Emerging markets defy global shocks as investors return to local assets

War, tariffs and volatility in artificial intelligence stocks have done little to slow the flow of capital into emerging markets, as economic reforms, deeper domestic capital markets and efforts to diversify away from U.S. assets reshape investor sentiment toward the asset class, Reuters reported.

Global shocks that once triggered sharp sell-offs across developing economies have so far failed to derail demand. Emerging-market debt inflows have reached their highest level in more than two decades, while governments have tapped bond markets at record levels.

Improved policymaking, stronger foreign-exchange reserves and growing pools of domestic investors have helped emerging economies absorb external shocks more effectively. The current rebound follows years of weak investment in emerging markets, during which a strong dollar, U.S. economic exceptionalism, crises, defaults and the COVID-19 pandemic weighed heavily on the asset class.


Global risks remain

The investment backdrop is far from risk-free. The war that began in February has largely restricted traffic through the Strait of Hormuz, pushing up global oil and fertiliser prices and raising concerns about food inflation.

Markets are also watching the U.S. Federal Reserve closely, with the possibility of higher interest rates posing a threat to emerging-market currencies. U.S. Treasury yields, which influence borrowing costs across developing economies, remain near multi-year highs.

Despite those pressures, investor interest has remained resilient.

Emerging economies have spent years strengthening central-bank independence and building foreign-currency reserves. Several countries, including Pakistan, Ghana, Ecuador, Nigeria and Argentina, have also received credit-rating upgrades, improving their appeal to international investors.

Debt attracts strong foreign inflows

Capital flows have provided evidence of the renewed interest. According to Institute of International Finance data cited by Reuters, foreign investors directed $214.4 billion into emerging-market debt through July, up from $177.7 billion during the same period a year earlier.

Emerging-market governments also issued about $19 billion of bonds in July, roughly twice the average issuance for the month over the past decade. That pushed total bond issuance for the year to a record $187 billion.

Currency markets have also remained relatively stable. Capital Economics' aggregate emerging-market currency risk indicator was near multi-year lows despite heightened geopolitical and economic uncertainty.

Equities face a tougher road

The picture is less positive for emerging-market equities. The sector has become increasingly concentrated in technology-heavy markets such as South Korea and Taiwan, leaving it vulnerable to sharp swings linked to the artificial intelligence investment cycle.

IIF data showed that investors withdrew $86 billion from emerging-market equities through July, nearly 10 times the outflows recorded during the same period last year.

Some major investors have consequently become more cautious about emerging-market stocks and hard-currency debt. Investors are also concerned about the greater exposure of developing economies to food-price shocks and weather events such as El Niño.

That has encouraged a more selective approach, with investors focusing on individual countries rather than simply following broad emerging-market benchmarks. Debt burdens and relatively low yields remain concerns in several markets.

Domestic capital markets provide a buffer

The experience of the COVID-19 crisis also encouraged emerging economies to strengthen domestic sources of funding. During the pandemic, foreign-investor withdrawals contributed to debt crises in countries including Sri Lanka and Ghana.

Since then, many developing economies have expanded their domestic investor bases and deepened local bond markets, reducing their dependence on foreign capital.

Reuters reported, citing research from JPMorgan and UBS, that local-currency sovereign bonds outstanding reached roughly $13 trillion by the end of 2024, compared with about $1.4 trillion of international hard-currency sovereign debt.

Large emerging economies such as Brazil and South Africa now rely heavily on domestic debt markets to finance government spending. A broader domestic investor base can help absorb global shocks and reduce the risk of sudden liquidity shortages.

Diversification drives the rebound

The shift away from U.S.-centric portfolios is another factor supporting emerging markets. Investors seeking greater diversification are increasingly looking beyond U.S. Treasuries and equities, particularly as concerns about elevated debt levels and valuations in developed markets persist.

Local investors are playing a greater stabilising role in emerging economies, changing the way global shocks are transmitted through their financial markets.

The biggest risks to the recovery include renewed inflation caused by higher energy and fertiliser prices, as well as potential food-price increases linked to adverse weather conditions.

Even so, the broader investment case for emerging-market local debt remains constructive. With domestic capital markets becoming deeper and investors seeking diversification across more countries and currencies, emerging markets appear better positioned to withstand global volatility than they were during the difficult decade that preceded the current rebound.

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