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: EUROZONE DEBT HOLDINGS VS. EUR HOLDINGS (INVERTED)
Source: BNY
Our take
We suspect that ECB President Lagarde will be asked more questions about the situation in her home country than monetary policy during tomorrow’s post-decision press conference. Even so, we are not seeing much of a spillover effect from French Prime Minister Bayrou’s resignation on broader Eurozone exposures. Should circumstances change, e.g., if elections are called, positioning may adjust accordingly but it appears that the steady accumulation of exposures remains the norm, and this will continue to be the case as markets progressively price in an increasingly dovish Fed path. After a lull through the end of Q2, we observe that market holdings of Eurozone sovereign debt are picking up again, which is broadly in line with the policy path. Indeed, even with the news of the confidence vote in France, flows into the OAT market remained very strong. What’s more interesting is that despite a notable rate gap, EUR hedging interest did not pick up to reflect some additional risk. Current cross-border holdings in the EUR are slightly below levels seen in mid-August (Exhibit #1) as the Fed’s outlook comes into play.
Forward look
Except for the JPY and NOK, cross-border positions around the G10 continue to congregate around the –1.0 level, indicating very little change in hedging interest relative to the rolling 12-month average. Even the dollar, at –1.15, does not indicate a strong preference to add to defensive positioning. We believe the market simply sees the policy paths canceling each other out, and any material hedging adjustments up ahead will depend on asset exposures rather than significant changes in FX valuations or interest rate movements. On the other hand, by definition, equilibria is meant to be disturbed, but idiosyncratic risk in European sovereigns doesn’t appear to be strong enough a force to do so.
EXHIBIT #2: EM APAC EQUITY FLOWS VS. CHINA EQUITY FLOWS
Source: BNY
Our take
It is understandable that the market’s political focus will remain on developed markets due to the sheer size of their assets and importance in asset allocation. However, the recent emergence of turbulence across emerging markets in South and Southeast Asia warrant close monitoring. Although local triggers and drivers differ, the populist grievances are similar to what we have seen in the developed world as well. Furthermore, some of the economies – such as Indonesia and Thailand – have until recently been seen as more attractive destinations due to favorable valuations and the prospect of better trend growth. For example, we have often cited Indonesia’s industrial policy on nickel reserves as a benchmark for global commodity producers to move up the value chain. Furthermore, Southeast Asian economies today are far more resilient in their funding mix thanks to stronger domestic savings, and monetary policy remains highly credible. However, global trade realignment and sluggish Chinese growth have challenged the growth narrative, only to be exacerbated by political developments, which international investors fear could destabilize fiscal and monetary policy trajectories.
Forward look
So far, while volatility has picked up, we do not see any prospect of material de-rating in Indonesia and Thailand or any spillover effects in the broader region. However, central banks will exercise extreme vigilance to provide currency support, and the broader dollar and Fed easing environment should also help with the process. Policy credibility remains crucial, which explains new Indonesian Finance Minister Purbaya’s immediate commitment to the budget deficit cap of 3% of GDP – a level which most G7 economies are struggling to reach. By all accounts, iFlow is not showing any sign of capital flight. Comparing flows into broader EM APAC vs. flows into China (which dominates the aggregate number), the former is outperforming marginally (Exhibit #2). Overall flows have been positive since trade global tensions eased in mid-Q2, but general positioning is not extreme and the marginal impact of the latest news is easing by the day. Nonetheless, there is a strong need for the economies in the region to rebalance their economies and shift swiftly toward domestic demand and productivity growth. Previous paths trodden by China and the Asian tiger economies up the manufacturing value chain may no longer be open or may, at least, be much narrower, and finding alternative routes toward middle- or higher-income status has become far more urgent.
EXHIBIT #3: SMOOTHED MONTHLY FLOW IN GILTS AND OATS, CROSS-BORDER INVESTORS ONLY
Source: BNY
Our take
For now, the political machinations in London and Paris are not causing additional stress in European sovereign bond markets and we would avoid comparisons with previous rounds of severe volatility in the respective markets. iFlow shows that both the gilt and OAT markets have been performing well since late Q2, and undoubtedly there were some tailwinds from the developments in U.S. Treasury markets earlier. However, given that fiscal trajectories in both the U.K. and France are not much better than that of the U.S., and without the productivity and demographics to match, cross-border investors appear to be limiting their exposure. In the OAT market, flows remain positive among non-EUR based investors and will remain a significant source of liquidity for their EUR allocations. However, flow averages are softer compared to flows from Eurozone investors. Cross-border interest in U.K. gilts has been comparatively poor throughout the year (Exhibit #3). The recent moves did not result in any form of “surge liquidation,” but the divergence vs. France is notable, suggesting that cross-border investors do not feel there is adequate compensation vis-à-vis the fiscal premia.
Forward look
The Bank of England has less capacity to cut rates relative to the ECB at present and the starting point for base rates is higher, which is generating greater upward pressure on funding costs. Furthermore, France can fall back on broader Eurozone sovereign balance sheets, and the upcoming EU budget will contain much stronger provisions for joint issuance, albeit mostly for defense purposes. In contrast, the U.K. has greater funding pressures on the external side and we believe one critical element is the current lack of weakness in GBP. The EUR is also highly valued, but this is more a reflection of manageable aggregate deficits. A better comparison for gilts is the U.S. Treasury market: in April, iFlow identified strong inflows back into the long end of the U.S. Treasury curve by international investors, even as the curve was steepening. Yields aside, we felt the sharp move in the dollar offered additional value for international clients and a similar adjustment is needed for gilts for cross-border flows to improve.
