MFS® Emerging Markets Debt Strategy - Quarterly Portfolio Update

Dan Schmidt: Markets navigated a mix of crosscurrents in the third quarter, but several positive factors shown through and really allowed risk assets to continue their year-to-date rally.

Katrina, great to have you here.

 

Katrina Uzun: It's a pleasure.

 

Dan Schmidt: So, let's dive right in. EMD performed well in Q3. The EMD hard currency sovereign asset class returned 4.8%. That extended the year-to-date rally for EMD hard currency sovereigns to beyond 10% year-to-date through September. EM corporates have also done well over that period, but slightly lagged EM sovereigns. But the real standout for the year so far has been EM local currency debt, which has generated returns in excess of 15% for the year-to-date period through September.

Where do we go from here? Is there still room for the asset class to run?

 

Katrina Uzun: Thank you, Dan. Yes, we do think there is still room, though the hard currency returns we think will most likely come from carry, rather than spread compression. But EM debt has certainly benefited from a really positive global backdrop. Growth has been stable, inflation is moderating and you have a weaker US dollar. That is a powerful combination.

But we are also being realistic. A lot of the recent rally in risk assets has been driven by the expectation of further Fed easing. And while we do expect further cuts from the Fed, we think the market might be pricing a bit too much, especially if the growth stays resilient or if the labor market doesn't weaken as much.

        

Dan Schmidt: And that's an interesting point. So, you mentioned softer labor data. That's interesting that it's pushing risk assets and markets higher?

Katrina Uzun: Exactly, and that's the paradox. Weaker labor market feed the expectations of further Fed easing, and that's a very positive environment for risk assets, and emerging markets debt in particular. But a weaker labor market also means potentially larger than expected weakness in the economy, and that's not exactly bullish.

So, on the other hand, if the weakness comes more about supply, labor supply constraints, then growth may hold up better than expected. And this is where I'm talking about immigration bottlenecks, for example. Either way, it's all about balance of risks and we think the market currently may be pricing too much aggressive Fed cuts going forward.

 

Dan Schmidt: All right. So, let's switch to the US dollar. The dollar has significantly weakened this year, that's been a tailwind for EMD, particularly on the local currency side. Does the team believe the US dollar is vulnerable to further depreciation from here?

 

Katrina Uzun: Yes, we do. Dollar valuations are very expensive and the structural factors, like the persistent twin deficits in the US, we have both the current account and the fiscal deficit in the US, that continues to weigh on the dollar. And add to that the further Fed easing, and you set the stage for continued weakness in the US dollar.

Interestingly, during the recent market volatility, the dollar didn't behave like a safe haven asset and that's a shift. Many of our global investors are thinking about reallocating assets away from dollar-dominated assets.

So yes, we do think that the dollar is in the structural weakness. We do think that this is the beginning of a new cycle for the dollar. And that's very positive for emerging markets and local currency debt in particular.

 

Dan Schmidt: Yeah, that's great. Is there any EM currencies in particular that the team's leaning into?

 

Katrina Uzun: Yes. We like Peruvian sol, for example, or Brazilian real. Or even Turkish lira. These are the currencies that have high carry. They also are backed by strong fundamentals. And some of these economies also have stability in their policy frameworks and that's a very good environment that gives us confidence in some of these currencies.

 

Dan Schmidt: Okay. So, let's shift to fundamentals now. When you look broadly across the EM landscape, how do EM country fundamentals look? Are they improving?

 

Katrina Uzun: Yes. Actually, fundamentals are doing really well. They're doing better than I've seen them in years, and that's because a lot of these emerging market countries acted early to control inflation. They cut rates well ahead of the Fed was able to cut rates. And now, if you look across emerging markets, many of them have inflation at a target and you see fiscal balances improving. And further cuts in these economies means that they will support their growth next year. So that's a really positive backdrop for fundamentals in EM.

