Developed market risks cloud strong EMD outlook

Developed-market fiscal deterioration threatens to disrupt an otherwise attractive emerging-market debt outlook, with EM local debt preferred over dollar debt and Latin America the strongest regional conviction.

• Global growth remains resilient because private-sector balance sheets are strong and global liquidity is still abundant, while inflation is expected to stay sticky but contained; recent price pressure is attributed mainly to a temporary energy-supply shock.
• Schroders’ country vulnerability model places the US and France in the “blind run” phase because of unsustainable financing needs, while most emerging economies remain in the “adjustment” or “equilibrium” phases.
• EM local debt is expected to return more than 11% over the next 12 months, supported by attractive valuations and high real yields; dollar-denominated EM debt is expected to return 7%, mainly through income.
• Latin America is the preferred structural region, supported by high real yields, market-friendly governments, strong external accounts and limited exposure to Middle Eastern oil shocks; South Korea, Hungary, South Africa, Mexico, Chile and Peru are also favoured in specific markets.
• Technical analysis is bearish on US rates, with the 30-year Treasury yield potentially reaching 6.25%; EM currency positioning has been partly washed out, but EM rates, currencies and credit charts have deteriorated.

Takeaway: Investors should use near-term caution because a disorderly rise in developed-market yields could weigh on EM assets, but the correction has improved entry points and leaves EM local debt, especially in Latin America, as the preferred opportunity over the next 12 months.