Weaker dollar, stronger fundamentals: Why emerging markets debt is back in focus

The weakening of the US dollar in recent years, following a decade-long period of strength, has created a significant tailwind for EM debt.

This shift comes at an opportune time: the asset class has grown more resilient in recent years, as many EM economies have strengthened their balance sheets and returned inflation to target. Combined with higher yields across both hard and local currency debt, the environment offers an attractive investment proposition to invest in EM debt.

Exhibit 1: Weaker dollar cycle started in 2022 following a decade of strengthening

_{Source: Bloomberg. Daily data from 1 January 2011 to 15 April 202C.}

For active managers, the backdrop is particularly favourable. A weaker dollar enhances the appeal of local currency EM debt, while also continuing to support hard currency debt — providing opportunities across the broader EM universe.

Why the dollar is vulnerable

The duration and severity of the Iran war, as well as its secondary impacts on inflation and growth, are still to be determined. It is worth noting, however, that the US dollar has failed to rally significantly since the war began, bringing into question its traditional safe-haven status.

In the longer term, we see several factors supporting the further depreciation of the US dollar — conditions that historically have been favourable for EM debt, particularly EM local currency assets. Four key drivers underpin our view:

• Valuation: By most metrics, the US dollar is trading at elevated levels relative to historical norms. This overvaluation suggests limited upside and increases the risk of mean reversion, especially in an environment where structural supports for dollar strength are eroding.
• Positioning: Investor positioning is heavily skewed toward the dollar. A shift in sentiment or fundamentals could lead to a broad-based reallocation away from the dollar and into undervalued currencies, including those in EM.
• Fundamentals: The US is running substantial twin deficits (fiscal and current account). Recent fiscal packages mean the deficit is set to widen even further over the next few years, and this trajectory is likely to put sustained pressure on the dollar.
• Policy outlook: The US administration has shown little resistance to a weaker dollar, removing a key support for the currency. Additionally, speculation about a dovish Federal Reserve under incoming new leadership is further eroding a critical pillar of dollar strength.

Together, these drivers point to continued dollar weakness — an environment that supports both EM hard and local currency bonds, as illustrated in Exhibit 2.

A weaker dollar generates beneficial secondary effects for EM assets. It allows many countries to build higher foreign exchange reserves, which can buffer against global volatility and help stabilise local currencies. It also reduces the cost of servicing hard currency debt, easing fiscal pressures.

In addition, a softer dollar tends to lift commodity prices, which is especially supportive for commodity-exporting EM economies. Taken together, these effects strengthen what is already a supportive global backdrop for EM.

Exhibit 2: Dollar depreciation benefits EM debt

_{Source: Bloomberg. Monthly data from January 2003 through October 2022. EM Local = JP Morgan GBI EM Global Diversified Index. USD = US Dollar Spot Index (DXY). GBI-EM GD FX Index = J.P. Morgan GBI-EM Global Diversified FX return Index. EM HC = J.P. Morgan EMBI Global Diversified Index. Dollar Weakening Cycle = 31 Jan 2003 - 30 Apr 2008. Dollar Strengthening Cycle = 31 Jul 2011 - 31 Oct 2022.}


EM fundamentals are stronger

Since the pandemic, many EM countries have made significant progress in strengthening their economic foundations. Balance sheets have improved, fiscal consolidation is underway — aimed at reducing deficits and ensuring long-term sustainability — and current account balances are strong.

Additionally, inflation has returned to target ranges in most EM economies as a result of prudent and proactive monetary policy over the last few years. With inflation under control, many EM central banks have been able to implement easing cycles, providing an additional tailwind for investing in local rates and reinforcing the case for EM debt.

Elevated yields present attractive entry points

At the same time, yields in both hard and local currency remain at elevated levels, offering attractive entry points for investors. In today’s market, investors are positioned to benefit not only from higher yields, but also from diversification and the tailwind of improving macroeconomic fundamentals across emerging economies.

Summary

The combination of dollar weakness, stronger EM fundamentals and elevated yields creates a uniquely favourable environment for EM debt. We believe both hard and local currency segments are well placed to deliver attractive, risk-adjusted returns, presenting a compelling opportunity for investors.

_Disclosure

_{This material is for institutional, investment professional and qualified professional investor use only. This material should not be shared with retail investors.}

_{This material is for general information purposes only, with no consideration given to the specific investment objective, financial situation and particular needs of any specific person. This material does not constitute any promotion of or advice on MFS investment products or services. The views expressed are those of the author(s) and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice. Past performance or any prediction, projection or forecast is not indicative of future performance. Diversification does not guarantee a profit or protect against a loss. The information contained herein may not be copied, reproduced or redistributed without the express consent of MFS. While reasonable care has been taken to ensure the accuracy of the information as at the date of publication, MFS does not give any warranty or representation, expressed or implied, and expressly disclaims liability for any errors or omissions. Information may be subject to change without notice. MFS accepts no liability for any loss, indirect or consequential damages, arising from the use of or reliance on this material.}

_{Important Risk Considerations:}

_{Emerging markets can have less market structure, depth, and regulatory, custodial or operational oversight and greater political, social, geopolitical and economic instability than developed markets.}

_{Investments in debt instruments may decline in value as the result of, or perception of, declines in the credit quality of the issuer, borrower, counterparty, or other entity responsible for payment, underlying collateral, or changes in economic, political, issuer-specific, or other conditions. Certain types of debt instruments can be more sensitive to these factors and therefore more volatile. In addition, debt instruments entail interest rate risk (as interest rates rise, prices usually fall). Therefore, the portfolio's value may decline during rising rates.}

_{The views expressed are those of MFS, and are subject to change at any time. These views should not be relied upon as investment advice, as securities recommendations, or as an indication of trading intent on behalf of any MFS investment product. Unless otherwise indicated, logos and product and service names are trademarks of MFS® and its affiliates and may be registered in certain countries.}

_{Distributed by:}

_{Singapore - MFS International Singapore Pte. Ltd. (CRN 201228809M); Hong Kong - MFS International (Hong Kong) Limited (“MIL HK”), a private limited company licensed and regulated by the Hong Kong Securities and Futures Commission (the “SFC”). MIL HK is approved to engage in dealing in securities and asset management regulated activities and may provide certain investment services to “professional investors” as defined in the Securities and Futures Ordinance (“SFO”).; For Professional Investors in China – MFS Financial Management Consulting (Shanghai) Co., Ltd. 2801-12, 28th Floor, 100 Century Avenue, Shanghai World Financial Center, Shanghai Pilot Free Trade Zone, 200120, China, a Chinese limited liability company registered to provide financial management consulting services.}

_{#68005.1 expiry 21 April 2027}