And at the IMF meetings last week, that was a real sense of progress across the many meetings that we've attended. Countries are really focused on reforms, on fiscal consolidation and on attracting investment. South Africa, for example, is formalizing its 3% inflation target, which just shows how much they've come and how far they've come in terms of gaining that credibility from the market. And in Latin America, Peru, for example, is another country that it just shows very solid, stable macro policy frameworks and strong external balances.

But there is still uneven progress across emerging markets that, if you dig a little bit deeper, some of these economies were able to lose some of that fiscal cushion that they've had and that leaves them with less room to maneuver. The IMF stressed the importance of sound policy frameworks, independent central banks and fiscal prudence of course. We think those are going to be key factors for these economies to do well next year.

 

Dan Schmidt: Okay, great. So, you mentioned the IMF and World Bank annual meeting last week in DC. Are there any other broad themes that you'd like to share with us? Or just how was the sentiment there at the meetings?

 

Katrina Uzun: That was a really good week. There was a lot of positive momentum in emerging markets right now. Policymakers are stepping in, they are tightening where it needed, tightening their policies. They are pushing the reforms forward, actively working to attract investment, and that was a very consistent theme across both the IMF and the World Bank meetings. There's also strong investor interest. The emerging market is back on the radar; people are looking for opportunities across emerging markets debt. And I guess it's not surprising, given the strength of the fundamentals and the weaker dollar environment.

That said though, the tone was not without caution. There are several risks that IMF identified, we're certainly watching those risks very carefully now, too. One is the legal uncertainty around the Supreme Court decision on IEEPA and how that's going to shape the trade policy going forward. Tariff volatility remains a concern, particularly in the Asia Pacific region, which is still dealing with the aftershocks of the prior tariffs. And then you have geopolitical tensions. Russia-Ukraine, China-Taiwan, Middle East, those remain unresolved, and they could flare up unexpectedly. So, while the markets have been resilient, they are priced for perfection, and we think this is the environment where having an active approach toward investing and being very selective is key.

 

Dan Schmidt: Okay. So, China's always a focus when it comes to the global economy. What's your latest things on China right now?

Katrina Uzun: China's situation is mixed. Because China really benefited earlier this year from some policy stimulus that the government has implemented, but that's fading now, and the domestic economy is showing some cracks. When you look at the exports, exports are actually doing quite fine outside of the exports to the US. And manufacturing is doing well as well. But if you look at sectors like consumption or services, those are struggling and those are the sectors that the government wants to prioritize.

Actually, at the IMF meetings last week, they did mention that the real estate and the property sector still remains unresolved in China and that weighs on sentiment. And they also don't expect a big fiscal stimulus coming in 2026, so China may actually, it may weigh on global growth next year.

Having said that, the government recognizes that some of this weakness is part of the adjustment process that the Chinese just needs to go through. And they've said multiple times that they will deliver more in the fiscal stimulus if they think the economy is slowing down too much.

 

Dan Schmidt: Okay, that's great. So, let's shift to the technical environment now. You alluded to this earlier, but we've seen a sharp increase in demand within EMD from investors so far this year. What's driving that, and how are technicals shaping up as we head into year-end?

 

Katrina Uzun: Technicals has been a big shift. After three years of outflows from the market, this year we are seeing consistent inflows. JP Morgan is reporting $14 billion of inflows year-to-date, mostly driven by local currency, but hard currency is also positive, about $4 billion in inflows. So, investors are coming back, both the dedicated emerging market debt investors, but also crossover investors. Part of that has to deal with the search for yield, but part of that is also about just a solid macro picture that is supporting the asset class at the moment.

And then issuance has been manageable and really well absorbed by the market. So that's a very good technical tailwind for the asset class. And you combine that with the weaker dollar or positive fundamentals; you really do have a good support from the demand side for the asset class.

