Tariffs, trade barriers and geopolitical tensions are just a few key risks painting heightened economic uncertainty under the new US administration. Ongoing back-and-forth on tariffs have created a painful whiplash for anyone trying to keep apprised of developments, with the latest headlines indicating further postponement of the 25% Mexican and Canadian tariffs on various imports until early April.
These mixed signals have called into question what new trade policies will actually come into play, whether there is a full-on trade war at play and what it could mean for the broader macroeconomic environment. As emerging market debt (EMD) investors, we’ve taken a closer look at how this rhetoric could impact the future of emerging markets debt.
Taking a page from our history books, there are two dominant global forces which tend to impact emerging markets debt as an asset class: economic growth and liquidity conditions. The asset class has previously faced performance headwinds when US policies have led to slower economic growth or higher interest rates.
As investors hedge their bets about what the latest geopolitical and trade developments mean in terms of risk and the future of the asset class, is important to note, however, that the EMD universe is very diversified, consisting of over 70 countries. In fact, idiosyncratic risk events have seldomly led to disruptions in the asset class.
Thus, while contrary to popular opinion, we anticipate a favourable market environment for EM debt in 2025 and believe that higher volatility induced by political noise and intense rhetoric could create opportunities for long-term investors looking at EMD. The key, however, is knowing where to look.
Tariff and foreign policy: Impact on EMD vs other economies
In our opinion, the focus of the new US administration will be on immigration, regulation, trade and foreign policy. Weighing potential risks, we look to tariffs as they could negatively impact global trade. We think that countries running large trade surpluses with the United States would likely see the biggest impact on their economies. China, and to a lesser extent Europe, could be particularly affected.
In these places, we would expect to see significant fiscal and monetary policy reaction to offset the impacts of higher tariffs imposed by the new US administration. We would also expect strong retaliation as tariffs could violate World Trade Organization (WTO) commitments, creating additional risks for global trade.
While US tariffs would have the potential to impact global trade, we believe emerging market countries should be less directly exposed given the significant growth in intra-EM trade observed over the past few years. In China, we expect to see a combination of strong fiscal and monetary stimulus and a weaker currency as the government implement measures to offset the impacts from US tariffs. China will likely continue to shift exports away from developed economies. EM countries now make up nearly 50% of Chinese exports.
Further, on the US foreign policy front, we believe the new US administration will adopt a more gradual and pragmatic trade agenda, aiming to avoid creating higher inflation for US consumers. In our opinion, US government policies will not significantly disrupt the outlook for the global economy. We expect the global disinflationary process to continue, albeit at a potentially slower pace, and anticipate additional monetary policy easing in developed and emerging economies. The gradual removal of monetary policy restriction should lead to lower global rates and improved liquidity conditions in 2025.
All in all, we anticipate a favourable market environment for EM debt in 2025 and believe that higher volatility induced by political noise and intense rhetoric could create opportunities for long term investors who uncover opportunities in the market.
Frontier markets shine in the search for EMD bright spots
One relative bright spot in our investment universe is frontier markets where local currency bonds play an important role in our strategy. From a structural perspective, more of these countries are making a conscious effort to open-up their capital markets to diversify their financing sources and reduce dependence on foreign currency debt issuance.
Measures to achieve this include strong reform momentum, often supported by multilateral organisations, the reduction or removal of capital controls and additional liquidity measures provided by the central banks. This means that many frontier market currencies offer opportunities for investment with currencies at or below our estimates of fair value supported by high real and nominal local interest rates. These currencies can provide an attractive combination of having a lower beta to the strong US dollar trend in addition to higher carry than is normally found in their larger, emerging market counterparts.
We also expect a number of these markets to continue to benefit from official sector support given their geopolitical importance. This means that they enjoy a combination of strong multilateral and bilateral support. For example, a high number of the markets in frontier space are currently on an IMF program, this benefits them both by cheap levels of financing and strong economic reforms that have been designed to promote a higher and more consistent level of potential growth.
This ample and diversified source of funding has been particularly evident in recent years and has been a strong provider of financial support. In previous years it was standard for emerging market managers to add a small number of frontier local markets to their portfolio in a rather concentrated way.
However, this evolution has convinced us that the frontier market asset class now has the diversification necessary to be relevant as a standalone asset class and has the potential to remain resilient amid the continued political noise that is likely to come.
In summary, we believe that long-term investors seeking opportunities in EMD through an active management approach may find bright spots that could be propelled forward in these volatile times. As we anticipate uneven tariff application across a diverse range of emerging market countries, we believe this may result in a wider dispersion of returns and the creation of additional opportunities for active investors looking in the right corners of the market.
Marcelo Assalin is head of the emerging markets debt team at William Blair Investment Management. The views expressed above should not be taken as investment advice.