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Emerging markets (EMs) encompass regions with significantly diverging fundamentals and a broad range of credit challenges—not the least of which is significant uncertainty around trade and monetary policy.

What We're Watching

Borrowers we rate in EMs are defaulting at a lower rate than those in developed economies. As of December, the 12-month-trailing speculative-grade default rate in EMs was 1.1%--a fraction of the 5.1% in the U.S. and 4.1% in Europe--after leading a global wave of defaults in 2022 in the wake of a tightening of policy rates from local central banks and the Chinese real estate slump.

After defaults in EMs dropped to just eight last year, from 14 in 2023, the region's "risky credits" continue to refinance upcoming maturities, buoyed by tight spreads and in anticipation of potential market turmoil amid ample U.S. policy uncertainty. Plus, they face the threat of lingering high interest rates in the U.S. and what it could mean for further monetary-policy easing by local central banks.

In addition, several recently announced measures from the U.S. administration, and potential responses, may undermine the credit resiliency so far displayed in EMs. These include 25% U.S. tariffs on steel and aluminum, reciprocal levies from trade partners, and the 25% tariffs on goods from Mexico, so far postponed twice. One of the main risks for EMs is China slowing down, given the large integration in supply chains and trade. For many EMs, this link is even stronger than that with the U.S.

What We Think And Why

With a few exceptions, the macroeconomic effect of the 25% import tax on aluminum and steel on the major EM economies is likely to be contained, as the largest exporters of these metals to the U.S. have export shares below 0.5% of their GDP.

Our analysis shows emerging markets in Asia may be hit hardest by reciprocal tariffs. About 12% of Vietnam's economy depends on U.S. demand, followed by Taiwan with 7% and Thailand hovering around 6%. And all three countries display positive tariff differentials with the U.S.

EMs in Latin America and EMEA face more limited risks, displaying trade deficits with the U.S. and relatively small tariff differentials.

Indirect effects heighten the downside risk to EM credit quality: the current economic uncertainty will likely delay EM investment decisions, with potential adverse spillovers on employment; sluggish than expected growth in the U.S. and China would have knock-on effects to the rest of the world; and geopolitical fragmentation could heighten risk aversion, with equity flows being negative outside China since October last year.

On the bright side, the maturity wall for EM risky credits looks manageable, peaking in 2027 at $3.6 billion—mostly in Latin America, and with the telecom sector having the highest concentration of debt coming due. And corporate spreads have been relatively stable contributing to solid--although decelerating--bond issuance (mainly unrated).

What Could Change

S&P Global Ratings believes there is a high degree of unpredictability around policy implementation by the U.S. administration and possible responses—specifically with regard to tariffs—and the potential effect on economies, supply chains, and credit conditions around the world. As a result, our baseline forecasts carry a significant amount of uncertainty. As situations evolve, we will gauge the macro and credit materiality of potential and actual policy shifts and reassess our guidance accordingly.

Although Mexican officials will likely remain pragmatic in their negotiations with U.S. officials to lessen the magnitude and duration of tariffs, a 25% imposed U.S. levy on goods from Mexico throughout 2025 would lead to a 0.5% GDP contraction in the year (1.7% below our pre-tariff baseline) through lower investment and consumption. In such a scenario, assuming the exchange rate depreciates 10%, this will add 90 basis points to inflation, prompting the central bank to pause interest rate cuts to anchor inflation expectations.

We think the risk of recession in the U.S. is substantially higher than the data suggest. While our quantitative model puts the odds of a recession starting in the next 12 months at just 5%-10%, our subjective assessment is that there's a 25% probability of a downturn—about twice the post-World War II unconditional recession probability of 13%—given the rising risk of persistent supply shocks and negative sentiment.

At the same time, expectations for Fed policy are in flux, with potential implications on EM interest rates and currency valuations. We now forecast the U.S. central bank will keep the federal funds rate at 4.25%-4.5% for most of this year before it resumes cutting late in 2025. We've also shifted upward, by 50 basis points, our median policy rate forecasts for nine key emerging markets for 2025 and 2026.

In this light, EM central banks, which are closely monitoring the Fed moves in order to manage interest-rate differentials, are likely to adopt a cautious approach to monetary policy normalization. Indeed, rate differentials are a key driver of capital flows, which influence exchange rates and, as a consequence, observed and expected inflation.

Writers: Joe Maguire and Molly Mintz