What explains the outperformance of EM LC bonds, and to what extent might this be sustained?

Local EM bond impact

Local currency bond returns include local bond returns and local currency (FX) returns. Country bond yields tend to move lower (bond prices rise) whenever local growth and inflation decline, making local interest rate cuts more likely.

Trump’s tariffs seem to tick both boxes – global growth, including in EM countries, is expected to weaken while non-US inflation is set to decline as Chinese goods formerly destined for the US are sold elsewhere at lower prices. The recent drop in oil prices due to global growth worries is also disinflationary.

Local EM currency impact

The impact of sharply increased US tariffs on EM local currencies is less straightforward. Before Trump was re-elected, markets expected that US policy changes would likely be dollar-positive. The thinking was that increased tariffs would narrow the US trade deficit, while Trump’s pro-growth policies would put upward pressure on US interest rates, supporting the US dollar.

However, the tariff saga has significantly weakened the US dollar, which fell nearly 5% versus the euro in April. Conversely, as shown in Chart 1, the effect on EM local currencies has been favourable.  

The main reason for the US dollar’s weakness is that while higher US tariffs were widely anticipated, the extent of the hikes and the disorderly manner of their implementation took most by surprise. With input costs expected to soar, the inflationary impact will likely be greater. The US growth outlook has also weakened significantly, with a recession now a possibility.

Why recent USD weakness could persist

Amid growing concerns about stagflation and generally increased US policy and economic uncertainty, US equities have especially borne the brunt of the tariff fallout. While this reflects increased domestic selling, we think a major contributor will also have been selling on the part of foreign investors. Over many years, helped by the ‘US exceptionalism’ narrative, foreign investors have built up very large holdings of US assets, which has certainly helped the dollar.

Going forward however, if policy concerns persist, foreign investors could further reduce their still-large US asset overweight and effective long dollar positions. The fact that US equities and the dollar remain historically overvalued on most measures may also be a consideration. Reducing foreign allocation to US assets, or even slowing their accumulation, would likely be negative for the dollar but positive for non-dollar assets, including EM LC bonds.

Some caveats for the weak USD case

There are caveats. Predicting currency moves with any great conviction is always difficult, and betting big against the US dollar hasn’t worked for well over a decade.
In the near term, despite growing speculation, the US dollar’s pre-eminence as the global reserve currency is unlikely to be challenged.

There are also multiple scenarios in which the US dollar could bounce back strongly. For example, recent deals, including the newly announced temporary agreement with China, suggest that ‘reciprocal’ tariffs may eventually end up off the table, with the baseline 10% rate and some sectoral tariffs remaining. While this would increase costs for US consumers, it may well not be enough to trigger a disruptive recession, fear of which was surely behind some of the dollar’s weakness this year.

Outlook is about much more than just the dollar

EM LC bond returns depend on more than what happens to the US dollar. With an index yield of over 6%, the income contribution will be sizeable [1].Furthermore, country-specific factors will continue be a key performance differentiator, highlighting the need for selectivity.

Even with higher US tariffs, country-level impact could vary considerably. For example, if some form of tariff reciprocity were retained, sizeable variations in US tariff differentials between countries could emerge, creating potential US trade winners and losers.

Putting everything together

We think the Trump tariff shock strengthens the investment case for EM LC bonds. Weakening global growth and falling inflation outside the US should make EM local interest rate cuts more likely, boosting EM local bond returns.

On the currency side, foreign investor may look to further diversify their sizeable US asset holdings, especially US equities, in the face of heightened policy uncertainty. This could support EM local currency returns. However, several caveats argue against adopting a high-conviction view on US dollar directionality.