Don’t Overlook the Emerging Market OpportunityDon’tOverlooktheEmergingMarketOpportunity

Key emerging market economies didn’t debate whether post-pandemic inflation was transitory. Instead, central bankers hiked rates earlier and steeper than their counterparts in developed markets to relieve price pressures. Today, relative advantages in economic growth prospects gained through that decisive action are among several factors that the PGIM Fixed Income team thinks warrant attention.

The pandemic introduced a challenging period for emerging market debt (EMD), as sharply higher rates, U.S. dollar strength, heightened geopolitical risk and significant capital outflows weighed on conditions. But now, amid a combination of favourable cyclical swings and longer-running structural trends, the asset class is providing fresh reason for optimism.

According to Denis Cole, Emerging Markets Debt Specialist for PGIM Fixed Income, a growth premium of 2% or more for emerging over developed economies was long the key to EMD’s historical outperformance versus U.S. high yield prior to the pandemic. After falling below 1.5% for a longer-than-usual span amid post-pandemic uncertainty, consensus forecasts show emerging markets poised to surpass the all-important 2% threshold.

“We believe emerging market growth outperformance is back after a lull post-COVID,” Cole said. “And that’s expected to stay high for the foreseeable future.”

Importantly, this recovery comes amid improvements in sovereign fundamentals and growth structures stemming from better policy implementation among emerging market governments and central banks. More disciplined fiscal and monetary policies have shifted debt structure bias toward domestic and high-quality funding, reducing emerging market sensitivity to higher rates and U.S. dollar strength. Structural resilience resulting from that discipline now contributes to growth-rate stability.

“These markets have faced everything you can imagine,” said Magdalena Polan, PGIM Fixed Income’s Head of Emerging Market Macroeconomic Research. “Yet, despite all the shocks, the number of countries in debt distress has stayed remarkably stable in the last few years.”

Indeed, emerging markets are maturing as they play a larger and larger role in the global economy. In 2007, emerging markets overtook developed markets in terms of share of global GDP amid China’s rapid rise. This year, emerging markets, excluding China, are expected to generate the majority of global GDP.

Solid fundamentals, including lower debt-to-GDP ratios than developed economies, also contribute to the burgeoning appeal. Longer term, younger demographics put emerging markets on a path familiar to developed markets shaped by Baby Boomers. Moreover, emerging markets, particularly in the global south, find themselves being courted to various degrees by the world’s two largest economic powers, with the U.S. and China vying for influence.

It all adds up to a unique long-term opportunity, according to Cathy Hepworth, Head of Emerging Market Debt for PGIM Fixed Income, whose recent research report concluded: “Given the favourable structural shifts likely to have a profoundly positive effect on EM markets over the next half decade, we believe current valuations do not adequately reflect the upside potential, and that now might be the time to make a strategic long-term allocation to EM debt.”