Emerging market debt: selectivity in a shifting backdrop
Q3 2026 update: Attractive opportunities emerge as stagflationary pressures abate, but selectivity remains essential.
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The stagflationary headwinds that weighed on the global economy last quarter are starting to ease. While tensions in the Middle East remain elevated, their impact on markets appears to have diminished. Although the recent recovery in oil flows through the Strait of Hormuz has already faltered, we still expect normalisation to resume soon, potentially pushing the global oil market into oversupply, especially if OPEC fractures further. Alongside subdued agricultural prices, this should help quell the recent inflation scare, which led investors and policymakers to take recently an overly cautious stance towards what has largely been a temporary supply shock driven rise in inflation.
This backdrop reduces headwinds for global bond markets and supports a tactically more constructive stance on interest rate duration. In addition, the potential for a short squeeze at the long end of the US yield curve should not be ignored, as market participants appear to have recently started to cover their excessively short or underweight duration positions.
Our global financial liquidity indicators remain at levels that are conducive to risk-seeking behaviour across markets. Global money growth remains supportive, but not so excessive as to sustain the recent inflation scare. In other words, there is still little evidence of demand overheating or credit excesses across major developed and EM economies.
The US dollar’s structural vulnerabilities are currently eclipsed by the hawkish posture of the new Fed chairman. This posture is likely to soften soon, easing energy supply shocks provide a reason not to hike. The Fed could also sooner rather than later be once again confronted with the realities of fiscal dominance that would make any meaningful tightening elusive. At that point, the dollar’s cyclical downturn, which began last year, is likely to resume thus providing new tailwinds to EM assets. We are also encouraged by the recent washout in crowded long EM currency positions, which has reduced the risk of a disorderly unwind of what is still left in EM carry trades.
EM local debt remains our top sectoral pick particularly in Brazil, Mexico, Colombia, Peru, South Africa, Hungary, Nigeria and Egypt. We expect these markets to deliver returns in excess of 10% over the next 12 months. Recent upward revisions to inflation expectations across several EMs appear overdone and are likely to reverse as energy and agricultural prices resume their recent correction. Despite the recent inflation scare, policy credibility remains broadly intact, real rates are still elevated, and balance of payments positions are generally sound. This explains the continued remarkable resilience of EM assets.
Despite less attractive hard currency debt spreads, the sector is expected to remain a strong income generator, with an anticipated 12-month total return of around 7%. Colombia, South Africa, Argentina, Egypt, Angola, Nigeria and Ecuador are among the issuers that still combine attractive spreads with renewed improvement in credit quality.
All these sectorial views are summarised in the scorecard below
Asia
Asian fixed income markets should find some relief, as the region has overcome initial fears of potentially catastrophic energy shortages notably thanks to China’s remarkable ability to aggressively reduce oil imports by drawing on its gigantic strategic oil reserves. Sentiment should recover more convincingly when the recent incipient recovery in oil imports from the Gulf regains traction. After having been very defensive in the region, we are now moving to a more neutral stance across the board.
We have become particularly constructive on India, notably on the oversold currency that could be supported by a renewed de-escalation of tensions in the Gulf, the more appealing valuations and initiatives by the authorities to attract foreign flows and add liquidity to the system. We equally remain constructive on the Malaysian ringgit despite short-term political noise.
Small tactical exposures to Indonesian bonds and the rupiah now look warranted given equally oversold conditions, under-ownership, improved valuations and Bank Indonesia’s attempts to restore confidence with rate hikes. However, a return to a bullish stance would require evidence that recent erratic policymaking and fiscal erosion are being contained, possibly through the appointment of a credible technocratic economic team.
Eastern Europe, Middle East and Africa
Central European local bonds remain attractive, supported by resilient and balanced growth, contained inflation and basic balances (current account plus FDI) firmly in surplus. Ten-year government bond yields still trade an estimated 50–70bp above our fair-value estimates. Within the region, we are most bullish on Hungary, where a recent pro-European shift, focused on safeguarding democratic institutions and fiscal sustainability, should allow further structural yield compression.
South African local and external bonds, along with the rand, remain core bullish positions. Despite internal divisions, the governing coalition continues to advance reforms, while prudent fiscal policy and credible monetary framework should anchor inflation expectations. Attractive valuations, high real rates, improving terms of trade and softer food and energy prices support currency stability and further 10-year government bond yield compression from current levels of 9.4%.
In Turkey, high yields (39%) and managed currency depreciation continue to make the carry trade attractive. Sticky inflation and the need to preserve exchange rate stability should keep the CBRT cautious on policy easing. However, we remain wary of political risk, given uncertainty around Erdogan’s path to another term and opposition party dynamics.
