Key Highlights

• EMEA vs. LatAm carry performance diverging sharply
• No sign of international inflow surge into Chinese equities
• Positioning and macro risks growing for France

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EMEA carry holds firm, while LatAm FX hedging pressure rises

EXHIBIT #1:  SMOOTHED MONTHLY FLOWS, EMEA VS. LATAM CURRENCIES

_Source: BNY

Our take

The less hawkish tone espoused by Fed Chair Powell at Jackson Hole has not proven to be a boon for the FX carry trade. We believe that most emerging market central banks will see the shift as increasing their own flexibility for policy adjustments rather than further widening policy differentials. Presently, it is not just the Fed’s rate path that is pressuring the dollar, but, if the net result is a weaker dollar and lower import prices, nominal rates could begin falling again in Q4 for many high-yielding currencies. Furthermore, our iFlow Carry index has been pushing against positive statistical significance for several weeks now. Even if a weaker dollar in the near term gives such strategies a further lift, we would be more inclined to fade these positions on a tactical basis.

Forward look

Our data also show that EMEA is the preferred region even if we assume the current environment is positive for carry. Even though headline rates are lower than LatAm peers, far tighter local labor markets and generally more hawkish policy stances are supporting allocations. Led by Central and Eastern European (CEE) economies, output gaps are very narrow due to strong defense-related investment flows, and neutral rates will likely stay close to current levels. The lack of exposure to U.S. tariffs, at least based on direct trade, is also a source of insulation for currency performance. In contrast, LatAm currencies are being sold and their performance gap vs. EMEA is at its widest point this year (Exhibit #1), led by Mexico and Brazil, while trade tensions with the U.S. remain a source of uncertainty. Risks arising from softer external (U.S.) demand are weighing on sentiment, forcing central banks to be far more defensive and cut rates at the earliest opportunity. A weaker dollar could also help limit pass-through inflation, which is why we favor duration in the region. Our flow data indicate that LatAm fixed income is finding strong demand, but hedging flows are now prevalent and forcing the overall smoothed FX flow to hit the lowest levels this year. In contrast, the likes of Poland, Hungary and South Africa continue to enjoy comprehensive asset rotation, whereby all domestic assets are benefiting from higher demand and holdings. We expect FX hedging to pick up in EMEA as well, but the bar will be higher. A more dovish ECB may be required to complement easier U.S. financial conditions before local central banks begin worrying about excessive currency strength.

External investors face tracking error risk, but inflows will be tentative

EXHIBIT #2: EQUITY INFLOWS INTO CHINA, OFFICIAL FIGURES VS. IFLOW

_{Source: BNY, Macrobond; four-quarter rolling sum}

Our take

Retail flows into Chinese equities have now pushed to the second-highest levels on record, but underlying index performance is struggling in the absence of earnings and macro data validation. While we anticipate some window guidance for domestic institutional asset managers to support the market, the biggest challenge remains attracting cross-border interest. Notwithstanding the risk of higher tracking errors, which would force some rotation, China and Hong Kong equities would likely favor long-term active allocations based on structural re-rating. iFlow data point to clear gains in cross-border flows into Chinese equities. Official National Bureau of Statistics (NBS) data as of March indicate only a slight pick-up in external interest, which suggests that even the February “AI-shock” to markets that precipitated a short period of excess performance in China’s technology sector did not “stop-in” foreign funds. If a theme with such long-term growth prospects fails to elicit stronger cross-border flows, it is difficult to see what will. Our leading equity flow indicator suggests that Q2 and Q3 inflows will turn the four-quarter rolling sum back into positive, but compared to surge flows before Q4 2021, interest is not strong.

Forward look

Tech is a strategic focus for Beijing, but in the near term, we continue to view consumer discretionary as the true litmus test of China’s efforts to reform industrial policy, enhance corporate profitability and lift corporate earnings, with a trickle-down effect into household spending. Consequently, this is the sector where price expectations must adjust and where improvements in household sentiment will be most visible. Yet, based on flows into EM Asia-Pacific consumer discretionary, this remains the weakest-performing sector, indicating confidence is even lower than last year. While we are still targeting sustained performance in Shanghai and Hong Kong indices into Q4, retail participation has probably peaked, and performance volatility will likely pick up. Cross-border interest will be positive, yet tentative, which also leads us to remain cautious on CNY performance.

French debt trajectory rather than stock a risk to OAT holdings

EXHIBIT #3: DEFICIT OUTLOOK, FRANCE, ITALY AND GERMANY

_{Source: BNY, OECD}

Our take

Compared to H2 last year, when French political instability was a persistent source of stress for the euro and OATs, the reaction to yet another confidence vote for another French Prime Minister, which he is expected to lose, is much more benign. Perception of policy risks in the U.S. and sustained dollar weakness may have also contributed to the change, and we acknowledge that there is a different fiscal narrative in place for the European Union. Nonetheless, we expect French bonds to continue performing poorly, and the country’s 10-year borrowing costs will likely rise above the Italian equivalent soon. Fiscal consolidation is a national imperative: The OECD warned in its latest update that “a softer stance on fiscal consolidation would support growth but push up the public debt ratio, raising bond yields and crowding out private investment.” Italy’s fiscal “starting line,” measured by public debt to GDP, may be high, but there is no sign of deterioration, and public investment prospects remain strong. The OECD even expects Italy’s budget deficit next year to run below Germany’s, while France’s is the only major Eurozone economy to struggle to manage a deficit below 5% of GDP, let alone the 3% Maastricht criteria. Lack of fiscal consolidation risks overshooting these levels (Exhibit #3).

Forward look

Our data also show that flows into OATs are extremely crowded after a surge in flows over the past quarter. Some flows may have been attributable to diversification away from U.S. Treasurys, and the OAT market does offer higher yields and liquidity relative to Bunds. However, this also means that the market risks repeating the process in Q2 last year, where similar reasons (liquidity and yields) pushed asset allocation preference into OATs due to a simple lack of availability in Bunds, while BTPs probably suffered from some stigma aspects. Germany’s new fiscal narrative and clear improvement in Italian numbers have eroded any perceived OAT benefits, while debt servicing will see limited relief as the ECB approaches terminal levels. Current levels of OAT positioning risk an even stronger round of sales compared to June last year after the snap election was called. The politics may yet prove less dramatic this time, but pent-up outflow risk is extremely high — another reason for the ECB to not call time yet on easing.

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