Despite recent volatility, emerging markets (EMs) continue to hold significant potential for investors. The current global trends and market conditions present several tailwinds that can drive growth and create opportunities in EM fixed income investments. Here, we explore these tailwinds and discuss the investment implications for the second half of 2024.
One of the key global trends to consider today is nearshoring, which offers a strong, long-term opportunity for neighbouring emerging economies. As the US and Europe move to relocate their production chains closer to home, this shift boosts foreign investment, trade flows, and infrastructure development. Consequently, it creates a favourable environment for fixed income investments in these regions.
Another trend worth noting is the diversification of FX reserves. Countries have been diversifying their foreign exchange reserves away from the US dollar and euro, particularly since the 2019 US-China trade war and Russia's 2022 invasion of Ukraine. This diversification into EM currencies and gold aims to mitigate the risks associated with sanctions and geopolitical tensions. It presents an opportunity for investors to explore EM fixed income assets denominated in local currencies.
Apropos of diversification, the need to diversify has extended, beyond reserves, to supply chains. Energy security has emerged as a global priority, as demonstrated by the EU’s embargo on Russian energy supplies in 2022. This event underscored the importance of diversifying production, sourcing, and distribution across multiple EM countries to reduce reliance on a single source or market.
As EMs play a crucial role in this supply chain diversification, it opens up avenues for fixed income investments in these regions.
Last, the global shift from traditional energy sources to sustainable alternatives, such as copper and lithium, has significant implications for EM countries. Being major suppliers of these commodities, EMs stand to benefit from the environmental, technological, economic, social, and governance effects associated with this transition. Investing in EM fixed income assets aligned with sustainable development goals can provide attractive opportunities for investors.
H2 2024 outlook: three possible market regimes to monitor
Recognising the significant influence that developments in the United States exert on emerging markets, it is vital to understand the market environment in order to be able make informed investment decisions. As we enter the second half of 2024, three scenarios have been identified for the US, each having different implications for EM assets and portfolio positioning.
In the base-case scenario, we anticipate the US economy decelerating in an orderly manner, leading to modest Federal Reserve rate cuts. The EM-DM (developing markets) growth differential becomes more prominent, allowing EM central banks to continue their easing cycles. This scenario is favourable for EM fixed income, with local currency debt outperforming and a weaker US dollar benefiting EM assets.
In the event of a faster-than-expected US economic deceleration, equities and risk assets could face downwards pressure, while the US dollar may strengthen. The Federal Reserve's ability to cut policy rates to support the economy could be limited, resulting in a potential repricing across the EM fixed income asset class and relatively flat total returns.
Although a low-probability scenario, an environment where growth and inflation re-accelerate could lead to a sell-off in US Treasury yields. EM FX and high-yielding EM debt would benefit in this reflationary environment, while EM duration may underperform.
Overall, regardless of the scenario that plays out, investors should be mindful of potential risks that could impact EM fixed income investments. Volatility in global markets could arise from the US political agenda, particularly for economies directly exposed to it, such as China and Mexico. The outcome of the US presidential election and subsequent foreign policy decisions could significantly impact military aid, economic sanctions, and diplomatic efforts in the Russia-Ukraine conflict. Potential tensions between the US and the EU on foreign policy could also arise. Last, while the impact on oil prices and risk appetite is expected to remain localised, any escalation or spread of the Israel-Hamas conflict across the region could introduce risks.
Considering the prevailing market conditions and the identified tailwinds, a positive outlook is being maintained on EM assets for the second half of 2024. The potential start of an easing cycle in the US and the resilient growth backdrop of EMs make EM fixed income investments attractive, particularly in the EM hard currency segment. However, it is crucial to emphasise the importance of country differentiation within the EM universe. Additionally, investors should keep an eye on reform and turnaround stories in frontier economies, which may present compelling opportunities.
