quarter of 2022, giving EM central banks ammunition to start cutting rates this year. This is quite unusual because EM central banks tend to follow the Fed and especially those in Latin America, which were the first ones to hike in this cycle and are now among the first to cut.
Secondly, EM spreads have appeared — and continue to appear — attractively valued, while other comparable US dollar (USD) spread products like US high yield appear a lot more expensive. Hence, EM sovereign spreads, particularly high yield sovereign spreads, have also diverged from other spread products due to the different dynamics driving them.