Key Highlights

• Preliminary September PMIs a key test for Eurozone’s “good place”
• China wealth effect may yet offer a positive surprise
• Severe HUF liquidation to lead carry holdings unwindss

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Manufacturing deterioration will put Q4 easing back on the ECB’s agenda

EXHIBIT #1: GERMAN MANUFACTURING AND SERVICES PMI STARTING TO DIVERGE AGAIN

_Source: BNY

Our take

Eurozone event risk remains fixated on the situation in France. Risk premia gauges on French government debt have fallen, but we have not seen any lift in EURUSD, which supports our view that the currency is still not seen as a favored haven play during times of broader trade and growth stress – all of which can dislodge the ECB from its current “good place.” Escalation of tensions in Sino-U.S. trade relations is generating a reaction amongst European governments, underscoring the impact on the global supply chain of recent developments, which can have a potential knock-on effect on European output. This looks set to exacerbate some of the trends we are already seeing in the manufacturing sector, as leading indicators are starting to show some sign of deterioration again. German manufacturing PMI continues to struggle to return to expansion (Exhibit #1), and the spread against services is widening again, pointing to stagflation risk due to the knock-on impact on wages. Bundesbank President Nagel, a hawk, warned on Wednesday that sticky services inflation means “no complacency” on rates, but this also means that financial conditions will remain too tight for industry and affect growth value-added. This is not a favorable environment for asset allocation.

Forward Look

We continue to see the EUR struggling for the rest of the year and downside surprises in upcoming PMI prints could open the door to December being a live meeting, as ECB hawks will need to see some more consistency in data to accede to easing, even if it is pre-emptive in nature. Meanwhile, apart from some surprises in the luxury goods sector (see below), European equity holdings also appear to have run their course in terms of holdings gains, especially in the defense segment. As this is a long-term investment theme, we don’t see material liquidation from current levels but incremental FX hedging may start to pick up to reduce exposures, especially while costs are relatively low for key investors in the U.S. and the U.K., where yields are more favorable. The ECB and markets that are overweight European assets this year will need to manage risk more actively to stay in a “good place.”

Luxury goods demand rebound could be a sign of equity-driven wealth effect

EXHIBIT #2: CHINA SERVICES AND GOODS IMPORT GROWTH

_{Source: BNY}

Our take

Throughout the year, we have been highlighting the divergence in European sectoral equity performance: defense holdings have surged amid a reinvestment and rearmament drive, while traditionally strong sectors such as luxury goods and automotive continue to struggle. Despite the strong gains in European equity indices this year, holdings of equities in these two industries are barely above the rolling 12-month average, and weak Chinese demand has been a critical factor for the lag. China’s impact on the automotive sector is more complex as now there is direct competition with European carmakers, not just in China but globally.

However, luxury goods is one area where European names have very little international competition, and poor revenue and earnings growth has been a function of softening demand, especially in China: the 2023 post-COVID reopening did not generate a sizeable boost, but there was demand in place only at the right price: companies noted strong purchases by Chinese tourists in Japan, which helped boost bottom lines, mostly due to the weak JPY.  Such behavior is now seen as symptomatic of China’s economy in general: volume growth without price growth, keeping disinflation pressures in place. Based on the latest earnings reports by key European luxury goods names, this may be about to change.

Forward look

Recently we highlighted some concern over large levels of retail participation in Chinese equity and gold markets. While there were clear risks of a major correction, the strength of the rally and the recent holiday season were also a good exercise in assessing whether a wealth effect was coming through the economy. Initial reports from the Golden Week holiday appear to support the “volumes more than values” narrative, but luxury goods companies highlighted surprising sales growth in China proper. Although we began the year arguing that a stronger CNY was not consistent with China’s inflation objectives, if it can help reduce import prices for discretionary goods such as luxury products, there are ancillary benefits as well to the Chinese economy. For example, Beijing would prefer the services value-added of the sale take place domestically rather than in Japan or elsewhere where exchange rates make a difference. Despite trade disputes, import demand for goods and services is broadly flat (Exhibit #2) at present rather than contracting, and CNY resilience is seen as complementary to this process. It will take time before the wealth drag from real estate is digested and some effects will be permanent, but we believe Beijing is now far more open to broader forms of asset appreciation to drive growth.

HUF now facing the strongest outflow in three years and leads carry liquidation

EXHIBIT #3: WEEKLY AVERAGE FLOW AND HOLDINGS

_{Source: BNY, Macrobond}

Our take

With iFlow Carry now moving back to neutral and at a pace which suggests a shift to negative significance is possible, there is value in early identification of some potential liquidation targets. We have been eyeing HUF for some time, and for the first time in three years there has been a sharp swing in sentiment. Although the current round of selling is the strongest in that time, current holdings levels in HUF remain comfortably above the rolling 1-year average. HUF has been net underheld before and with rates across CEE set to fall further, support will be more limited.

Forward look

The recent selloff in HUF also underscores the role of prior positioning in amplifying trend reversals. Before the October shift, HUF also went on its best buying spree in the last three years as well – with four straight weeks of net inflows average at 1.0 in scored flow (weekly average basis) or higher. There have been longer streaks in the past but with far less conviction. We have also highlighted the strength of underlying asset flow contributing to the process, which likely left asset owners extremely over-exposed on the currency side. Given expectations of further policy easing and limited fiscal impulse, HUF and much of CEE will likely see bonds continue to be well-supported, but hedging flows will likely accelerate as hedging costs fall. We anticipate such positions will be repeated across EMEA and Latin America

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