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key points
- Emerging Market (EM) debt markets had strong performance in the second quarter, as the weakening U.S. dollar boosted currencies, while sovereign credit tightened and EM rates outperformed global rates.
- Tariff uncertainty appears to be disinflationary in the EM, giving EM central banks the leeway to keep cutting rates. We see continued weakening of the USD as a tailwind for the sector.
- In the third quarter, we still see significant value in EM debt. We believe that especially in this environment, value is best identified through country-level macroeconomic and political research, and stand-alone analysis of risk factors like currency, credit and interest rates.
EM debt markets had strong performance in the second quarter, with positive contributions from almost all the risk factors that drive returns for the local currency sovereign, hard currency sovereign and corporate EM debt segments. The weakening U.S. dollar boosted currencies, while sovereign credit tightened and EM rates outperformed global rates.
President Trump’s April 2 “Liberation Day” tariff announcements dominated headlines for much of the quarter and initially sparked considerable volatility in global markets, including EM. As is often the case with macro-driven selloffs, the market tends to “over correct.” Thus, despite an initial widening of most sovereign credit spreads, many came back in as Trump paused the tariffs for 90 days and volatility subsided.
Emerging markets debt had strong performance in the second quarter as EM currencies strengthened vs. a weakening U.S. dollar, EM rates outperformed global rates, and sovereign and corporate spreads tightened"
While tariffs generally strengthen the currency of the country imposing them, in this case they clouded the U.S. economic outlook and worked against the USD. As a result, investors looked for global investment opportunities and implemented short-dollar trades, which added to downward pressure on the USD.
Asset class flows during the quarter underscored that trend. While the flows were negative overall, local currency funds had net positive inflows of $1.4 billion, compared with negative $5.1 billion for hard currency funds, which are denominated in USD. In both fund categories, outflows were heavy in April but turned positive in May and June.
Downward rate pressure
The tariff uncertainty also contributed downward pressure on EM interest rates, as Trump’s announcements served as a “disinflationary shock” for EM, and consensus projections fell for EM growth and inflation. While the U.S. Federal Reserve held rates steady in June, EM central banks continued to cut rates, as did the ECB and several developed market central banks.
EM debt investors also appeared to shrug off the potential trade war between the U.S. and China. While many countries tried to negotiate after Trump’s tariff salvo, China came back with reciprocal tariffs – threatened levels reached 145% on Chinese goods and 125% on U.S. goods, before a truce was called. Yet the tension remains, as both countries accused each other of violating the truce.
Similarly, continuing violence in the Mideast and Europe failed to significantly rattle world markets, even as ceasefires in Ukraine and Gaza proved to be elusive. Israel had the world on edge with its 12-day battle with Iran in June. Despite the conflict escalating with U.S. airstrikes on Iran nuclear facilities, a ceasefire was agreed to and has generally held . After a spike in oil prices leading up to the conflict, prices settled at the end of month lower than the start of the quarter.
Display 1 shows the performance of the three EM debt sectors, with the local currency index returning an especially strong 7.62%. As discussed, currencies were the biggest driver with EM rates rally also contributing. The hard currency sovereign index returned 3.32%, with spread compression contributing two-thirds of the gain, including lower-quality credits like Ecuador, Ghana and Egypt. The hard currency corporate index returned 1.58%, benefiting from U.S. Treasury rates falling and sovereign spread tightening.
All 3 EM Debt sectors had strong 2Q25 performance
Source: J.P. Morgan, Morgan Stanley Investment Management calculations. As of June 30, 2025. Corporate Credit Spread and Sovereign Credit Spread return attributions are modelled by decomposing the overall spread return to its two components: the sovereign spread and the corporate spread over the sovereign. It is not possible to invest directly in an index. Data provided is for informational use only. Past performance is no guarantee of future results.
All 3 EM Debt sectors had strong 2Q25 performance
DISPLAY 1
3Q25 Outlook
U.S. tariff policy is likely to remain a major wild card, especially as the 90-day pause set by Trump expires and active bilateral negotiations continue. The potential inflationary impact in the U.S. remains uncertain, and the U.S. Fed is watching keenly for signs of pricing pressure while also fending off pressure from Trump to lower rates.
But outside the U.S., tariff uncertainty appears to be disinflationary, giving EM central banks the leeway to keep cutting rates. While forecasts for EM growth and inflation are both down from a year ago, we see continued weakening of the USD as a tailwind for the sector. Asset flows from investors are also likely to be supportive, continuing the inflows to both local and hard currency funds we saw in May and June. We believe this trend reflects shifting sentiments by global investors: away from the belief in “U.S. exceptionalism” and toward an increasingly attractive EM opportunity set.
With more than 100 countries in the EM universe, many have minimal trade with the U.S. and will be less directly impacted by tariffs, but others more so. This environment underscores the importance of country-level macroeconomic and political research, and stand-alone analysis of specific risk factors like currency, credit and interest rates.
Bottom line: In the third quarter, we still expect to see significant value in EM debt, despite the strong performance in the first half of the year. For one, real-yield differentials remain wide in favor of EM over developed markets. EM issuers represent an expanding opportunity set – especially those outside of the major benchmarks -- but require significant analytical expertise to identify the best opportunities. As always, we will continue our focus on differentiation amongst countries and credits as the best way to deliver EM value for our clients.
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