Emerging markets have increasingly forged for themselves a path less dependent on external conditions, making local currency debt one of the most mispriced narratives in global markets.
Read this article to understand:
- Why the narrative of emerging markets (EM) as a high-beta proxy to global flows is outdated, as sound macro policies have reduced EM vulnerabilities to external conditions
- How inflows into the asset class can create a virtuous circle amplified by improved fundamentals
- How the rise of a robust domestic investor base is an underappreciated structural shift in EM local-currency fixed income
The current oil shock emanating from the US/Israel war on Iran is giving emerging markets the opportunity to (once again) prove their mettle. This is helping to dispel a common market misperception that EM fortunes are dictated by external conditions, such as the US dollar cycle, or episodes of sudden stops of capital flows as in the Taper Tantrum of 2013.
In that misperception, capital flows, rather than fundamentals, are the dominant driver of returns. More recently, this view has been reinforced by the so‑called “debasement trade” and the scramble to increase allocations to non‑dollar assets. In this telling, EM is effectively framed as a high‑beta proxy to global liquidity.
That narrative is increasingly outdated
What it overlooks is how profoundly emerging markets have changed. The degree to which the pursuit of sound macro policies in EM has reduced their vulnerabilities to external shocks tends to be overlooked.
As a result, EM today is no longer a monolithic, high-risk proxy for the global cycle. Treating the asset class as such masks the heterogeneity beneath the surface and ignores the substantial improvements many countries have made in policy credibility, macro management, and institutional strength. This all means that opportunities in the sector now come from being selective, and not just taking a broad market exposure.
Fundamentals – sound macro means better resilience
The recent crisis is a case in point. A few years ago, an oil shock of the recent magnitude would have led to a blanket sell-off in EM assets, such as happened in 2022. Instead, the recent price action has been much more orderly, with investors increasingly distinguishing between countries where strengthened macro positions provide several degrees of freedom to respond to and weather the external shock.
Compared to previous commodity shocks, which would have elicited knee-jerk rate hikes by EM central banks, many have instead been able to maintain their composure into this oil shock, choosing to wait and see before reacting. The reasons for that are important:
- First, inflation was benign in the run-up to the crisis, with credible monetary policy being instrumental in dampening demand pressures.
- Second, exchange rates have remained relatively stable, a reflection of improved balance of payments and macro policies.
- And finally, policy rates in EM have remained above their neutral levels, suggesting some buffers to absorb an increase in inflation expectations.
Moreover, higher yields in EM continue to provide adequate compensation for the added perceived risk of EM exposure, with real yields not only higher than their developed market (DM) counterparts (see Figure 1), but also sitting at the upper end of their historical ranges.
Figure 1: EM real yields – elevated and historically strong, per cent
Note: EM 10-year real yields (unweighted).
Source: Aviva Investors, Macrobond. Data as of April 2026.
Externally, the picture has also improved materially, providing some buffers to absorb the current shock.
Many EM countries now run current account surpluses, and where deficits persist, they are generally modest and manageable. In many cases, ongoing deficits are comfortably funded by foreign direct investment, resulting in stable or positive basic balances in countries including Colombia, Mexico, Peru, Poland and Egypt. This has supported a sustained build‑up of international reserves, which now sit near record highs across the asset class, and have been instrumental in driving the relative stability of EM currencies.
Finally, improved fiscal metrics have facilitated a more holistic approach to macro policymaking. While fiscal profligacy is frequently associated with emerging markets, the post‑pandemic experience has challenged that stereotype. Many countries have taken meaningful steps to tighten their budgets and stabilise public finances, sometimes more decisively than developed markets.
In several cases, revenue windfalls have been used, not to fuel excess spending, but to generate primary surpluses and reduce debt vulnerabilities. A good example is South Africa, where reforms and more disciplined fiscal choices have put the country’s debt on a downward path for the first time in nearly two decades.
More importantly, countries have been able to tap into this fiscal space, cutting fuel levies for instance, to mitigate the impact of higher oil prices on inflation. This kind of coordinated response across monetary and fiscal policies is a welcome sign of maturity, with policymakers displaying increasing sophistication and judiciousness in assessing the macro trade-offs associated with their policy responses.
Taken together, these improvements have strengthened policy credibility, and fixed income markets are increasingly reflecting that reality. Notably, this doesn’t just apply to the more “mature” emerging markets. Rather, countries undertaking material structural reforms such as Turkey, Egypt and Nigeria, and which would have been historically crisis-prone, have instead been standouts in this crisis, undertaking orthodox policy responses.
