Emerging Market Debt: Resilience in a more volatile world

Emerging markets (EM) entered 2026 from a position of strength. The March oil shock disrupted the market narrative, but not the underlying cycle. While the initial reaction was sharp, the absence of broader market dislocations, resilient credit markets and the rebound in April all pointed to a repricing rather than a regime shift, reinforcing our constructive view on EM fixed income.

EM debt has undergone a significant adjustment since the post-Covid inflation shock, the aftershocks of Russia’s invasion of Ukraine and more recent geopolitical episodes such as ‘Liberation Day’. Rates reset higher, currencies cheapened, investor positioning was reduced and policymakers rebuilt credibility.

As a result, EM now enters this phase with stronger carry, healthier external balances, rebuilt reserve buffers and more orthodox central banks than in previous energy-shock episodes. This stronger starting point helps explain why the recent surge in oil prices generated volatility, but not broader financial stress.

The year began in a supportive environment, with a softer dollar, easing US real yields and still-light investor positioning. This combination supported both FX and local markets, while hard-currency debt benefited from carry and improving credit fundamentals.

This benign backdrop was abruptly interrupted by the escalation in the Middle East. The market reaction followed a familiar pattern: local curves sold off sharply, front-end pricing shifted from rate cuts toward renewed tightening expectations, and oil-importing currencies underperformed. Local debt led the move, as the narrative shifted rapidly from disinflation to energy-driven inflation risk. March proved challenging, with EM hard-currency debt posting its weakest monthly performance since 2022, while local markets experienced their largest drawdown since the Covid shock.

The shock also revealed clear dispersion across the asset class. Performance diverged along macro fundamentals: oil exporters outperformed importers, high real-rate markets proved more resilient, and regional differences widened. LatAm and CEEMEA¹ held up better than Asia, supported by higher carry, stronger terms of trade and, in many cases, more credible policy frameworks, while Asia lagged given lower carry and greater sensitivity to the energy shock.

More importantly, we believe what did not happen is more telling. There was no generalized loss of market access, no balance-of-payments stress and no indiscriminate sell-off across EM FX or credit. Compared with previous energy shocks, the adjustment remained contained.

April confirmed this resilience. As geopolitical tensions partially eased, EM assets rebounded strongly, with credit retracing most of its widening and local markets recovering as extreme tightening scenarios were priced out, leaving EM among the best-performing segments of global fixed income year-to-date as indicated below.

Our central scenario is not a return to the pre-shock environment, but rather a regime shaped by an ongoing oil shock and elevated uncertainty. Markets are tentatively leaning toward de-escalation, with partial normalization of shipping flows and oil prices stabilizing at elevated levels. However, the persistence of the shock remains the key uncertainty, leaving the backdrop better described as an unstable equilibrium than a settled regime.

In this context, EM central banks are unlikely to embark on a broad-based tightening cycle. While inflation risks warrant close monitoring, particularly where energy pass-through is rapid, the recent repricing from rate cuts to outright hikes already appears demanding in many markets and selective and limited hiking cycles may still emerge. We believe that central banks are more likely to act tactically to anchor expectations, especially where real rates are low, currencies are vulnerable or the oil shock proves persistent. The implication is targeted tightening rather than a generalized policy response, with a pause remaining the dominant baseline.

This reflects a stronger starting point than in previous cycles. Real rates are materially higher, providing a built-in buffer against inflation shocks and reducing the need for defensive tightening. External balances have improved, FX reserves have been rebuilt and central banks have maintained credibility. Together, these factors provide policymakers with greater flexibility and reduce the need for mechanical reactions to external shocks.

The broader backdrop remains supportive. Lower US real yields and a softer dollar continue to underpin EM FX and local markets, while carry remains among the most attractive in global fixed income. In a more range-bound environment, this income cushion becomes the first line of defence.

Flows reinforce this view. After several years of outflows, investors remain structurally underweight EM. Should geopolitical conditions stabilize, capital can return quickly, particularly into liquid, high-carry segments.

Overall, the cycle remains intact, but the drivers of returns are evolving. Broad beta is giving way to greater selectivity, with increasing emphasis on carry, fundamentals and differentiation across countries.

