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Witold Bahrke
Senior Macro and Allocation Strategist
EM Debt when the cycle matures
Relative resilience
EMD has weathered the (rates) storm relatively well: Q3 drawdowns much smaller than in core fixed income. Similar returns to US HY, which has much lower duration, though.
Rollercoaster
YTD, EMD returns showed typical late-cycle volatility as monetary conditions tightened.
EMD as diversifier
Correlations with G7 bond returns are negative over the past 12M.
MACRO: K-shaped economy keeps monetary tightening risks in check
Growth
Gradual slowdown. Cyclical backdrop resilient but more volatile. Rate risk morphs into credit risk. EM–US growth gap widening (chart).
Inflation
Disinflationary trend intact. Geopolitical risks peak ahead of the midterms. Reversaal of energy price spike delayed, not derailed.
Policy
Moderate monetary headwinds prevail but Fed hikes are overpriced. Lower leg of the K (consumers) outweigh inflationary impact of upper leg (AI).
Key Macro Risk
The AI innovation cycle: euphoria extended, or a credit crunch amid an issuance wall, crowding out on other bond segments?
MARKETS: Muddling through, but volatility persists
Review
Our preference for local currency EMD played out well in Q3. A cautiously constructive stance on overall EMD risk proved too optimistic as monetary headwinds gathered pace in Q3.
Tactical horizon
Risk appetite to recover into year-end due to dovish Fed repricing and falling oil prices. Maintain an overweight in local EMD. Spread risk tilted to the upside as the credit cycle turns.
Strategic horizon
Global Evolution view: Expecting solid carry-driven returns. Preference to shift towards hard currency EMD as duration turns into a tailwind. Elevated vol argues for a tactical approach.
The upper leg of the K
Investments, the swing factor of the business cycle, remain the key driver of global growth.
Growth cycle as good as it gets
A gradual turn in the credit cycle is confirmed, as past monetary easing fades and the real rate spike begins to bite.
AI capex cycle intact
Strong margins signal sustained strength in the AI-driven global capex cycle.
US cushion wearing thin
Declining savings & wealth creation have cushioned US households. This can only run so far.
The weak spot
Household income is under pressure from persistently high energy prices and declining wage growth.
The lower leg of the K
We expect household demand to be the weak spot, causing global growth to slow.
A silver lining
The lower leg of the K limits monetary tightening risks.
Underlying inflation falling
Despite persistently high energy prices, underlying US inflation is trending down. The mother of all central bank fears (2nd round effects) is not materializing.
EM angle: El Niño vs. structural improvements
El Niño poses upward pressure on headline inflation over the coming months. Medium-term, the EM-DM inflation gap will likely remain historically tight as energy pass-through to EM inflation has declined.
Impulse set to fade
The inflationary impulse from tariffs and energy is set to fade in H2.
Tightening as expected
Late-cycle tightening plays out largely as expected. We expect one more Fed hike over 12M.
Manageable
A game-changer vs. 2025, but tightening stays < 1 std. dev., not enough to put the cycle at risk.
K-shape prevents over-tightening
Strength in the upper leg of the K is offset by weakness in the lower leg.
Source of volatility
That said, especially the Fed has induced volatility into the market place.
Late-cycle bellwethers
Monetary tightening, a turning credit cycle & a concentrated profit cycle (AI). Very low forecast dispersion suggests macro complacency.
Herd behavior & recency bias
Analysts not only run in the same direction (first), they also expect the status quo to prevail (second).
Diversification is of the essence
However, a maturing cycle means a wider range of potential outcomes → diversification is of the essence, but harder to find!
Fundamental risks
The macro backdrop remains resilient, for now mostly pointing towards stable spreads.
Sentiment hasn't cleared, yet
Sell signal in early 2026 and YTD returns close to flat. Continues to argue for a cautious approach to overall EMD risk.
Q4 rebound more likely than not
A better-than-even chance of a rebound in risk appetite, as Fed & ECB hikes are over-priced and the rate shock peaks.
Credit risk:
Global Evolution view: Monetary tightening and the resulting rate risk are now cascading into credit risk. A maturing credit cycle and heavy DM issuance spell moderate spread widening risk.
EM FX risk: Fundamental support
As we expected, local EMD outperformed despite a challenging environment for overall risk appetite. We believe there’s further upside based on a widening EM-US growth gap, USD positioning & valuation (EMFX fair).
Bottom-line
Carry & duration drive positive return expectations, but risk around spreads is biased to the upside.
Heavy DXY positioning, a widening EM-DM growth gap (first) and improving valuation (second) favours local EMD tactically.
Higher term premium
Policy uncertainty & central bank surprise potential lifted the term premium. Together with the reversal of the savings glut, this points to a higher range for core yields.
Duration decoupled
Duration decoupled from the growth backdrop as macro disappointments failed to contain yields. IN the coming months, we expect the upward pressure from inflation expectations to reverse and the term premium to stabilize (risk to the downside).
Falling UST rates support hard currency EMD over the strategic horizon
Peaking oil, dis-inflation, a fully-priced Fed & a clearer Fed reaction function creating downside risk to core yields next year → hard currency EMD to regain the upper hand in an asset allocation context.
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