Key Highlights

• EUR losing ground as investors add to equity hedges
• PLN the strongest performer in EM ahead of upcoming NBP meeting
• APAC FX flows improving without any sign of equity unwinds 

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Euro hedges starting to rise materially as equity valuations extend

EXHIBIT #1: COMPARISON OF EUR AND USD CROSS-BORDER HOLDINGS

_Source: BNY

Our take

The NATO conference has crystallized the European defense project which will drive public investment well into the European Union’s next budgetary cycle. Although such concentrated spending was probably not what Draghi had in mind when his team authored the competitiveness report, the scale of spending will help support growth and the productivity benefits are evident for trend growth. We expect much of the 1.5% of GDP in “resiliency and security” component of defensive spending will fall upon more conventional types of public investment and boost domestic demand. Even without optimal trade deals with the U.S. and China, there will be a clear rebalancing in Eurozone and EU economies. However, assets across the respective blocs have re-rated strongly throughout the year, and we now seriously question whether positioning in European equities – especially in aerospace and defense – is now exhausted. For cross-border investors, we can see that after a period of resilience, EUR hedges are starting to pick up strongly, with an increase of around 20% since late May (Exhibit #1). This has taken place even though asset values continue to perform well in equities and fixed income, due to gains in levels and ongoing inflows. 

Forward look

We believe hedging has picked up while EUR spot levels are improving for two key reasons. Firstly, the equity exposures are particularly at risk as Eurozone and broader EU equities continue to have large exposures to overseas earnings. Consequently, there is a tipping point whereby unhedged flows which push up the euro start to erode into earnings due to earnings translation losses. Secondly, current euro levels will continue to generate downside surprises to inflation. While duration can perform well, longer-dated yields may struggle without additional fiscal impulse. The net increase in sovereign supply to fund defense is already reflected in current yields but further steepening to encourage additional follow-through is difficult without a turn in the growth cycle. Additional duration gains are possible, but the ECB will also be wary of allowing real rates to rise as growth softens and it may require a weaker euro to compensate. Increased cross-border hedging is a natural reaction to such FX valuations risk, in any hitherto well-performing market.

PLN close to fully offsetting its election-related hedges

EXHIBIT #2: DAILY AND MONTHLY SMOOTHED FLOW IN PLN

_Source: BNY

Our take

In our preview of the NATO summit, we identified CEE as the region which will benefit the most from a sharp rise in defense spending. However, led by PLN, the region’s assets were performing very defensively ahead of the summit due to various forms of idiosyncratic risk, which markets would naturally extend into loss of EU or NATO funding. It does come as a surprise that Spain could face some financial strains in the wake of President Trump’s warning that tariffs would double on Spanish exports to the U.S., though we struggle to see how such carve-outs are possible in an EU-U.S. deal. Even Hungary, which is traditionally seen as being at risk of funding loss due to policy differences with Brussels, has accepted the 5% figure but called for the EU to reform its fiscal process to allow for national-level flexibility. This is a view that will be widely shared across the EU. The biggest beneficiary of increased investment on NATO’s eastern flank remains Poland, and we can see that inflows in recent sessions have been very strong and the currency has gone some way toward offsetting the severe outflows that occurred around the presidential election.

Forward look

The National Bank of Poland’s decision is the only major policy event in emerging markets next week and the market expects the policy board to maintain current settings while opening up a chance of a move in September. Assuming the global risk environment remains favorable, albeit with some reluctance, flow preference will be in markets which have recently underperformed. As stated above, positioning in high-performing Eurozone assets now look excessive so it is an opportunity for the CEE region to generate some rebalancing interest in its favor. Even on a standalone basis, the currency has enough scope to revert to its traditionally overheld position as the tailwinds from the NATO summit and stable domestic fundamentals are accounted for.

APAC FX flows turning favorable amid equity resilience

EXHIBIT #3: HOLDINGS IN APAC FX AND EM APAC EQUITIES

_Source: BNY

Our take

If markets are concerned about excessive total return exposures to Europe and are starting to hedge out their currency risk, the opposite is happening in APAC. Holdings have surged above the 1-year average in EM APAC equities, representing a gain of over 15% (comprised of changes in levels and flow) since the end of April. During the initial improvement phase in May, we noted that there was a notable period of hedging interest through the end of May – actively encouraged by the region’s central banks, which feared export losses on real money portfolios which are traditionally overweight U.S. assets. The Hong Kong Monetary Authority’s push of USDHKD toward the top of the trading band even as the initial public offerings pipeline in the market accelerates is a clear sign of unease with equity flow trends. However, markets are not taking this policy view to heart as the past two weeks have seen a sharp reduction in underheld positions in APAC FX even as equity exposures are rising. This indicates that asset allocators see value in owning APAC FX outright.

Forward look

From a valuations perspective, we agree with the view that APAC FX needs to appreciate. This remains a part of the natural rebalancing process of economies: if it has happened in Europe for much of H1 with much success, there is no reason for APAC central banks to show excessive concern. Allowing a period of FX strength may even help in trade negotiations with the U.S., even though many officials in the region have explicitly stated that a stronger currency is not a U.S. demand. We remain cautiously optimistic on APACF FX for now but acknowledge that if there is to be a true emulation of European re-rating, fiscal injection is needed. Germany approved a major fiscal package without any domestic political incident this month, and Japan is expected to move on spending ahead of upcoming lower-house elections. Beijing’s intentions remain the biggest source of uncertainty as despite the rhetoric on household support, we have seen very little realization and the burden on monetary stimulus remains excessive.

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