Emerging market (EM) debt performance has slowed in 2024, impacted by robust US economic growth and persistent inflation. Despite tighter EM credit spreads, higher US Treasury yields and a strong dollar have created challenges, leading to increased EM bond yields and weaker currencies.
Fundamentals for EM debt remain supportive, with resilient economic conditions and favorable fiscal dynamics presenting opportunities for monetary easing. Projections indicate EM gross domestic product growth will remain above potential at 3.9% in 2025, with inflation expected to decrease to 4.2% from 5.9% in 2024.
Fiscal deficits are anticipated to hold around 5.7% of GDP, with government debt-to-GDP at 60%. The overall basic balance for EM is projected at 2% of GDP, indicating solid external accounts. The financial sector remains strong, with limited adverse effects from rising interest rates.
Risks, however, are present, particularly due to uncertainty surrounding the Trump administration's trade policies, which could disrupt global trade. Countries with substantial US trade surpluses may face economic challenges that lead to fiscal and monetary responses.
In 2024, EM hard currency sovereign and corporate credit spreads compressed significantly, reflecting positive fundamentals and low default rates. Although spreads are less appealing than in 2023, yield levels remain attractive due to higher US Treasury yields. Future returns on EM hard currency debt in 2025 are expected to be driven by lower US Treasury yields and carry rather than credit-spread compression.
The US dollar is likely to remain strong, creating headwinds for EM local markets while currency depreciation may help offset tariff costs unevenly across EM countries. Local rates are expected to be supported by prudent EM central banks amidst stable economic activity.
Frontier markets are emerging as a bright spot, with local currency bonds playing a crucial role. These markets are diversifying financing sources and reducing reliance on foreign currency debt. Strong reform momentum and multilateral support are enhancing their economic prospects.
Despite some loss of momentum in EM debt, the economic landscape remains resilient, and the potential for monetary policy easing exists. While political uncertainties pose risks, they may also create opportunities for long-term investors.