UBS Equities-Global Strategy _EM Credit Mid-year Outlook - How to naviga...

ab13 June 2025Global ResearchGlobal StrategyEM Credit: Mid-year Outlook - How to navigate 2H25Fiscal dynamics, valuations and oil to weigh; US flows to partly offsetConflicting factors are pulling EM credit in different directions as the middle of the year approaches. On the macro side, EM fiscal G-R dynamics, taken as a whole, are weakening (point #1 below) while valuations are expensive again by historical standards (at least 1 STD below 10y avg. across all rating buckets, see Figure 1EM spreads are now again 1 STD or more below their 10y average acros the rating buckets; C are even tighter than on 18 Feb (when EMBI spreads botomed)). Additionally, recent oil-related gains are likely to reverse, we think, and could lead to up to a 20bps direct hit on an index level (see point #2 below). On a less concerning note, the negative macro impact from US tariffs is more contained than seen in the immediate aftermath of US tariff announcements in early Apr (see: What US tariffs mean for EM credit?) as the $ value of tariffs effectively halved (Figure 5Have US tarifs botomed? UBS econ team calculates that the $ value of US tarifs more than halved betwen 9 April peak ($1,059bn) and now ($509bn) - almost equaly driven by: (1) the 90-day pause in reciprocal country tarifs (above 10%) and; (2) sharp decline in China tarifs. A ful reinstatement of the former after the 9 July deadline, would take tarifs back to the $70bn-$70bn range. ). UBS now also expects only a moderate increase in US HY default rates -- to 1.25% by YE (from 0.4% in May), which would be substantially below a 30y avg. (of 3.1%). On the flows side, EM debt looks set to benefit from a (possibly prolonged) process of reallocation of US portfolios from an "underweight" starting point (point #3 below).Wider spreads outlook; but expect positive total return by YE due to UST&carryOn a net basis, and by also factoring in UBS's US credit views (Figure 2UBS's US credit spreads cal implies 60bps-70bps EMBI widening in 3Q25 and a moderation thereafter in 4Q25 (helped by UBSf for backloaded 10bps Fed cuts)), we see EM credit spreads on an EMBI GD level ending the year 40-50bps wider - or around 360bps. From a total return standpoint, our macro framework implies total returns of 3%-4% by YE as gains from UST (10s at 3.80%) and carry more than offset possible losses from wider spreads. Challenging spreads starting point (the BBB/BB/B avg. is only ~20bps above 5y lows but ~80bps below recent widest levels in Apr) and lack of visibility on US tariffs create upside asymmetries to EM spreads in our view. In other words, another Apr-vol-driven-like spreads widening phase cannot be ruled out. We are, therefore, not fans of summer-carry-collection strategies and generally see alpha being generated by sticking to IG (see last paragraph).#1 Falling G-R to slow credit rating improvements; who is more exposed?The post-Covid years of 2021-2023 have seen a rare combination of abnormally high nominal GDP growth