Egypt opted to allow its exchange rate to weaken as a first line of defence against the oil shock, while Turkey chose to use its large reserve pile to keep its disinflation on track. Nigeria meanwhile has resisted the temptation to reintroduce fuel subsidies, preserving its newly acquired fiscal space.
Capital flows are returning but this time is different
Despite the currently challenging external environment, the return of capital inflows has the potential to create a virtuous circle for EM assets. Importantly, flows are not returning to the crisis‑prone emerging markets of the past, but to markets that are more resilient, better-funded domestically, and far less dependent on foreign capital than in previous cycles.
Yes, money is being pushed out of dollar assets, but EM is uniquely positioned to pull that capital in. The key difference in this cycle is that emerging markets arguably “need” these flows less than they once did – and that changes the dynamics entirely.
Falling financing needs, less external dependence
Gross financing needs have been declining across much of the EM universe over time. The post‑COVID widening of fiscal deficits has largely normalised, and in several cases reversed (see Figure 2). The increased cost of servicing debt that resulted from higher interest rates has been offset in part by a greater commitment to generate primary surpluses, lowering financing pressures.
Figure 2: EM’s declining financing needs, per cent
Note: Gross financing requirement, percentage of official reserves.
Source: Aviva Investors, Fitch Ratings, as of December 31, 2025.
Looking ahead, prudence remains the guiding principle. With geopolitical risks and trade tensions on the rise, many policymakers are taking a more cautious approach. Combined with the impressive build‑up in reserves, this means EM economies are better insulated from external shocks and structurally less reliant on foreign capital than at almost any point in the past two decades.
The composition of financing has also improved markedly.
Government debt is now increasingly denominated in local currency, allowing countries to move decisively away from the “original sin” (the inability to borrow internationally in their own local currency). As credibility and policy orthodoxy have improved, local markets have deepened, maturities have been extended, and rollover risks reduced. Currency mismatches, once a defining vulnerability, have steadily diminished.
The rise of the domestic investor
Perhaps the most underappreciated structural shift in EM fixed income has been the rise of the domestic investor base.
Over the past decade, non‑resident ownership of local-currency government bonds declined steadily, following a series of external shocks, from the Taper Tantrum in 2013, to the Chinese yuan devaluation in 2015, and the dollar bull cycle of 2018. But rather than leaving a vacuum, domestic players have stepped in.
Liquid banking systems, fast-growing pension funds and other institutional capital pools have transformed local bond markets, replacing foreign investors as the marginal buyers of local debt, creating deeper, more stable markets in which to channel domestic savings (see Figure 3).
Figure 3: EM holders of local debt, percentage of total
Source: Aviva Investors, International Monetary Fund (IMF), national authorities (central banks, ministries of finance), as of December 31, 2024.
Crucially, these local investors now act as shock absorbers. Their steady participation reduces the risk of disorderly sell‑offs driven by hot money flows from overseas investors, providing some relief against gyrations in capital flows. As reliance on offshore capital has declined, so too has volatility.
Indeed, volatility in EM local debt has been falling relative to other fixed income asset classes and in some cases now rivals that of developed market bonds. The expected volatility spike as a result of the Middle East conflict has been in line with past crises and not out of line with developed-market bond volatility (see Figure 4).
Figure 4: Local debt volatility now comparable to developed markets, per cent
Past performance is not a guide to future returns.
Note: EM local currency debt, 90d rolling total return volatility.
Source: Aviva Investors, Bloomberg, as of April 30, 2026.
A new regime for EM rates
All of this points to a structural shift now underway. Pending a resolution to the current global supply shock, emerging markets are entering a regime of lower equilibrium interest rates.
Yield differentials versus developed markets are likely to continue compressing as improved fundamentals are recognised. But beyond that, the return of inflows into an asset class with reduced financing needs and stronger domestic anchors has the potential to reinforce the rally, creating a self‑sustaining virtuous cycle.
As EM moves into a more mature phase following the sharp repricing in rates over recent quarters, different EM debt will also behave in distinct ways, based on their own fundamentals. That dispersion is not a risk – it is an opportunity. It allows investors to move beyond the index, adopting a selective, country‑by‑country approach to capture duration and curve opportunities where fundamentals justify them.
The era of treating emerging markets as a single trade, heavily influenced by external conditions such as trends in the US dollar, is ending. Instead, it’s becoming difficult to overlook the fact that local debt markets have held up better than expected even in challenging environments, thanks in large part to policy credibility and discipline, monetary stability, and domestic-market depth. What comes next is an asset class defined less by vulnerability, and more by choice.
