Heading into the US/Israel conflict with Iran, EM fundamentals were on a solid footing. Growth was steady, inflation was moderate, interest rates were firmly above inflation, and most countries had limited external financing needs, supported by elevated foreign-currency reserves. The primary economic effect of the conflict has been higher energy prices, which are putting upward pressure on inflation and may keep growth subdued relative to prior expectations. However, assuming that tanker transit through the Strait of Hormuz can gradually return to normal, the economic effects should be manageable.
Prior to the energy price shock, EM central banks were easing monetary policy, though they remained prudent by maintaining a gap between policy rates and inflation. This approach has served policymakers well, and it may allow central banks to be relatively patient regarding the path of future policy. Combining the view that energy prices will continue to moderate from recent peaks with an expectation that EM currencies should resume appreciation against the US dollar, we do not expect inflation to rise significantly in most countries.
Renewed interest in diversification has been favourable for EM assets; investor flows and primary markets have demonstrated resilience to the current geopolitical volatility. Over the long term, structural forces continue to benefit EM debt, including stronger growth prospects relative to developed markets and a widening set of investment opportunities across nearly 90 countries, spanning sovereign, corporate, and local-market bonds. In our view, EM debt offers value as a strategic allocation, with attractive yields that can generate income over time.
