Despite strong year-to-date performance in what feels like a resilient market, seasoned EM sovereign credit investors are publicly emphasizing caution. They recognize that stretched valuations, described as a 'glass overflowing', and potential US recession risks create significant downside vulnerability.
Rather than retreating from popular but crowded frontier market trades, bullish investors are expanding their search for alpha. They are moving further down the liquidity spectrum to find new, less-trafficked opportunities, signaling a deepening commitment to the asset class despite positioning concerns.
The focus in distressed sovereign debt has shifted beyond country fundamentals. Investors are now performing deep analysis on novel state-contingent debt instruments created during recent restructurings in countries like Zambia and Sri Lanka, scrutinizing their complex trigger mechanisms and payout structures for alpha.
The initiation of the Fed's cutting cycle is the critical trigger for a weaker dollar against EM currencies, outweighing any mixed forward-looking commentary. This is because the cycle's start begins to erode the US carry advantage, a key structural factor supporting EM FX performance.
A strategic divergence exists in EM corporate credit. Mandate-bound real money funds feel compelled to stay invested due to a lack of near-term negative catalysts, while more flexible hedge funds are actively taking short positions, betting that historically tight spreads will inevitably widen over the next 6-12 months.