CONTRIBUTORS
Christy Tan
Investment Strategist
Franklin Templeton Institute
Lukasz Labedzki, CFA
Senior Analyst
Franklin Templeton Institute
Priya Thakur, CFA
Analyst
Franklin Templeton Institute
Preview
You can’t change the wind, but you can adjust the sails to reach your destination.”
A new wind of change is clearly affecting global debt markets. The global monetary policy tightening cycle has run its course, and most major central banks in developed markets have started cutting interest rates. The direction and degree of change are the topics of this paper. We will consider a variety of fixed income sectors and review both the shift in global monetary policy and the changes likely to come in US policies with the return of President Donald Trump and his America First agenda. US fixed income and emerging markets debt (EMD) both begin the year as generally attractive for investors. Inflationary pressures have declined over the past few years while growth has continued. However, the new administration is calling for broad changes in trade policy, with threats of tariffs posing risks to both allies and geopolitical rivals in both developed and emerging markets (EMs). Questions also surround China's trajectory as the largest developing economy continues to undertake a variety of stimulus measures and prepares responses to the likely US trade pressures.
In this paper, we present an analytical framework for assessing fixed income opportunities in the United States and EMs during 2025.
We will consider three key questions for investors and develop an outlook for each one based on our analysis:
- Will falling rates produce a different return profile for bonds than what we’ve experienced over the last few years?
A wind of change will produce a different return profile for bonds and support a broad range of opportunities—but the winds may shift direction during the upcoming year, making an alert, active approach very timely.
- How might changes in the term premium affect fixed income performance?
The term premium, which is the amount by which long-term bond yields exceed short-term yields, is typically positive, but over the past 10 years it has been quite low and sometimes negative. A recent rise in the term premium signals a major wind of change that investors will need to remain aware of in 2025.
- Will 2025 be similar to 2024, when the formula for outperformance was to reduce exposure to duration risk and look for diversification opportunities presented by EMD?
Many of the fixed income sectors that performed well in 2024 appear likely to continue delivering attractive returns in 2025, but relative performance appears likely to change. It may be advantageous to maintain flexibility in duration and income strategies, and EMD will likely offer opportunities for outperformance as well as for diversification.
Conclusion
The economic outlook for EMs, in our view, remains favorable compared to developed markets. The normalization of interest rates in the United States and Europe is expected to increase the flow of capital to higher-yielding international assets. We believe that investors will start to view EM fixed income as a core component of their long-term strategies rather than a tactical allocation, despite the challenges posed by higher financing needs and geopolitical uncertainties.
Understanding country-specific factors will be critical, as various regions and countries will experience different outcomes based on their stage in the monetary easing cycle and how global trade relations and supply chains evolve. Investors should focus on fundamentally improving economies with credible policy records, as we believe these are likely to outperform.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal.
Fixed income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls. Low-rated, high-yield bonds are subject to greater price volatility, illiquidity and possibility of default.
Equity securities are subject to price fluctuation and possible loss of principal.
Special risks are associated with investing in foreign securities, including risks associated with political and economic developments, trading practices, availability of information, limited markets and currency exchange rate fluctuations and policies; investments in emerging markets involve heightened risks related to the same factors. Sovereign debt securities are subject to various risks in addition to those relating to debt securities and foreign securities generally, including, but not limited to, the risk that a governmental entity may be unwilling or unable to pay interest and repay principal on its sovereign debt. To the extent a strategy focuses on particular countries, regions, industries, sectors or types of investment from time to time, it may be subject to greater risks of adverse developments in such areas of focus than a strategy that invests in a wider variety of countries, regions, industries, sectors or investments.
China may be subject to considerable degrees of economic, political and social instability. Investments in securities of Chinese issuers involve risks that are specific to China, including certain legal, regulatory, political and economic risks. There are special risks associated with investments in China, Hong Kong and Taiwan, including less liquidity, expropriation, confiscatory taxation, international trade tensions, nationalization, and exchange control regulations and rapid inflation, all of which can negatively impact the fund. Investments in Hong Kong and Taiwan could be adversely affected by its political and economic relationship with China.
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