In brief

  • Our central scenario is for 10%+ returns in 2024 across emerging market debt (EMD) sectors with local currency debt remaining our preferred opportunity.
  • Our base case remains for sub trend economic growth with EMD supported by improving EM growth alpha and strong fundamentals.
  • A peak in US Treasuries amid a slowdown in developed markets combined with steady Chinese growth provides a benign backdrop for EMD performance.

2023 has been a good year for EMD investors. EM corporate debt investors have been rewarded with returns of over 8%, while EM sovereign and local currency debt investors have each achieved a return of over 10% so far this year1. These returns are surprising given the backdrop of the Federal Reserve (Fed) hiking rates four times to the highest levels in 20 years, predictions of a US recession, banking failures and continued concerns over real estate in China.

Macro tailwinds

Yet, the macro environment within emerging markets continues to provide support for EMD. We expect emerging market economies to grow at a rate of 3.9% in 2024, a slight slowdown from 4.3% in 2023, but still in comfortable expansionary territory. In addition, we estimate that EM growth alpha (the difference between the economic growth in emerging market countries vs developed market countries) will continue to improve in 2024 to 2.9% from 2.6% in 2023, as developed markets continue to slow. This resilience of growth is led by Asian countries while we expect Latin American growth to continue to cool. If achieved, an EM growth alpha of 2.9% would be the highest level the market has experienced since 2013.

The emerging market inflation trend is still EMD investors’ friend. Headline inflation continues to benefit from lower commodity prices, although services inflation remains above pre-2020 averages. The disinflation environment provides EM central banks with room to cut rates, but markets have already increased their expectations for cuts in 2024 and are unlikely to move further unless there is unexpected economic weakness. As such, terminal rates are expected to remain above historical lows.

The continued downward trend of inflation in the US is also a positive for EMD assets. However, if the US inflation rate settles at 2.5%, this may not be low enough for the US rate cuts expected by the market to materialise without a deterioration of the labour market or a harder economic landing. As such, investors should proceed with caution. With that said, EM disinflation will be enough for EM central banks to continue to cut rates independently.

Chinese outlook becoming positive

Market forecasts are turning more positive for China, with economic growth expected to stabilise at around 4.5-5% in 2024. ~5% GDP growth is likely to be the official target again in 2024 following strong Q3 GDP and a surprise move in favour of more fiscal stimulus. We believe the ~5% growth target can be achieved for multiple reasons. Firstly, a stabilisation of the housing market with more supportive measures on both the demand and supply side. In addition, we expect there will be a further expansion of fiscal policies for infrastructure and manufacturing investment. Finally, a continued expansion of consumption as households reduce precautionary savings.

We believe the policy from China is pro-growth; support for real estate is more effective (and should stabilise the sector) and we expect the fiscal and credit measures to put a floor on growth (in case of private sector retrenchment).

Being mindful of tail risks

Going into 2024, our central scenario is for 10%+ returns across EMD sectors, with local currency debt our preferred sector. Investors should however be vigilant to mind the tail risks in US. The “Fed is done” narrative has been supportive of EMD assets, but market participants may get overexcited about rate cuts in 2024, particularly if economic activity and inflation prove more resilient than expected.

On the other hand, if a recession becomes more likely, then risk aversion can dominate market reaction. Recession is a more probable tail scenario than above trend growth, but uncertainty remains around timing. Credit spreads are not priced for this scenario and would be expected to widen, although this would be offset by the expectation of a rally in US treasuries which would still point to low positive returns. Similarly, in local currency debt markets, we would expect EM central banks to cut rates in a hard landing scenario but the EM currency movement vs the US dollar remains a wild card if we move away from a “soft landing” scenario.

Local outlook

With the Fed done, and amid slowing inflation, we expect EM central banks to cut rates in 2024. This is becoming increasingly priced-in for many countries. The theme for 2023 in local rates markets was of disinflation leading to high real rates after EM central banks were quick to hike policy rates to combat inflation. We expect increasing pressure on EM central banks to cut interest rates in 2024 as growth slows. Even after being one of the top performing fixed income asset classes in 2023, we project returns of 11.8% for EM debt in 2024, driven largely by carry.

We continue to favour longer duration positioning in local rates markets. Our favoured long positions are areas where inflation will fall, such as the Czech Republic, Hungary, Colombia and Turkey, and where central banks will cut rates, which adds Mexico and Brazil to this list where real policy rates are still expected to be over 5%, even after incorporating one year ahead market pricing of policy rate cuts.

In EM foreign exchange (FX), there is a delicate equilibrium during the transition between soft to hand landing. We are cautiously constructive and favour carry names such as MXN, INR and BRL along with good idiosyncratic stories such as PLN and TRY. We expect to be tactical on EMFX depending on the speed of the US economic slowdown.

Sovereign outlook

The current option adjusted spread is near our fair valuation estimates of around 400. However, this should not be a constraint given the supportive fundamental backdrop of robust economic growth, falling inflation and an improving rating outlook. Spreads of 500+ are unlikely unless a harder recession becomes more prevalent in market expectations.

We believe that the sovereign rating cycle has turned, where we expect the number of upgrades of sovereign credit ratings to be larger than downgrades for the first time in five years. There were no sovereign defaults in 2023 and risks of defaults in 2024 remain concentrated in smaller countries at just 1.1% of the index.

Technicals will likely be an important part of driving 2024 returns with net supply expected to be slightly negative. Issuance is expected to increase in the investment grade portion of the market and decrease in high yield. As such, any inflows into the asset class will likely be a strong catalyst for the asset class performance.

We continue to prefer quality high yield and BBB rated issuers such as Paraguay, Oman, Mexico and Costa Rica, while being selective in higher risk stories with improving catalysts like Turkey and Colombia. These long positions are offset by underweights in investment grade issuers with tight spreads in China, Malaysia and Qatar.

Corporate outlook

Corporate fundamentals remain resilient though recession risks warrant more caution in high yield. Earnings growth rates are expected to recover in 2024, with regional differentiation expected to increase with Asia leading and Latin America lagging. That said, all regions, including Latin America, start from a position of strength and can weather downside risks.

The downside risks to earnings are most pronounced for commodity sectors; however, low leverage provides buffers across the asset class. Refinancing risks seem manageable for most companies and default rates are expected to decrease, even in a higher for longer scenario. We still expect interest expense to rise but the EM easing cycles in 2024 should help those corporates with access to local funding and as such this remains an idiosyncratic rather than systemic risk.

Supportive policy measures in China are likely to help growth in 2024, with sectors like consumer goods, technology media and telecoms expected to benefit.

However, uncertainties in the real estate sector, regulatory concerns, and geopolitical risks will likely keep investors reluctant to reengage. Spreads continue to trade in a narrow range around or inside historical averages.

While spreads may be less compelling, a more favourable outlook for earnings growth, all in yields, technicals, and lower interest rate uncertainties support a tactical addition of risk. We prefer pockets of value across quality investment grade and high yield spread across regions, with meaningful overweights in Mexico, UAE and Saudi Arabia. The focus will be on bottom-up differentiation, particularly in deep value high yield at this point of the cycle. In a downturn, fundamentals validate the ‘buy the dips’ strategy.

1 Bloomberg: J.P. Morgan Asset Management, as of December 2023.