Morgan Stanley believes that against the backdrop of sharply rising US Treasury yields and a strengthening dollar, emerging market fixed income and foreign exchange assets, while under pressure, are likely to undergo an orderly adjustment rather than a violent sell-off; however, spreads no longer offer any cheapness, and investors need to wait for valuation overshoots before adding positions.

Sharply climbing US Treasury yields, expectations that the Federal Reserve will hike rates two more times, a stronger dollar, and persistently elevated oil prices 鈥?this combination would normally be enough to cause emerging market assets to significantly underperform. Yet this year's reality has been surprising: returns have weakened somewhat, but the adjustment process has been remarkably orderly, and emerging market assets have still outperformed across multiple dimensions.

James Lord, head of emerging market foreign exchange strategy at Morgan Stanley, pointed out that oil prices, US Treasury yields, and the dollar together currently explain roughly 55% to 60% of the return variation in hard currency (i.e., bonds denominated in major international currencies such as the US dollar) and local currency (i.e., bonds denominated in domestic currencies) emerging market fixed income, whereas before the outbreak of the Iran conflict, this proportion was only about 25%. This means the sensitivity of emerging markets to external shocks has risen substantially.

Morgan Stanley's baseline judgment is that from current levels, emerging markets are more likely to enter a low-return range rather than experience disorderly selling. But as spread buffers are exhausted, market vulnerability cannot be ignored if another global risk event occurs.

Local Currency Bond Market: Fund Inflows Lead Returns, Divergence Largest in a Decade

Structural concerns in local currency emerging markets are building. James Lord noted that the carry on the current emerging market foreign exchange index is at historically low levels, while fund inflows into local currency bonds have already far outpaced actual returns.

Data shows that over the past three months, local currency emerging market bond returns have been only around the 45th historical percentile, while fund inflows have reached as high as the 90th percentile; measured on a calendar-year basis, this divergence is the largest since 2013.

Morgan Stanley believes a slowdown in fund inflows is almost a high-probability event. Nevertheless, the resilience the market has demonstrated so far indicates that investors still have faith in improving emerging market fundamentals.

The key support for this judgment lies in monetary policy credibility. Real interest rates in several emerging market central banks are already at relatively high levels, particularly in Brazil, Colombia, and Turkey, providing the market with a certain buffer. The bank believes:

Carry trades in Egypt and Nigeria remain attractive due to high real interest rates, solid fundamentals, and continuously advancing reforms, and Morgan Stanley maintains a bullish stance on them. Hungary, meanwhile, is expected to drive yields lower and push the euro lower against the Hungarian forint (EURHUF) due to long-term structural improvements and its potential convergence toward the eurozone.

Sovereign Credit: Spreads No Longer Cheap, Buffer Space Thinning

Compared with the local currency market, sovereign credit has performed even more impressively. Since late June, US Treasury yields have risen by nearly 90 basis points cumulatively, yet emerging market sovereign spreads have barely budged this year. Historical patterns show that once US Treasuries suffer a sell-off of more than about 50 basis points, emerging market spreads usually widen accordingly 鈥?but this time, the market reaction has clearly lagged.

James Lord attributes this to three reasons:

First, compared with previous risk-aversion cycles, current emerging market fundamentals are more solid, current account imbalances are within controllable ranges, and policy responses have generally remained within an orthodox framework;

Second, recent debt maturity pressures are far more manageable than in 2022;

Third, market technicals have provided support 鈥?emerging market sovereign bond supply has been relatively moderate, while large-scale issuance of US corporate debt has reduced the concentration of cross-market investors' positions in emerging markets.

However, current spreads can hardly be called cheap. Emerging market sovereign spreads are currently around 200 basis points, in line with Morgan Stanley's year-end baseline forecast, and the average level is basically aligned with US corporate credit of the same rating. This means that if another global shock occurs, the market has almost no extra safety cushion.

In response, Morgan Stanley, while acknowledging intensifying challenges, still chooses to keep its spread forecast unchanged. Its logic is that part of the rise in US Treasury yields reflects economic growth resilience rather than purely risk-aversion sentiment; inflation is still falling; higher all-in bond yields will eventually attract demand back; and if oil prices fall significantly, it would simultaneously ease inflation pressure and Federal Reserve rate hike expectations.

Although the baseline scenario is relatively mild, Morgan Stanley's strategic recommendations still lean defensive.

James Lord pointed out that for currency pairs highly sensitive to global factors and with low carry, tactically hedging against further dollar strength is a reasonable choice, with the South African rand (ZAR) and Mexican peso (MXN) particularly worth watching.

In addition, Morgan Stanley reminded investors to watch the outcome of Brazil's presidential election. The bank believes that market pricing has not yet fully reflected tail risks under a pessimistic scenario; if the election result points to expectations of fiscal consolidation, both fixed income and equity assets could see considerable gains.