Key Highlights

• European FX valuations tolerable until inflation falls
• Fiscal direction will help or hinder currencies of economies in stagflation
• Indonesia and Turkey a timely reminder of positioning risk

European currency rally can continue until strength eats into earnings incomes

EXHIBIT #1: EQUITY INDEX VS. FX CORRELATIONS IN EUROPE

^{Source: BNY}

Our take

Germany’s new fiscal plans have passed the Bundestag without incident. Although the funds will take time to feed through to the domestic and Eurozone economy, the market is increasingly confident that this will have a lasting positive effect on Germany’s growth structure. Consequently, valuation models will also change for German and European assets. Equities will show lower dependence on external demand and FX earnings translation will decline over time. However, the timing is important and displacing foreign earnings too quickly could weigh on performance. Re-rating and rotation have pushed the performance correlation between European currencies (EUR, SEK and CHF) and their respective stock indices to the highest positive levels in three quarters. In light of the tariff risks from the US and demand weakness in China, this relationship is not sustainable.

Forward look

Our data shows that EUR underheld positions are close to normalising as there is some convergence in terminal rate expectations between the ECB and the Fed. The recent re-pricing in equity markets has pushed valuations out of line with earnings expectations: consensus estimates for Q1 EPS are flat for the Stoxx 600, while estimates for Q2 EPS have declined by 4.3% year-to-date, partially reflecting the 2% gain in the euro’s nominal effective exchange rate (NEER). However, the index itself is up by 18.7%. ECB tolerance for the euro surge could also come into question if tradables inflation declines later in the year as export income falls, which could have a knock-on effect on non-tradable income. Europe is not yet at escape velocity for the euro to become a growth currency with a permanently positive correlation to earnings and equity performance. We believe levels are approaching where hedge ratios must start growing again on cross-border investment into Europe, and associated currencies will peak accordingly.

Stagflation risk becoming prevalent globally, but currency responses will differ

EXHIBIT #2: DISTRIBUTION OF INFLATION FORECAST ADJUSTMENTS FOR OECD ECONOMIES

^{Source: OECD, BNY}

Our take

The latest Interim OECD Economic Outlook has a very clear warning for the global economy: stagflation is becoming persistent and more prevalent. Their latest forecast round notes that despite moderating global growth, “inflationary pressures persist in many economies, with headline inflation recently turning up again in an increasing share of economies (Exhibit #2) …and underlying inflation is now projected to remain above central bank targets in many countries in 2026.” What was once seen as more of story isolated to the UK and some commodity bloc economies is spreading as supply problems in labour and goods persist. Stagflation is often unfavourable for currencies as asset allocation disfavours such economies. In this “race to the bottom,” fiscal resources matter more and will have a major bearing on currency performance.

Forward look

Getting fiscal right is crucial for economies in stagflation. Higher inflation in the Eurozone is no longer a drag on the euro because real rates are now higher. The market sees the productivity boost from impending fiscal stimulus to offset supply problems over time. This narrative is credible because Germany and the Eurozone have fiscal headroom. In contrast, the UK does not have this luxury – as the mini-budget of 2022 showed – so fiscal restraint to help “engineer a slowdown” matters even more than monetary policy to bring inflation back to target. The New Zealand dollar, in our view, remains the most attractive currency in this context as fiscal restraint has helped bring down inflation to the extent that the central bank has more space to cut rates than expected. In turn, the outlook for real rates is increasingly positive and will support the NZD on the crosses.

Idiosyncratic risk is amplified when positioning is crowded

EXHIBIT #3: IDR AND TRY CURRENCY HOLDINGS VS. ALL EM CURRENCY HOLDINGS

^{Source: BNY}

Our take

The domestic drivers behind recent volatility in Indonesian and Turkish markets may have served as triggers, but we believe the main reason behind the extreme moves is that these are very popular positions, driven by high carry and favourable long-term narratives. TRY’s experience this week yielded some spillover effects as markets have markedly increased exposures to the country over the last 12 months. Both countries are strategically important in their respective regions so spillover risk from financial instability remains high. We do not seem them as isolated incidents, but at the same time we acknowledge that global resilience against such shocks is also strong, not least because of a growth in emerging market home bias, thereby limiting the risk of destabilising capital outflows.

Forward look

The TRY and IDR remain materially overheld, but profitability risk is now high, and we expect a return to neutral levels in these currencies soon, even though idiosyncratic risk remains high. Although the market is not in a strictly pro-EM FX or pro-carry environment, we note that EM FX holdings have now recovered to the best levels since the US election last year (Exhibit #3). There is some concentration risk in CEE currencies and more recently, Latin American currencies have done well. Even though the CLP, BRL and MXN have acquitted themselves well of late, domestic risks are never far away, on top of external issues such as trade and weak commodity prices. We expect these currencies to come under pressure in the near term.

Bottom line

Outside of the US, positive narratives have started to run their course, and the Fed decision overnight indicates that although the dollar has peaked, policy differentials remain fluid and not clear enough to sustain a prolonged bear trend. As inflation globally is revised higher, financial conditions need to remain tight and slip-ups are possible from all corners. It is increasingly apparent that fiscal policy is the most important adjustment mechanism to bring economies back into balanced price and output growth. Those who move early and/or credibly will reap the benefits of asset allocation.

Additional Charts

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