CONTRIBUTORS
Nicholas Hardingham, CFA
Portfolio Manager, Franklin Templeton Fixed Income
Stephanie Ouwendijk, CFA
Portfolio Manager, Research Analyst, Franklin Templeton Fixed Income
Robert Nelson, CFA
Portfolio Manager, Research Analyst, Franklin Templeton Fixed Income
Joanna Woods, CFA
Portfolio Manager, Research Analyst, Franklin Templeton Fixed Income
Sterling Horne, Ph.D
Research Analyst,
Franklin Templeton Fixed Income
Carlos Ortiz
Research Analyst, Franklin Templeton Fixed Income
Jamie Altmann
Research Analyst, Franklin Templeton Fixed Income
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:
- How 2025 reopened the EM local market debate.
- EM local opportunity, and how this may hinge on USD overvaluation, but not de-dollarisation.
- Similarities and differences with the 2003–2012 EM local cycle.
- 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.
Endnote
- The emerging market debt universe is divided into hard currency and local currency assets. Hard currency assets are those denominated in USD, EUR, GBP, JPY or another major developed market currency, and these instruments are often issued under developed market law as well (typically US or GB). Local currency assets are those denominated in emerging market countries’ own currencies, such as MXN, BRL, ZAR or IDR. These are typically issued under local law. EM local debt usually carries both exchange rate risk and local duration risk for USD and EUR-based investors.
DEFINITONS
The JP Morgan EMBI Global Diversified Index (EMBIGD) tracks liquid, US dollar emerging market fixed and floating-rate debt instruments issued by sovereign and quasi-sovereign entities.
The JP Morgan GBI-EM Global Diversified (GBI-EM GD) is a premier benchmark tracking local currency bonds issued by emerging market governments.
The JP Morgan CEMBI Broad Diversified Index tracks liquid, US dollar emerging market fixed and floating-rate debt instruments issued by corporate entities.
The Citi Broad Real Effective Exchange Rate Index measures the inflation-adjusted value of the US dollar against a trade-weighted basket of currencies.
The FTSE Frontier Emerging Markets Government Bonds Index tracks local currency bonds issued by frontier emerging market countries.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal.
Fixed income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls.
International investments are subject to special risks, including currency fluctuations and social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. Investments in companies in a specific country or region may experience greater volatility than those that are more broadly diversified geographically.
The government’s participation in the economy is still high and, therefore, investments in China will be subject to larger regulatory risk levels compared to many other countries. There are special risks associated with investments in China, Hong Kong and Taiwan, including less liquidity, expropriation, confiscatory taxation, international trade tensions, nationalization, and exchange control regulations and rapid inflation, all of which can negatively impact a portfolio. Investments in Hong Kong and Taiwan could be adversely affected by its political and economic relationship with China.
The allocation of assets among different strategies, asset classes and investments may not prove beneficial or produce the desired results.
Sovereign debt securities are subject to various risks in addition to those relating to debt securities and foreign securities generally, including, but not limited to, the risk that a governmental entity may be unwilling or unable to pay interest and repay principal on its sovereign debt.
WF: 10917260