Egyptian assets have become more appealing now that the country weathered recent geopolitical shocks, supported by IMF led macro stabilisation, resilient tourism, stronger remittances and softer than feared inflation. We still prefer 12-month T-bills yielding 24%, given their superior carry versus longer dated bonds and the prospect of slower policy easing.
We reiterate our bullish view on Nigeria and Angola sovereign dollar debt. While lower oil prices could lead to a correction after the recent substantial spread compression, the improvements in credit metrics should prove durable.
Latin America
Brazilian local bonds and currency should remain supported by substantial buffers: elevated yields of around 14.5%, broadly contained inflation and exceptionally strong external accounts. These buffers should help absorb election-related volatility and lingering fiscal uncertainty. However, the upcoming presidential election is likely to generate bouts of volatility, which may require temporary position reductions for risk-management purposes.
We reiterate our positive stance on Mexican assets, notably thanks to a stable political backdrop given the president’s high approval rating and the reduced tensions with the US. Mexican bonds and currency also benefit from improving trade dynamics, still strong interest rate support while the unfavourable fiscal dynamics of recent years remain largely contained.
Our bullish thesis on Colombian bonds has been validated by the favourable outcome of the June presidential election. The country appears to be moving away from the left-wing populism of the previous administration, which left public finances in a vulnerable position. We expect the new economic team to address these fiscal challenges, supporting a further improvement in market sentiment and driving additional yield compression from still-elevated levels of around 11.70%.
We remain fundamentally constructive on Chilean and Peruvian assets, which should be supported by more favourable political outlooks, improving fiscal dynamics, strong external positions and appropriate FX reserves buffers.
Several Latin American sovereigns should deliver 12-month returns in excess of 8%, despite historically tight dollar bond spreads. These returns appear most achievable in Argentina, Ecuador, Colombia and Mexico, supported by stable credit metrics and still attractive yield levels. Venezuela still offers significant recovery potential, but the ongoing correction may have further to run before more compelling re-entry opportunities emerge.
EM corporates
The credit cycle for EM corporates is normalising, becoming more balanced after two years of improving fundamentals.
Latin American credits remain attractive as political momentum continues to shift toward market friendly leaders. This should improve investor sentiment and the macroeconomic backdrop for corporates. High-yield TMT and Mexican banks have solid sector fundamentals. Brazil offers opportunities, though high real rates remain a key challenge.
EEMEA corporates have stabilised after the de-escalation of the US/Iran conflict. Ukrainian corporates continue to offer above-average yields and resilient operations. Turkish corporates face a tougher backdrop, given high interest rates, an uncompetitive currency and sluggish domestic consumption.
Asian corporates remain supported by a strong local bid. Hong Kong property is a bright spot thanks to rising stock market, new homebuyers from China and improving inventories. Pockets of Chinese real estate also offer opportunities.
Quantitative analysis
The Schroder country vulnerability model has not flagged any major early-warning signal across key emerging market economies. Most countries remain in the favourable phases of the cycle, either in “adjustment” or in “equilibrium”. Latin America is improving overall, while Asia and EEMEA have experienced some deterioration in risk scores from highly positive levels, partly reflecting the negative impact on the balance of payments of the recent energy shock, which is now fading.
EM asset valuations deteriorated, though EM local rates remain undervalued, especially in Latin America. EM real effective exchange rates have moved to fair value on average, except IDR, INR and KRW, which cheapened substantially this year. EM hard currency debt spreads look unappealing, although select EM dollar frontier markets still offer value.
Chart and Sentiment analysis
The technical outlook for US rates is mixed. Yields are evolving in triangles that should break to the upside. Short term, the recent rejection of the top of this triangle, combined with very light consensus positioning in duration, is encouraging.
Chart patterns are also mixed for EM debt. The tightening in EM credit spreads looks overdone, though momentum remains very strong. The recent correction in local rates and currencies needs to end soon to avoid threatening this sector’s long-term bullish trend. The recent positioning washout in EM local debt is an early sign the correction could be over soon.
The forecasts stated in the document are the result of statistical modelling, based on a number of assumptions. Forecasts are subject to a high level of uncertainty regarding future economic and market factors that may affect actual future performance. The forecasts are provided to you for information purposes as at today’s date. Our assumptions may change materially with changes in underlying assumptions that may occur, among other things, as economic and market conditions change. We assume no obligation to provide you with updates or changes to this data as assumptions, economic and market conditions, models or other matters changed.
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