Capital Ideas^™ 
Investment insights from Capitals Express Investments

In 2024, numerous factors appear to be turning in favour of emerging markets (EM) debt despite the potential for weak global economic growth. A more dovish U.S. Federal Reserve (Fed) should support a rebound for EM economies. This is likely to benefit both higher-rated local currency debt — and to an extent, dollar-denominated debt — which spans a wide variety of economies and markets, extending all the way to the riskier and smaller economies often referred to as the frontier markets.

We see the largest opportunities within core (higher rated) local currency sovereign debt, along with select investment-grade (rated BBB/Baa and above) and high-yield dollar-denominated sovereign issuers. If incoming inflation data permits the Fed to cut rates, it should allow the central banks in EM countries to move in a direction that better reflects their domestic outlooks. Dollar-denominated issuers may also benefit from potentially lower funding costs. In most of the core economies, inflation is expected to decline throughout 2024. Falling interest rates should be positive for duration, especially for local currency debt holders. 

While EM currencies recovered in 2023, the strength of the U.S. dollar could still pose a challenge, even though the dollar looks overvalued on most fundamental metrics. This could change with lower U.S. rates, although the process of unwinding dollar strength is likely to be gradual given the real rate level is still supportive of the dollar over other major currencies, and growth outside the U.S. remains relatively weak. Elections in several EM countries could also disrupt the status quo.

The table below shows how EM currencies and debt have performed before and after the Fed began cutting rates in previous cycles. Both local and hard currency (dollar-denominated) bonds have rallied the most prior to earlier rate cuts, while EM currencies have performed better after the rate cuts began.

The U.S. may escape recession, even if global growth remains weak

EM assets have historically been highly correlated with U.S. economic growth. The U.S. economy looks poised to maintain an economic growth rate above 2%, even as it contends with the lagged effects of tightening financial conditions. Labour markets remain robust, although rising consumer debt has caused some concerns. 

Outside of the U.S., growth is expected to remain relatively weak. Compared to the U.S., Europe was hit more heavily by the energy shock, and the region still faces some of the most difficult policy challenges with the tradeoff between inflation and growth. Eurozone economic activity has stabilized at subdued levels, and there remains a significant risk of contraction in some economies. However, we could experience a recovery in the second half of 2024, if increased investment in areas like the energy transition and defence picks up, inflation comes down and consumers start to see the benefits of stronger real income growth.

China is likely to have to adjust to a decelerating growth rate in the coming years. Elsewhere in the emerging markets, we expect continued economic expansion in Asia (outside of China), a deceleration in Latin America and broadly stable growth in Europe, the Middle East and Africa. 

Core emerging markets bonds may benefit from declining rates

If monetary policy loosens in major developed markets, a decline in interest rates could work in favour of local currency EM bonds. While EM countries have traditionally struggled with inflation, more developed EM central banks have raised interest rates earlier and more aggressively than the developed world to prevent people’s inflation expectations from accelerating.

Inflation now looks ready to return to central bank comfort zones for most EM countries by the end of 2024. As a result, a long duration position looks attractive in many Latin American markets, including Brazil and Mexico. Long duration positioning also looks compelling in South Africa, whose real rates are near the upper end of historical ranges and have more room to decline than U.S. Treasuries.

Central banks in Asia are likely to cut rates later than the rest of the EM world. Asian local currency debt tends to be more correlated with global markets, but duration opportunities still exist. In China, low yields seem justified by stubbornly low inflation and growth challenges.

Caution is still warranted in Central Europe. Inflation does seem to have rolled over (although it appears unlikely to return to target as projected), and growth has been sluggish. However, those trends are reflected in local yields, with aggressive easing cycles priced into bonds.

Across hard currency debt, spreads are fairly tight within the core investment-grade EM economies. But compared to U.S. investment-grade corporate bonds, spreads look reasonably attractive, thus presenting some relative value opportunities. Absolute yield levels also remain reasonably high. Part of the appeal of these holdings is that they provide diversification benefits to portfolios. South Korea and Mexico are examples of some higher rated credits in which we have conviction.

Some corporate U.S. dollar issuers may also present value. Fundamentals within EM corporates look solid as most EM corporate treasurers have taken a prudent approach to borrowing. The geographic representation and risk structure of EM corporates is quite different from sovereigns, and thus provides an element of diversification.

Frontier markets face greater challenges

The Fed’s pivot should reduce external financing pressures on frontier markets, but they will likely continue to face headwinds from relatively weak global growth, persistent dollar strength and higher U.S. rates than in the prior two decades (even with a more dovish Fed). Spreads on most of these credits are still relatively wide, offering a significant valuation cushion in many cases. However, selectivity is key. 

Attractive opportunities, but some risks to consider

Over half the world’s population will be asked to go to the polls in 2024. In addition to parts of the developed world, this includes many core EM countries, such as India, South Africa, Indonesia and Mexico, as well as a number of countries that are potentially heading toward or already in the midst of debt restructuring, such as Sri Lanka, Ukraine and Ghana. With so many economies heading into an election year, volatility could potentially increase, so diversification will be key for investors. Likewise, geopolitical risks remain elevated and warrant careful monitoring.

Overall, developing economies have proven to be resilient in recent years, and we believe emerging markets debt will remain compelling for investors if fundamentals and starting yields continue to look broadly attractive. These markets were thoroughly tested in 2023 and came out stronger for it. In addition to the aggressive U.S. rate-hiking cycle, emerging markets also had to contend with wars, U.S. banking stress in March and a sharp bond selloff. The fact that the more developed EMs were able to weather this volatility without significant impact demonstrates the progress these economies have made.