Market review

In February, hard-currency emerging market debt (EMD) returned 0.98% [1], while local-currency EMD returned -0.57% [2]. In EM corporate debt, the total return over the month was 0.71% [3].

In hard-currency EMD, there was a positive contribution from spreads, which tightened by 33 basis points (bps). This outweighed the negative impact of US Treasury yields. The US 10-year Treasury yield rose by 34bps to 4.25%, marking the worst monthly performance since September. The January US jobs report exceeded expectations, with the addition of 353,000 non-farm payrolls (versus 185,000 expected) leaving the unemployment rate unchanged at 3.7%. Inflation was also higher than expected, with the annual headline rate only falling to 3.1% in January (versus 2.9% expected). As a result, investors pushed back the likely timing of the US Federal Reserve’s (Fed’s) first rate cut to June.

In local-currency EMD, the stronger US dollar weighed on foreign-exchange returns (-0.73%). Meanwhile, local EM bonds (+0.16%) contributed to performance in February. In EM corporate debt, the tightening of spreads offset the negative effect of rising US Treasury yields.

Outlook

February was a better month for EMD as spreads rallied in line with risk assets, supported by the ongoing hopes of a soft landing. The probability of a US recession continues to decrease. However, the end of the US economy’s relative growth advantage could benefit EM, as the gap between EM and developed-market growth widens.

The ‘Goldilocks’ scenario for EMD would combine the current expected rate path for the Fed, resulting in slower US growth and a weaker US dollar. The two scenarios that could lead to a more challenging environment for risk assets would be higher interest rates due to inflation remaining elevated or markedly lower bond yields due to financial stability risks.

We continue to see value in the high-yield and frontier markets due to attractive spreads and yields. That said, we remain cautious where countries have challenging amortisation schedules and a significant need for market access given the higher cost of financing. For countries at risk of default, we expect continued support from multilaterals and alternative sources, which would provide ample room for spread compression and a fall in yields.