Emerging market debt resilient while developed government bonds remain under pressure
May 2026 update: Thanks to strong macroeconomic buffers, EM debt has recovered swiftly following the initial sell-off in response to the Iran war.
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Emerging markets debt (EMD) rebounded strongly in April, recovering swiftly from the brief sell-off in March triggered by the Middle East conflict. This rapid market recovery is yet another illustration of the asset class’s resilience in the face of a challenging global environment characterised by persistent geopolitical risks and continued upward pressures on developed market government bond yields.
The strong EMD rebound in April was broad-based, with gains observed across both hard currency and local currency segments. Latin American assets have outperformed so far this year, as the region has benefited from its relative insulation from Middle East tensions and its positive exposure to higher commodity prices.
Hard currency debt, as measured by the EMBI Global Diversified Index, returned +2.9% in April, bringing year-to-date performance to +1.6%. Within this segment, investment grade posted a modest +0.3% gain this year, reflecting limited valuation appeal given tight spreads of around 90bps for this sub-sector. In contrast, EM high yield has outperformed, delivering +2.75% year-to-date, supported by more attractive spreads near 400 bps and the appealing pockets of value in several high-yielding and commodity-linked sovereign and corporate credits.
Local currency debt, tracked by the GBI-EM Global Diversified Index, also performed strongly, gaining +2.8% in April and bringing year-to-date returns to +0.5%. Performance has been driven primarily by currency appreciation combined with high carry. Latin America again led within this sub-sector, delivering +8.5% so far this year, supported by strong currency gains in the Brazilian real (+10%), Colombian peso (+4%), and Mexican peso (+3%).
We maintain our view that the conditions are in place for the continuation of these positive trends, especially for EM local debt and dollar high yield as both segments appear well-positioned to deliver our 2026 expected returns of 10-12%, supported by a combination of cyclical and structural factors:
Cyclical dynamics: manageable impact from the Iran war thanks to appropriate buffers
From a cyclical perspective, the economic impact on EM of the Middle East crisis is expected to be manageable assuming, as we expect, that the recent de-escalation between the US and Iran leads to a re-opening of the Strait of Hormuz in the next few weeks.
We expect oil prices to soon return to the low $80s levels after the recent spike but the inflationary impact that the crisis has already created should still add approximately one percentage point (pp) to EM inflation, driven by price pressures from energy (+0.4pp) and food (+0.6pp).
Importantly, several EM economies are entering this energy shock with significant buffers at a time when the policy frameworks are also in reasonably good shape. This can be illustrated by figure 1 and by the following observations:
- Inflation levels in EM are starting from a lower base compared to the previous 2022 energy shock that followed Russia’s invasion of Ukraine.
- Real policy rates remain elevated across many EM economies, providing a buffer against the current uptick in inflation. In this regard, EM central banks’ credibility has broadly strengthened over the past decade.
Figure 1: EM Inflation and real policy rates
Source: Schroders Economics Group, LSEG Data & Analytics – 31 March 2026. 1Major EMs, equal-weighted
This backdrop allows policymakers to look through what is largely a temporary supply-side shock. Rather than being forced to tighten aggressively as was the case in previous shocks, many EM central banks appear to have earned the right to pause, with some even possibly resuming easing cycles very soon when energy price pressures start to abate.
Mexico offers a clear illustration of this policy credibility. Despite heightened geopolitical volatility in March, Banxico proceeded with a rate cut without triggering adverse market reactions. This suggests that policy credibility is now sufficiently strong to support pro-active counter-cyclical action without undermining investor confidence.
With regards to economic activity, we estimate the Iran war to be currently on course to subtract 0.5 to 1 percentage points from EM GDP growth, driven by weaker consumption (-0.6pp) due to higher prices and demand destruction as well as the deterioration in net trade (-0.4pp) linked to higher energy import costs. Most of this impact will be felt in Asia and Central Europe while Latin America remains more insulated from this stagflationary headwind.
Despite these headwinds, strong balance of payments positions are broadly helping EM to absorb reasonably well the current geo-political shocks.
Strong EM external position, ample global liquidity, and the continuation of the US dollar cyclical downturn
The majority of EM economies now exhibit stronger balance of payments dynamics, supported by healthy current account balances and robust foreign exchange reserves buffers.
Moreover, the recent resilience of EM assets has corroborated our view that EM economies have become significantly less dependent on volatile external capital flows than in previous cycles, reducing vulnerability to external shocks. In this regard, EM debt remains under-owned despite a gradual recovery in fund inflows over the past year.
As can be seen in figure 2, after a brief episode of outflows from the asset class in March, inflows have subsequently resumed, thus maintaining the asset class in positive territory this year.
Figure 2: EMD fund flows (annual - $bn)
Source: JP Morgan, 30 April 2026
We believe that this reallocation of capital that started last year in favour of EM debt is still in its early stages. One of the factors driving this reallocation is the cyclical US dollar downturn that has also started last year, and which appears to be regaining some traction. It is worth noting that the US dollar is increasingly failing to act as a traditional safe haven as evidenced by the lack of a convincing greenback rally during the recent geo-political shocks.
In particular, during the March volatility episode, most EM central banks, Turkey being a notable exception, did not need to intervene aggressively to support their currencies, preserving foreign exchange reserves buffers and domestic liquidity while avoiding any noticeable deterioration to key sovereign credit metrics.
This continued resilience of EM debt is equally supported by the continued abundance of global financial liquidity. Our measures of global monetary aggregates continue to grow at levels that are historically consistent with markets being in risk seeking mode.
Hungary as an example of recent EM resilience
The recent strong returns of Hungarian fixed income assets provide a useful example of how both cyclical resilience and structural improvements continue to support EM debt. Compared to the energy shock at the onset of the Ukraine war, Hungary has entered the current shock in a much stronger position as macroeconomic fundamentals have improved significantly:
- The current account has shifted from a deficit of around -6% of GDP on the eve of the Ukraine invasion to a surplus of approximately +1.5% currently, reflecting a stronger external position.
- Inflation has declined sharply from double-digit levels at the onset of the invasion of Ukraine to 1.4% when the current Middle East crisis started.
- The fiscal deficit has narrowed from -7% to -5% of GDP during the same time period despite the recent surge in pre-election spending.
- Monetary policy has tightened meaningfully, with the policy rate rising from 3% to 6.25%, reinforcing monetary policy credibility.
In addition, following the April 2026 Hungarian elections, there has been a notable shift in policy direction towards a more pro-European Union stance, moving the country away from earlier populist policies under the previous leadership of Prime Minister Orban. This evolution may further enhance investor confidence and support long-term economic stability.
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