Over the past year, emerging markets (EM) debt has proven to be resilient, with hard currency credit outperforming despite challenges in local currency markets due to a strong U.S. dollar.
As we look ahead to 2025, we’re closely watching the impact of shifts in U.S. policy, global trade tensions, and China’s growing role as a lender. In addition, many EM countries are improving their financial strength through reduced dollar exposure and structural reforms, creating compelling investment opportunities.
Below, I answer eight questions we believe may be top of mind for EM debt investors.
1. Which EM debt segments and regions saw the strongest and weakest performance over the past year?
EM credit, which is denominated in hard currency, has performed strongly, driven by significant compression of credit spreads in the high-yield space. Sentiment toward the asset class has been supported by a combination of positive factors such as strong global economic growth, declining inflation, and robust multilateral and bilateral support.
In this environment, high-yield credits outperformed high-grade credits as investors continued to price out credit risks, leading to a material compression in the risk premia. This phenomenon took place across regions.
However, in the EM local currency space, returns have been more subdued due to the impact of the strong U.S. dollar on the performance of EM currencies.
2. How have past U.S. policies impacted EM debt market outcomes?
EM debt tends to be impacted by two dominant global forces: global economic growth and global liquidity conditions. U.S. policies that have resulted in weaker economic growth and/or higher interest rates have typically created headwinds for the performance of the asset class.
But the EM debt universe is very diversified, consisting of more than 70 countries, so idiosyncratic risk events have seldomly led to disruptions in the asset class.
3. Will any potential policy shifts under the Trump administration impact your approach to EM debt?
We believe the focus of the Trump administration will be on immigration, regulation, trade, and foreign policy.
In the United States, we expect higher tariffs on imported goods to lead to a temporary increase in inflation, pressuring consumer discretionary spending and economic activity. While we do not expect the U.S. Federal Reserve (Fed) to initially react to transitory inflationary pressures, the path toward monetary easing has become less certain.
Globally, higher tariffs could negatively impact trade. We believe that countries running large trade surpluses with the United States are likely see the biggest impact on their economies.
China, and to a lesser extent Europe, could be particularly affected, prompting significant fiscal and monetary policy responses to counter the impact of higher tariffs imposed by the Trump administration. We expect a combination of robust stimulus measures and a weaker currency as the Chinese government seeks to offset tariff-related pressures.
In addition, China is likely to continue redirecting exports toward EMs, which now account for nearly half of its total exports. Meanwhile, potential tariff violations of World Trade Organization commitments could heighten risks for global trade and invite strong retaliatory measures.
While U.S. tariffs could impact global trade, we believe EM countries are less directly exposed given the significant growth in intra-EM trade observed over the past few years.
While U.S. tariffs could impact global trade, we believe EM countries are less directly exposed given the significant growth in intra-EM trade observed over the past few years.
4. Will U.S. foreign and domestic policy have any impact on international sentiment toward EM debt?
On the foreign policy front, we believe the Trump administration’s intentions to mediate international conflicts could potentially result in significant de-escalation of the wars in Russia and Ukraine and the Middle East. The recently agreed-upon ceasefire in Gaza is a good example.
Despite all these risks, we believe the Trump administration will adopt a more gradual and pragmatic trade agenda, aiming to avoid creating higher inflation for U.S. consumers.
In our opinion, U.S. domestic policies will not significantly disrupt the outlook for the global economy. We expect the global disinflationary process to continue, albeit at a potentially slower pace, and anticipate additional monetary policy easing in developed and emerging economies.
The gradual removal of monetary policy restriction should lead to lower global rates and improved liquidity conditions in 2025.
All in all, we anticipate a favorable market environment for EM debt in 2025 and believe that higher volatility induced by political noise and intense rhetoric could create opportunities for long-term investors.
5. How do you view China’s evolving role as an EM lender?
In our opinion, China’s role as an important provider of bilateral support to EM countries will not change as the country continues to pursue strategic interests in the space and competes with Western countries for influence over developing countries.
6. Are there any EMs that have successfully reduced their U.S. dollar exposure?
There are many EM countries that have successfully reduced their dollar exposure in recent years. We can see this in many of the metrics we use to measure the level and direction of sovereign vulnerabilities.
Angola has reduced its absolute level of external debt and boosted its reserves through a combination of debt negotiation and tough reforms such as subsidy reduction.
Other countries, such as Ghana, have extended the maturity of their external debt to reduce short-term vulnerability.
Countries in the Commonwealth of Independent States region have reduced their external debt vulnerabilities. Some have structurally improved growth from talented human capital inflow from Russia. Uzbekistan has opened its economy to global trade and international investment and boosted growth with strong reform efforts.
Egypt, meanwhile, has boosted foreign exchange reserve levels through a combination of International Monetary Fund (IMF) and bilateral support from the Gulf Cooperation Council.
Although this trend is not all encompassing, there are many EM countries that are on an improving fundamentals trend, with strong multilateral and bilateral support. This helps to reduce vulnerabilities to the U.S. dollar and can be evidenced by a turn in the credit ratings cycle.
There are many EM countries that are on an improving fundamentals trend, with strong multilateral and bilateral support.
7. Are rising debt levels impacting the attractiveness and risk of EM debt?
EM debt credit fundamentals remain supportive. Economic conditions are still resilient; fiscal, debt, and external dynamics are supportive; and disinflation is creating opportunity for monetary policy easing.
We believe EM gross domestic product (GDP) growth could accelerate from 3.5% in 2024 to potentially above 3.7% in 2025. Concurrently, we expect inflation to fall from 6.1% in 2024 to 4.3% in 2025. Stronger growth and lower inflation should lead to improved fiscal and debt dynamics, in our opinion.
In addition, we anticipate fiscal deficits to improve from 4.9% of GDP in 2024 to 4.2% of GDP in 2025, and overall government debt-to-GDP to remain stable at 57%. We also expect solid external accounts, and we believe aggregate basic balances could remain at around 1.5% of EM GDP.
Importantly, fundamentals of the EM financial sector remain positive, with rising interest rates only having a limited impact on asset quality. This strong fundamental picture has resulted in a positive turn in the credit rating cycle.
8. What are compelling opportunities in EM debt right now, and how do you believe investors position might themselves for the coming years?
One relative bright spot in our investment universe is frontier markets where local currency bonds play an important role in our strategy.
From a structural perspective, more of these frontier market countries are making a conscious effort to open their capital markets to diversify their financing sources and reduce dependence on foreign currency debt issuance.
Measures to achieve this include strong reform momentum, often supported by multilateral organizations; the reduction or removal of capital controls; and additional liquidity measures provided by the central banks.
This means that many frontier market currencies offer opportunities for investment, with currencies at or below our estimates of fair value supported by high real and nominal local interest rates. These currencies could provide an attractive combination of lower beta compared to the strong U.S. dollar trend and higher-than-normal carry compared to their larger EM counterparts.
We also expect a number of these markets to continue to benefit from official sector support given their geopolitical importance, meaning that they enjoy a combination of strong multilateral and bilateral support.
For example, a number of frontier markets are currently on an IMF program. This provides frontier markets with cheap financing and strong economic reforms designed to ensure a higher and more consistent level of potential growth.
This ample and diversified source of funding has been particularly evident in recent years and has been a strong provider of financial support.
In previous years, it was standard for EM managers to add a small number of frontier local markets to their portfolio in a rather concentrated way.
However, the evolution of frontier markets has led us to believe that the asset class now has the diversification necessary to be relevant as a standalone investment.
Marcelo Assalin, CFA, partner, is the head of William Blair’s emerging markets debt team, on which he also serves as a portfolio manager.
