Emerging market debt outlook: The return of ‘Goldilocks’

As we enter the final quarter of 2025, a key question for investors to ponder is whether emerging market debt can sustain its impressive year-to-date momentum. While there is an argument that much of the upside has been priced in by markets, improving sentiment and robust fundamentals suggest that there is more potential in this rally. Given that the asset class has been beset by global macroeconomic and geopolitical challenges, ranging from slowing global growth to US tariffs to violent military conflicts, returns have been impressive. Supportive external factors such as a weaker US dollar and anticipated Federal Reserve rate cuts provide additional scope for optimism. Furthermore, domestic demand for local currency bonds is strong, while the stabilization of foreign investor flows are positive signs for EMD prospects.

A stellar 2025 for emerging market debt

Our outlook from earlier this year projected strong performance prospects for both local and hard currency EM debt. At the time, we held a slight preference for hard currency bonds, but as 2025 unfolded, local currency debt has proved to be the stronger segment (as of August 31). Local currency debt (as measured by the JPM-GBI EM Index) returned 13.8% in USD terms, with contributions of 6.2% from currency appreciation and 7.2% from bond performance. The performance has been broad-based across EM regions and countries, and across both bond and currency returns. Clearly, EM FX has been an important factor in returns in 2025, although this has been largely due to the weaker USD. Indeed, in unhedged EUR terms, the local currency index has returned a very modest 0.7% — resulting from the 12% relative gain by the euro versus the US dollar this year. The turnaround since the start of 2024 is notable (Figure 1).

Hard currency bonds (as measured by JPM-EMBI GD) have also proved robust performers, delivering a return of 8.7% for the first eight months of 2025 (Figure 2). Of that, the Treasury component contributed 4.7%, while 3.8% came from spread compression and carry. By country, Mexico was among the best performers — the Mexican yield curve is well defined with duration that is about one year longer than the index. Elsewhere, Ecuador’s bond market has benefited from the easing of political uncertainty as President Daniel Noboa was re-elected following a second round of voting in April.

We retain a constructive outlook for EMD

We maintain our positive stance on prospects for emerging market debt, even as market volatility and macroeconomic uncertainty remain features of the investment landscape. Several external and internal factors reinforce our constructive outlook, which is underpinned by our overall house view of the global economy. That view concentrates on developments in the United States, where, despite a whirlwind of tariff headlines and geopolitical uncertainty, we envisage a soft economic landing that is complemented by three Federal Reserve rate cuts this year.

Within the emerging markets universe, we anticipate looser monetary conditions to evolve as the impact of tariffs dampen inflationary pressures via weaker output growth and forced consolidation. The weaker US dollar further bolsters this assessment as this currency dynamic has historically been supportive of strong returns in EMD — and has been evident in performance this year. While some low-income countries in the EM universe are grappling with debt service burdens and the overall EM debt-to-GDP ratio has risen, the comparison with developed markets continues to be favorable (Figure 3).

The tailwind from investors reallocating US exposures

Moves by investors aiming for greater diversification in portfolios, particularly in terms of reducing US asset exposures, presents potential for EMD to benefit. After an extended period of outflows, there is a strong argument that this ‘under-owned’ asset class could be poised for a lift from such a reallocation. Moreover, the US tariff-related tensions have also started to ease, with many (though not all) trade negotiations advanced and proving less onerous than initially feared. We believe these factors enhance the investment case for EMD at this time. And we are not alone — as Figure 4 shows, the outflows from EMD appear to have been stemmed; and while flows into EMD are modest, there has been a notable improvement.

Weighing prospects for local and hard currency EM debt

From a valuations perspective, we believe local currency debt presents a more attractive outlook than their hard currency counterparts. In the local currency space, lower domestic rates and the ongoing pressure on the US dollar (from hedging sales/flows) are likely to remain key themes as we move forward. Can central banks in emerging market countries continue to provide support? Many have lowered rates further in 2025 and have thus far proven adept at navigating shifting fiscal and monetary dynamics. This is an important element in the relative attractiveness of emerging market debt, especially in a world where their developed market counterparts face significant structural and cyclical challenges. However, should inflation begin to creep higher once more, the headroom to reduce rates could shrink.

For hard currency EMD, spreads are already at multi-year lows which leaves little room for meaningful compression from here. Instead, this segment can benefit from favorable conditions for US duration, as well as additional carry from what we believe can be a relatively stable spread environment. In addition, rates-sensitive issuers should benefit from a decline in Treasury yields and high yield (HY) bonds could continue to see positive outcomes from possible country-specific developments in places like Lebanon (e.g., a new government) and Ukraine (end of war), among others. A robust primary market would augur well for hard currency sovereigns; net issuance has been healthy and is expected to outpace that of prior years. To illustrate the appetite for new paper, a recent $5.5 billion sukuk deal by Saudi Arabia was more than three times oversubscribed.¹ A continuation of this theme would reduce refinancing concerns and allow favorable market sentiment to persist.

A robust environment for EM debt

While headline risks remain, we still see many reasons to believe that EMD will continue to perform well for the remainder of 2025. The macro backdrop remains largely favorable, with additional rate cuts and a soft landing envisaged. Decelerating US growth should incentivize the Fed to persevere with rate cuts. This would provide a Goldilocks environment for EM debt: EM spreads are supported, Treasury yields are lower, and the US dollar remains weak. Alongside this, underlying EM country dynamics such as credit rating upgrades outnumbering downgrades bolster our positive view.

The impact of tariffs on economies and sentiment has evolved and markets have proven resilient as it grew more clear that the US administration’s use of tariffs is as much for leverage rather than as an end in itself for trade. The impact of higher prices on US demand for some EM-made products pose a risk for EM countries. But as noted in our midyear Global Market Outlook, US tariffs can reduce inflation in other regions as many countries have opted not to retaliate and, in some instances, have cut pre-existing levies on US products; in addition, the weak dollar also dampens the inflation effect. Emerging market debt performance thus far in 2025 has reflected this, with generally lower rates and more fiscal consolidation across most emerging economies.

We believe this ‘Goldilocks’ scenario for EM debt can persist for several quarters, underpinning prospects for both hard currency and local currency markets. We retain a positive outlook for the asset class, with a preference for local currency debt.