Assessing local market allocations in emerging markets

Summary

The exceptional performance of EM local markets¹ in 2025 reopened the debate over whether changes in the US-dollar (USD) and a reassessment of “US exceptionalism” have strengthened the long-term case for EM local-currency assets. We find that the case has improved relative to its longer-term history, supported by an expensive dollar, a narrower US yield advantage, attractive EM real yields, stronger EM external balances, and more credible EM central banks. However, most of these drivers appear cyclical rather than structural, and EM foreign exchange (FX) is likely to remain the main source of volatility and drawdown risk in blended EM debt (EMD) portfolios. For USD-based blended EMD portfolios, the evidence supports a 20% to 35% strategic allocation to EM local debt. With a supportive cyclical backdrop, we are comfortable positioning toward the upper part of that range, while stopping short of a maximum allocation, given downside risks from the conflict in Iran and the potential for the artificial intelligence (AI) investment cycle to reinforce US growth exceptionalism. Within local-currency markets, we remain highly selective, requiring sufficient carry to compensate for volatility, resilient external positions and currencies that have not already priced in too much good news.

In this quarterly deep dive, we look at:

1. How 2025 reopened the EM local market debate.
2. EM local opportunity, and how this may hinge on USD overvaluation, but not de-dollarisation.
3. Similarities and differences with the 2003–2012 EM local cycle.
4. The risk-adjusted case: better, but not transformed for EM.
    

Conclusion: Allocation requires a constructive but disciplined stance

Historical data indicates a 20%–35% allocation to EM local debt within a broader USD-based EM fixed income portfolio is a sound strategic range for our strategies. That allocation is large enough to benefit from favourable cycles, but not so large that the portfolio becomes overwhelmed by the volatility of the asset class. We’re comfortable with larger allocations on the condition that we’re strategically selective both in the alpha generation process and in our approach to risk management within EM local markets.

The current environment supports being constructive but not indiscriminate. The best opportunities are likely to be selective, favouring countries with attractive real yields, credible central banks, manageable fiscal risks, resilient external balances and currencies that have not already priced in too much good news. Frontier local markets provide an additional opportunity for diversification, particularly where managed FX regimes reduce volatility and local yields remain attractive.

EM local debt deserves renewed attention after 2025, but not a wholesale re-rating. A weaker USD cycle would improve the return outlook and continue to draw investors back into an asset class that could well have room to run after a long drought of inflows. And EM fundamentals are better than in previous cycles. But we don’t expect to see a sustained regime shift in risk-adjusted returns for the asset class, and we’re mindful of the sensitivity that EM FX has to periods of market stress. We favour an allocation that focuses on country selection and patience. We would rather wait for exceptional opportunities and let valuation, policy credibility and external resilience determine where to take risk. The factors that have contributed to a stronger exchange rate environment in EMs and a weaker USD are more cyclical than structural, and while long-term changes to the USD’s unique role in the global economy may be afoot, it is the cyclical factors that are we expect will play a much larger role for the foreseeable future.