Key Highlights

• FX hedging the only way to mitigate the pain of higher equities
• Energy and materials equity holdings still inconsistent with demand outlook
• EM duration back in play but EM EMEA struggles for traction

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Hedges rising, with recovering NAVs pointing to very limited appetite for FX risk

EXHIBIT #1: QUARTER-TO-DATE EUR HOLDINGS VS. DM EMEA EQUITY HOLDINGS

_Source: BNY

Like almost every single risk event over the past quarter, geopolitical issues in the Middle East are now considered resolved and markets are reverting to a risk-on form. The “U.S. exceptionalism” case for equities is seemingly back on track, but with higher levels of hedging to reflect associated trade, fiscal and geopolitical risks which will likely continue to come and go over the medium term. Such behavior is now extending globally. For example, European equities are a few percentage points away from record highs again, and our flows show that EUR hedges are building up due to valuation concerns. The pain trade is clearly equities higher, but asset allocators appear determined to minimize FX exposures for now.

Our take

In his testimony before the House of Lords yesterday, Bank of England Governor Andrew Bailey highlighted that investors are rethinking overweight dollar positions. This may be true as we have seen in iFlow how cross-border hedging of the dollar has picked up along with an improvement in U.S. asset holdings. Yet, the dollar’s safety properties, as seen over the past two weeks, indicate that non-dollar asset holdings cannot run low hedge ratios either. As FX correlations remain fluid and valuations look rich, it is prudent for asset allocators to minimize volatility where discretionary control is stronger, such as FX.

Forward look

Risk on and equities higher remains the pain trade, but the dollar is no longer benefiting from unhedged cross-border inflows. The prospect of earlier Fed cuts will only add to hedging interest as rate differentials narrow. However, other equity markets are not seeing their own versions of “exceptionalism” due to persistent geopolitical risk and earnings translation headwinds. Consequently, the contribution of FX to portfolio returns in H2 could prove more muted.

Cyclical sectors continue to recover, challenging current growth outlook

EXHIBIT #2: YEAR-TO-DATE DEVELOPED MARKET ENERGY AND MATERIALS INDUSTRY GROUP HOLDINGS

_{Source: BNY}

Oil prices are very soft this week as geopolitical tensions and supply risks from the Middle East ease, but there appears to be very little sign that equity holdings are “normalizing” back to valuations consistent with Brent below $70/bbl and bearish or recessionary pricing back in the crude market. This does not appear to be a crude-only story either as materials equities are now well above April lows and even above the average level over the past year.

Our take

Both industries are pricing in an earnings outlook for equities which is totally inconsistent with expected growth and demand. If the pain trade remains prevalent for equity investors, then it is possible that these holdings were necessary because cyclical industries were the only source of value left in global equity markets. This is our base case, but we need to be cognizant of the tail risk that a global growth upswing cannot be ruled out. This week’s survey data out of Europe, for example, has surprised across the board, especially related to output indices.

Forward look

We recently cited the International Energy Agency’s “Oil 2025 publication,” which clearly states that “a peak in global oil demand is still on the horizon.” Supply disruptions, by definition, are short-term in nature and cannot offset the recalibration of OPEC+ supply versus structurally weaker demand. For miners and the broader materials sector, China’s marginal demand is not growing strongly enough to support a price lift. Furthermore, downside pressure on producer prices due to stiff domestic competition in industrial outputs will continue to challenge raw materials costs. If China delivers fiscal stimulus along German lines, then we would see merit in reassessing valuations, but such prospects look very limited for the remainder of the year.

LatAm sovereign flow set to overtake EM EMEA flow again

EXHIBIT #3: MONTHLY SMOOTHED FLOW, EM LATIN AMERICA AND EM EMEA SOVEREIGN BONDS

_{Source: BNY}

Given the lack of interest in owning outright FX risk, for carry-seeking macro positions we continue to see emerging market (EM) duration as the most likely destination. However, contrary to our expectations, EM EMEA duration continues to struggle and on a monthly smoothed basis, flows back into Latin America duration look set to overtake EM EMEA again – which in fairness has been the natural position throughout the year due to high nominal yields.

Our take

Monetary policy is generally tight across EM EMEA and Latin America, but asset allocators have continued to limit their appetite for broader allocation to these assets. Original prospects for good diversification flow out of the U.S. between mid-April and early May swiftly gave way to geopolitical concerns. Presently, flow momentum for duration in both markets is soft, but EM EMEA is clearly struggling more. Given the current ECB and Fed outlook, markets may have concluded that policy space for EM EMEA has all but closed. In contrast, given the high starting point for nominal rates in Latin America, there is still scope to build positioning.

Forward look

We believe that flows back into EM duration in general is a long-term trend, but much will depend on asset liquidity as much as quality. This is one area where EM EMEA will never be able to match that of Latin America or EM APAC. For CEE, with Eurozone entry largely off the agenda, investment flow will likely remain specialized. Turkey and South Africa are stronger prospects, and real rate improvements in both will help stabilize flow, subject to tariff developments over the coming weeks. In contrast, high nominal yields, led by Brazil and Mexico, continue to anchor demand. Similar to the surprising gains in materials equities, Latin America duration may also be seen as a value play given markets are not positioned for a cyclical upswing. However, we expect hedge ratios to stay relatively high for EM duration globally.

Bottom line

We acknowledge that risk appetite looks set for a period of robust performance as defensive positions established around early June roll off. On the other hand, with U.S. fiscal risks and tariff deadlines approaching, the “risk on pain trade” across different assets look more measured, especially in FX markets. Nonetheless, we continue to question the durability of such flows given the cyclical outlook. The marginal impact of discrete event risk is diminishing, but earnings and sustained data disappointments will be far harder to dismiss.

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