 

Dan Schmidt: Okay. So, it sounds like the important things, technicals, fundamentals, they paint a pretty favorable backdrop for EM debt. But on the other hand, you have valuations, spreads within EMD are tight. They've mostly recently tightened through 300 basis points. How are you viewing valuations right now?

 

Katrina Uzun: Spreads are tight, but we are still finding value in this environment. The key is being selective. So, we are leaning into higher quality sovereigns with solid balance sheets. So, these are countries like Guatemala, Paraguay, Uzbekistan, Bulgaria, Kazakhstan, names that can weather a tougher global environment or a potential slowdown in the global growth. That might mean giving up a little bit on the yield, but we do think that you're going to be justified with a better risk-adjusted return there.

In corporates, we're a bit cautious. You have to be very selective because some valuations just don't justify the liquidity or the macro risks there. But even in corporates, we're finding value in sectors, more defensive sectors, like utilities for example. They, we think, will provide us with a good risk-adjusted profile.

And then we're adding two rates also. So, we like rates in Peru, in South Africa because disinflation and some stable currencies there. That gives room to central banks to continuing easing, that's a very positive environment for rates.

 

Dan Schmidt: That's great. Thank you. Any closing comments and thoughts before we wrap up today?

 

Katrina Uzun: Well, I would just say emerging market resilience has been remarkable this year. And it's been helped of course by the fundamental profile but also helped by just a really positive macro backdrop. So, we see plenty of opportunities to take advantage of the current market environment.

That said though, we are mindful of the downside risks. So be it China slow down, or geopolitical tensions, or too much optimism about how much Fed is going to be easing going forward. So, as we head into 2026, staying selective, being very disciplined in your approach, we think is going to be key to providing good return to our investors.

 

Dan Schmidt: Great. Thank you so much, Katrina, for joining me today. Really appreciate the insights. You certainly have given us a lot to think about.

 

Katrina Uzun: It's a pleasure, Dan. Thank you.

 

Dan Schmidt: Thank you.

 

 

 

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The views expressed are those of the speaker and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice from the Advisor. No forecasts can be guaranteed. Past performance is no guarantee of future results.

 

Important Risk Considerations:

The strategy may not achieve its objective and/or you could lose money on your investment.

Bond: Investments in debt instruments may decline in value as the result of, or perception of, declines in the credit quality of the issuer, borrower, counterparty, or other entity responsible for payment, underlying collateral, or changes in economic, political, issuer-specific, or other conditions. Certain types of debt instruments can be more sensitive to these factors and therefore more volatile. In addition, debt instruments entail interest rate risk (as interest rates rise, prices usually fall). Therefore, the portfolio's value may decline during rising rates. Portfolios that consist of debt instruments with longer durations are generally more sensitive to a rise in interest rates than those with shorter durations. At times, and particularly during periods of market turmoil, all or a large portion of segments of the market may not have an active trading market. As a result, it may be difficult to value these investments and it may not be possible to sell a particular investment or type of investment at any particular time or at an acceptable price. The price of an instrument trading at a negative interest rate responds to interest rate changes like other debt instruments; however, an instrument purchased at a negative interest rate is expected to produce a negative return if held to maturity.

Emerging Markets: Emerging markets can have less market structure, depth, and regulatory, custodial or operational oversight and greater political, social, geopolitical and economic instability than developed markets.

International: Investments in foreign markets can involve greater risk and volatility than U.S. investments because of adverse market, currency, economic, industry, political, regulatory, geopolitical, or other conditions.

Derivatives: Investments in derivatives can be used to take both long and short positions, be highly volatile, involve leverage (which can magnify losses), and involve risks in addition to the risks of the underlying indicator(s) on which the derivative is based, such as counterparty and liquidity risk.

High Yield: Investments in below investment grade quality debt instruments can be more volatile and have greater risk of default, or already be in default, than higher-quality debt instruments.

Please see the applicable prospectus for further information on these and other risk considerations.

The portfolio is actively managed, and current holdings may be different.

 

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