Key Highlights

• BoE and RBA both flag stagflation but currency outcomes differ
• Prospect of Ukraine deal may upend European sector allocations
• China reflation pricing creeping into bond holdings

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Clear recovery in GBP flow affirms BoE’s stagflation view

EXHIBIT #1:  CROSS-BORDER HOLDINGS, AUD AND GBP

_Source: BNY

Our take

July’s U.S. CPI figures may not have generated too much of a surprise, but the prospect of global stagflation continues to linger and will likely be addressed at the upcoming Fed meeting. The recent Bank of England and Reserve Bank of Australia decisions both addressed sharp divisions within policy bodies regarding the state of the labor market, particularly why clear loosening in job creation was not translating into softer wages. Productivity challenges are generally seen as the culprit, as shown by the RBA’s statement that “wages growth has eased from its peak but productivity growth has not picked up and growth in unit labor costs remains high.” Such conclusions normally preclude aggressive easing up ahead, and both the BoE and RBA were reluctant to pre-commit. Yet we can see that there is far more interest in reducing GBP hedges on a cross-border basis comparatively. Higher benchmark rates might be one aspect, in addition to the four votes on the MPC which stated a preference for a hold. On the other hand, not all economies’ inflation (or even stagflation) impulse are created equal. The market continues to assign a material discount to Australian growth from China factors, such that the external drag on prices is expected to continue having a strong effect on monetary policy.

Forward look

The September Fed meeting may reveal divisions similar to the BoE, but labor-based stagflation fears in the U.S. – while clearly present – will likely be more subdued compared to the U.K. and Australia. For example, U.S. core services inflation is running at 2.2% y/y vs. 4.7% y/y in the U.K. The U.K. labor market’s structural deficiencies are well known, while Australia’s current predicament has some “Dutch disease” elements to it and will take time to adjust – and part of the process requires prolonged real effective exchange rate weakness through the nominal channel. Tariff transmission is a clear risk to U.S. prices, but on the other hand the country’s productivity advantages, especially on a relative basis, are not in doubt and continue lending some support to real wages. Stagflation seldom presents a positive case for asset allocation, but we expect currency reaction functions to be highly idiosyncratic.

European defense holdings buckling, while energy finally moves above 1-year average

EXHIBIT #2: EQUITY HOLDINGS, AEROSPACE AND DEFENSE VS. ENERGY, DM EMEA

_{Source: BNY}

Our take

The European Commission and national governments are clearly perturbed at the prospect of being shut out of the Alaska Summit and a role in determining the terms of any ceasefire or settlement in Ukraine. However, it appears the market is taking a different approach with respect to the risks to asset allocation. Primarily, there is understandable concern that any durable ceasefire may reduce demand for defense products on the margins. It’s important to recognize that this is not a de-rating story for European growth: investors do not question the funding ability, investment intent and the allocations for European reinvestment, but if the balance shifts further toward infrastructure and more conventional expenditure (which may still loosely be classified as defense, e.g. the Strait of Messina Bridge project), then sectoral allocations require material adjustment. After peaking at nearly 60% above the rolling one-year average, developed European defense holdings are adjusting lower. Such a drift is not new and the result of the summit is highly uncertain, but there is reason to be more defensive than usual due the nature of even risk.

Forward look

Due to challenging external conditions, we do not foresee the likes of automotive or luxury goods sectors improving soon. Meanwhile, sector-specific tariffs continue to loom over pharmaceuticals, and we suspect that the EU is still working to confirm that its current trade deal with the U.S. represents a hard ceiling. One sector which has underperformed globally this year but has finally moved above its rolling 12-month average is energy (Exhibit #2). Given the cautious view on growth issued by energy and commodity agencies, we doubt the 20% uplift in holdings over the past three months is due to demand prospects. Furthermore, as any ceasefire is likely to exert further downside pressure on oil prices, margin expansion is also off the table. Overall, we see Europe now moving relatively early toward a more defensive asset allocation posture, moving away from investment growth-supported sectors to a dividend-based framework. Income-based allocations will likely strengthen with the prospect of renewed ECB cuts.

CGB moves above 1-year average holdings, narrows gap versus peers

EXHIBIT #3: SOVEREIGN BOND HOLDINGS. CHINA VS. EM APAC

_{Source: BNY}

Our take

One region where central banks certainly wouldn’t mind inflation rising is in APAC. Although the tariff truce between China and the U.S. has been rolled into November, the lack of certainty for economies in the region in their tariff schedules probably means that the discount to growth generated from falling external demand will extend for the rest of the year, and this is even before sector- or product-specific tariffs bite. Furthermore, the dollar’s soft performance against regional currencies has also prevented any positive pass-through risk, though we acknowledge that EM APAC central banks have generally adopted a stance favoring currency stability for now. Disinflation is normally a good environment for bond performance, but outright levels matter and the policy trajectory for the region has deterred surge flow. On the other hand, there are certainly green shoots for prices in China in the healthiest possible manner, where core inflation has strengthened to the highest levels in 15 months, albeit at low levels. Even so, yields are starting to grind higher in the CGB market, and in recent sessions our data show that holdings figures for the asset class have moved above the rolling 12-month average for the first time this year. Overall EM APAC holdings have also been better held over the past two months, but the improvement in CGB holdings is faster – allowing its holdings gap vs. regional peers to close to the lowest levels year-to-date (Exhibit #3).

Forward look

The front-end of Asian sovereign bond curve is expected to remain well anchored and we expect a generally accommodative approach to continue, but with a different focus. For much of Asia, if volatile trade relations with the U.S. are the “new normal,” we expect governments to redouble efforts to stimulate domestic demand. The latest initiative from Beijing – subsidized interest rates for consumer loans – is another example of credit enhancement which requires low policy rates. However, if core inflation in China continues to rise, coupled with stronger purchasing power as a result of sustained CNY resilience, there will be hopes that medium-term growth expectations can rise and result in some healthy steepening in curves throughout the region. China exporting some inflation based on domestic demand pull rather than the traditional commodity price channel is highly beneficial for EM APAC which needs to diversify from U.S. demand. Furthermore, with soft current inflation, real rates can also improve without relying on low or even negative deflators (the case in China for much of the last few years), which makes cross-border inflows a much better proposition. However, we note that any such flows from dollar-based investors will likely retain high hedge ratios due to low APAC policy rates, at least until the Fed outlook takes a decisively dovish turn.

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