As the cycle evolves and dispersion increases, selectivity becomes the key driver of returns. Through the shock, we kept hard-currency exposure broadly stable, reducing duration as volatility spiked, and rebuilding it as valuations improved. The portfolio now combines around 3.5 years of duration, a double-digit yield, a BBB- average rating and approximately 25% CDS/CDX protection, remaining invested but not complacent.

In sovereign credit, we remain cautious on the most expensive segments, particularly low-carry investment-grade names where spreads offer limited room for error. By contrast, higher-yielding sovereigns continue to offer a more compelling combination of carry, valuation and upside potential, with risk premia that remain adequately compensated.

This leads us to focus on oil exporters, reform-driven stories and selected distressed or post-distressed situations where valuations still reflect outcomes significantly more adverse than our central scenario. This positioning remained broadly unchanged during the March shock. While higher oil prices increased volatility, they did not alter our preference for issuers with manageable external liquidity profiles and spreads already incorporating a degree of macro uncertainty.

Alongside selective exposures to Angola, Ecuador, Venezuela and Ukraine, we continue to favour Argentina and Côte d’Ivoire as differentiated expressions of reform and recovery.

FX remains a key source of alpha in the current environment, and we have reduced dollar exposure in favour of selected EM currencies where carry, valuation and external dynamics offer the most compelling asymmetry, while the resilience of global growth despite recent volatility continues to support the broader EM FX backdrop.

Latin America remains a core area of conviction. The Brazilian real and the Mexican peso and continue to stand out among liquid EM currencies, offering attractive carry and operating in deep markets capable of absorbing renewed inflows. Both should benefit from a gradual normalization of geopolitical risk. In Brazil, elevated real rates and supportive terms of trade provide a meaningful buffer, while in Mexico, carry remains compelling and the broader macro framework helps limit downside risks despite higher energy prices.

Local rates remain an area under close monitoring and one we have actively managed throughout the recent volatility. We reduced duration sharply when the oil shock triggered a broad VaR-driven adjustment across EM markets, before selectively rebuilding exposure as curves priced increasingly aggressive tightening scenarios. More recently, however, we have moderated exposure again as oil prices remained above USD100 and several central banks are now expected to begin or resume hiking cycles.

Our focus therefore remains on identifying selective opportunities in markets where real yields remain high, curves are steep and policy credibility provides central banks with some room to avoid overreacting immediately to a supply-driven inflation shock. At the same time, while awaiting greater clarity on the persistence of higher energy prices and the extent of inflation pass-through, we maintain a measured and flexible approach.

This continues to point toward Central and Eastern Europe (CEE), South Africa and Brazil. In CEE, valuations increasingly reflect inflation risks, while political developments are becoming more supportive (see Hungary below). South Africa offers one of the steepest curves in the EM universe alongside high real yields and a gradually improving political and fiscal backdrop. Brazil remains particularly compelling, with nominal yields close to 14%, elevated real rates and sufficient policy credibility to allow the easing cycle to resume once inflation uncertainty recedes.

Asia remains the counterpoint. Lower carry, higher energy sensitivity and weaker buffers make the region less attractive on a risk-adjusted basis, although selective opportunities remain.

None of this means ignoring the downside. March highlighted how quickly EM can de-risk when oil, rates, and geopolitics move in tandem. Protection remains embedded in the portfolio. We increased CDS/CDX hedges during the escalation phase, only partially reducing them as markets stabilised, and have recently added back exposure as markets retraced part of the March sell-off.

With around 25% protection still in place, the objective is not to neutralise beta, but to preserve convexity: protecting capital in tail scenarios, retaining dry powder, and maintaining flexibility across hard currency, local rates, and FX.

The recent oil shock has not derailed the EM cycle, but it has changed its nature. Stronger fundamentals continue to provide resilience, yet the environment is becoming more complex and differentiated. As broad beta gives way to dispersion, returns will increasingly be driven by carry, fundamentals and country selection. In this context, maintaining exposure remains justified, but with a greater emphasis on selectivity and active allocation.