Anthony Kettle, Senior Portfolio Manager for EMD, discusses key themes for the asset class in the year ahead, the impact of geopolitical fragmentation on the EM universe, and potential investment opportunities in both countries and sectors.

Key takeaways

• EM credit markets are facing a paradox at present – while spreads have reached historically tight levels, powerful mitigants remain in place. Low default rates, reasonably high all-in yields, and sustained investor appetite for carry provide meaningful support to the asset class. Many investors continue to seek attractive carry opportunities, which is broadly supportive of EM credit.

• Separately, EM local markets have captured strong investor favour, likely driven by a compelling combination of high real interest rates, orthodox monetary policy frameworks, and attractive valuations in many FX markets – particularly given the recent terms of trade boost from commodity strength. This dynamic is attracting meaningful inflows.

• Our three key themes are monetary policy orthodoxy (which provides the potential for strong performance from EM local markets), shifting geopolitics: (including new policy approaches towards LatAm, and Middle East emergence as an economic power), and EM fundamental strength (stronger fiscal dynamics and improved corporate balance sheets).

Greenland: the land of ice is a hot topic

The initial market response to the Greenland issue has been notably muted compared to April's "Liberation Day" announcement. This reflects two key dynamics:

• Markets now perceive Trump’s administration tariff announcements as opening positions in negotiations rather than definitive policy, resulting in more measured reactions.

• Greenland tensions are distinctly Europe-centric, creating fundamentally different market mechanics to last year's broad-based trade war. While technical vulnerabilities exist for the USD – stemming from positioning and still-low hedge ratios – the risk of broad US asset firesales remains low. The bar for divestment from US assets remains high, underpinned by superior US economic returns.

The broader geopolitical implications are significant. These tensions will likely accelerate European defence spending, reduce reliance on US technology, and drive European capitals to enhance trading relationships with China. Importantly, the Greenland episode reinforces the USD debasement narrative, evident in the surge in gold buying and ongoing bouts of USD weakness. This creates a powerful backdrop for EM fixed income, particularly in local markets, while USD weakness also eases onshore funding conditions across EM.

Growth, inflation, and policy shifts appear favourable

EM inflation is expected to stabilise near central bank targets in 2026, following approximately a 1 percentage point decline in 2025. While core inflation remains elevated in several economies, the underlying disinflationary trend is clear and supportive. This backdrop enables a continued, though moderating, path of potential rate cuts concentrated in the first half of 2026, with the bulk of easing concentrated in high yielding countries driven by domestic conditions.

From a growth perspective, EM ex-China is forecast to maintain trend-like momentum, while China is expected to slow to around 4.5% from 4.9% in 2025. Key growth supports include Asia's technology cycle and China's continued fiscal support should growth disappoint. Separately, the EMEA EM outlook remains benign, with central banks likely to maintain supportive stances alongside fiscal expansion.

The combination of moderating inflation, supportive monetary policy, and resilient growth creates an environment where carry returns will likely become the dominant return driver. We expect this to sustain positive fund inflows into both EM credit and local markets, which should maintain reasonably low spread volatility despite limited room for further tightening given current valuation levels.

The trajectory of the dollar is critical

We expect a bearish USD trend to persist this year, supported by several factors: rich USD valuations, heavy global positioning in US assets, the waning of US exceptionalism as growth normalises, and the Fed's rate cutting cycle eroding the USD's carry advantage. These structural headwinds could provide a multi-quarter tailwind for EM assets.

We forecast a modest decline in the USD, which should sustain positive EM inflows. Historically, periods of USD weakness have coincided with stronger fund flows into EM, as the currency becomes less attractive while EM assets gain relative appeal. That said, we remain cautious on the pace of recent moves – the USD has declined sharply in recent weeks, and overshoots remain possible. This argues for tactical flexibility rather than aggressive directional conviction.

The stars are aligning for local markets

The most structural shift for bond investors, however, is the deep monetisation of EM local currency debt – now representing 90% of EM issuance – combined with FX market liberalisation and growing retail participation. Real rate differentials between EM and developed markets are at decade highs, making EM local bonds particularly attractive; Brazil, Mexico, and Dominican Republic offer compelling compression opportunities on rate curves, in our view.

For local markets specifically, the outlook is particularly attractive. In a weaker USD environment, investors can access compelling carry while positioning for meaningful gains in the FX space. This creates a potential dual-return opportunity as investors seek diversification away from USD-denominated assets – an increasingly important consideration given current US valuations and geopolitical dynamics. We therefore anticipate that EM local markets will likely outperform EM credit in 2026, driven by this combination of attractive real yields and currency tailwinds.

An evolving geopolitical backdrop

Geopolitical shifts under the Trump administration, with its transactional approach combining tariffs, sanctions, and ideological alliances, is reshaping the EM landscape fundamentally. The administration's backing of ideologically-aligned leaders (eg. Argentina's Milei) while opposing those not aligned with US interests (eg. Maduro in Venezuela) is creating asymmetric opportunities for EM bond investors.

We also see the Middle East's emergence as an economic superpower – with index weights rising dramatically over recent years – as a key trend in EM and over time we expect that diversification from oil revenues will support fiscal resilience. De-Sinicisation and resource competition between the US and China further favour resource exporters with improving terms-of-trade, while manufacturing exporters exposed to tech tariffs face growth headwinds.

Ultimately, fiscal consolidation is becoming the critical divider of relative performance: countries pursuing credible fiscal reform should outperform those with deteriorating imbalances. The map of structural winners thus rewards LatAm reform-minded economies, select Asian exporters leveraging AI capex tailwinds, and energy-rich sovereigns with strengthening fiscal framework – while penalising low-yielders with fiscal deterioration, China-exposed manufacturers facing tariff drag, and countries politically misaligned with US geopolitical strategy.

Current investment opportunities

In the credit market, some of the higher yielding countries still represent interesting opportunities.

In LatAm, Argentina and Ecuador are among sovereign opportunities with spread compression potential, while some of the better stories in Sub Saharan Africa, such as Nigeria, still offer reasonably attractive yields. In the distressed space, many investors appear to be focused on opportunities in Venezuela and Lebanon.

Regarding sectors, metals & mining, high yield transport and financials are all favoured due to supportive macro conditions, with technology-related exporters (Taiwan, Malaysia, Singapore) benefiting from the AI capex cycle.

In the local markets space, there are strong fundamentals in high yielding EMs like Brazil.

A selective, active approach is key

Alpha generation will depend on identifying sovereigns with improving fundamentals, reform catalysts, and rating upgrade potential rather than broad exposure, with high yielders boasting better fundamentals remaining preferred to crowded IG names.

While EM corporate default rates may rise modestly in 2026, defaults are expected to concentrate in a small number of large, already-stressed credits, with overall fundamentals remaining robust. In terms of sovereigns, we expect default rates to remain below historical averages this year.