iFlow > Investor Trends
Appearing every Wednesday, Investor Trends provides a deep dive into patterns and behaviors in equity, bond and currency markets around the globe, underpinned with deeper macro insights.
Geoff Yu
Time to Read: 5 minutes
EXHIBIT #1: SMOOTHED WEEKLY FLOW, EURUSD AND EURGBP
Source: BNY
Our take
With the September ECB decision fast approaching, we acknowledge that the risk of a cut is very low. If anything, the hawkish members of the Governing Council have found their voices – with Isabel Schnabel even warning that global central banks need to thinking about hiking rates earlier than desired due to inflation risk. The flash CPI figures for the Eurozone show inflation being on-target but, crucially, sequential figures remain positive and there is no sign of negative pass-through. The shift in rate pricing – with the Fed still set to cut in September with even higher headline inflation levels – is starting to exert itself in flow trends. Through July, the EUR was clearly net sold against the dollar and GBP amid the “higher for longer” narrative in the U.S. and U.K. (Exhibit #1). However, this turned around materially in August, with the EUR managing net purchases on both legs. The shift in Fed pricing is evident, while EURGBP is now seen as a “differentiation” barometer for European stagflation, and this is a race which the Eurozone is happily losing.
Forward look
The outcome of political matters in France may yet have an impact on Eurozone asset allocation. ECB President Lagarde stressed Monday that European fiscal matters need to be addressed, but the market appears comfortable pricing in risks through the bond market alone rather than via the currency. This stands in contrast to the U.K., where the long gilt vs. GBP correlation has snapped back into place, as bond prices and the currency fall in tandem. Even more worryingly, the declines in the latter are not supporting the FTSE 100 through earnings translation, which indicates more comprehensive asset outflows. As the franc also faces its own idiosyncratic issues, the market might, with some reluctance, be stuck with the euro for now as a safety valve. However, as ECB member Simkus warned, October could see a rate cut back on the agenda: in the current environment, allowing unimpeded euro strength as risk premia rises globally is not conducive to policy objectives either.
EXHIBIT #2: EQUITY HOLDINGS, SOUTH AFRICA, BRAZIL AND INDIA
Source: BNY
Our take
The global geopolitical focus this week has shifted to China this week as the leaders of the Shanghai Cooperation Organisation and other heads of state revisit their own alignments or strategic postures in an increasingly uncertain world. Trade is at the forefront of talks, and Brazil’s President Lula is seeking to maintain the momentum from Tianjin by convening a virtual meeting of BRICS leaders next Monday to discuss Donald Trump’s trade policy. The leaders of the Brazil, South Africa and India were all present in China. All three face “punitive” tariffs, so the push for a response or alternatives is understandable. However, geopolitics aside, we note that the market is taking the economic risks in stride. As of the end of August, our data indicate that none of these three markets are currently at a holdings discount in their equity markets (Exhibit #2), as measured in terms of current holdings relative to the rolling 12-month average level. In all three cases, manufacturing export exposure to the U.S. is limited, and we believe long-term investors are more focused on improved domestic demand and higher growth figures, rather than being a part of the international manufacturing supply chain, which is the case in much of Asia.
Forward look
We acknowledge that these three markets can serve as strong diversifiers in global equity portfolios. The current clamor for “real asset” protection in commodities, especially gold, may lend Brazil and South Africa further support. Crucially, policy credibility on the monetary and fiscal side is strong in all three, with general fiscal prudence anchored by hawkish central banks. However, within iFlow, equities is probably the worst-performing asset class. Holdings of INR, BRL and ZAR are comfortably positive while bond flows are also solid. The bottom line is that market exposure to total country risk is looking excessive, even relative to a positive story. Some hedging needs to start coming through, and we believe paring back currency longs is the most efficient approach, especially as high real rates continue to support local duration.
EXHIBIT #3: SHORT UTILIZATION, EUROPEAN SOVEREIGNS WITH MATURITIES OF 10Y+
Source: BNY
Our take
Weak fiscal trajectories in the U.K. and France are not new, but operational decisions by the prime ministers of France and the U.K. have added to the sense of uncertainty. As of yesterday, the yields on 30y French and U.K. government bonds have hit multi-decade highs as the market is struggling see any path leading to clear improvement in conditions. Domestic policy execution aside, the current monetary policy environment is clearly having an impact on yield curves: the ECB is ruling out near-term rate cuts, while the Bank of England, based on current data, is also unable to communicate a clear easing cycle, even from a high baseline. Nor is the situation in the U.S. helping, as steepening in the U.S. Treasury curve tends to have a similar knock-on effect globally. The biggest in issue in Europe, however, is the acute lack of growth and productivity gains, and this is where we see term premia being affected the most. August saw a sharp rise in short utilization (Exhibit #3) in the 10y+ part of the curve, whereas investors still see adequate compensation in current U.S. yields and dollar levels.
Forward look
We expect steepening risk to remain in place in Europe due to stagflation concerns, though the U.K. arguably faces bigger challenges in the near-term and gilt markets will remain on the defensive ahead of the budget in Q4. In contrast, France will enjoy the broader German and Eurozone fiscal anchor, especially as joint issuance is not as controversial as it was in the past, especially with greater defense spending in play, in which France will play an integral role. However, gilts also remain a secondary reserve asset, and we would also not rule out similar behavior vs. the U.S. Treasury market in Q2, where after “Liberation Day,” the fall in the dollar and much higher yields generated significant external demand. We see further GBP declines as necessary to generate similar interest, as the record level of bids for the October 2035 gilt indicates yields are already offering adequate “compensation.” We believe that like the U.S., the bond markets in the U.K. and France will continue to challenge the upper bounds of yields until clear evidence of spending restraint is seen.
