Key Highlights

• Dollar not seeing any additional tariff premia
• EM equity flows defying tariff risk
• Foreign investors keeping the faith with gilts for now

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Dollar flow and holdings behavior unlikely to resemble April

EXHIBIT #1: YEAR-TO-DATE USD HOLDINGS, CROSS-BORDER BASIS

_Source: BNY

Our take

Current behavior in the dollar is completely different compared to April, when markets were blindsided by the size of the tariffs and subsequent escalation with China until a détente was reached in May. Based on cross-border positioning data, there has been a modest pick-up in underheld positions, indicating overseas investors are adding to their dollar hedges (Exhibit #1). However, there are several caveats. Firstly, due to strong U.S. asset performance, NAVs have increased in any case and the rise in hedging levels relative to last year’s average could simply be a reflection of recent buoyancy in asset performance. Secondly, if markets truly want to reduce U.S. exposure to tariff risks or other idiosyncratic factors (e.g., fiscal), April’s changes in holdings are far more instructive. We would likely see cross-border holdings improve due to selling of U.S. assets and the lifting of corresponding hedges. Our data indicate there has been no sign of strong asset liquidation since early May.

Forward look

While April is not being repeated, our data continue to show that ongoing dollar hedging indicates “U.S. exceptionalism” strategies are not as strong as before. Based on our best estimates, current increases in underheld dollar positions continue to run ahead of asset price increases, which indicates higher overall hedge ratios. This differs from, for example, Q4 2024, during which dollar holdings improved markedly (mostly at the EUR’s expense) while other underlying assets also proved resilient. The dollar has corrected lower materially since April and this has helped compensate for fiscal- and trade-related risk premia, which would otherwise have been reflected in equities and fixed income valuations. We expect a general period of range-bound performance in underlying assets which should also limit additional derogation in dollar holdings in the near term, but renewed challenges can arise as the full impact of tariffs, or even just the associated uncertainty starts to feed into the real economy.

Opportunities sought in EM equities despite tariff risk

EXHIBIT #2: YEAR-TO-DATE WEEKLY SMOOTHED FLOW, EM APAC AND EMEA EQUITIES

_{Source: BNY}

Our take

U.S. equity markets are not alone in showing far stronger immunity to trade-related stress. Despite the lack of deals throughout much of emerging markets, which could result in some very high headline tariff rates, our flow data indicate a resurgence in EM equity exposures. EM APAC equity flows were resilient throughout May and after a brief dip toward quarter-end, Q3 flow interest has started on a strong note. Despite risks stemming from lack of tariffs deals between the wider APAC region and the U.S., the market has been comfortable adding to exposures to capture stronger savings buffers and the prospect of any reflation push in China. EM EMEA interest is more surprising as flows are approaching some of the strongest levels seen this year, even though tariff and idiosyncratic risks remain elevated. For example, over the past week we have seen strong inflows into Poland and South Africa, even with the later facing a combination of domestic political stress and tariff risk. For the MENA region, moderate inflows into the UAE and Turkey are strong enough to overcome light outflows in Egypt and Israel.

Forward look

Fundamentally, we continue to see flows into EM equities as a reallocation story into markets which have been historically under-positioned. Even during the earlier rise in demand for U.S. alternatives this year, the shift was toward concentrated sectors in Europe where the defense and public investment theme was in play. Ease of access and liquidity also played a role, but we have been highlighting that through the end of Q2, and these positions look exhausted and are seeing some reductions. Meanwhile, EM economies are far less exposed to balance of payments stress than during previous cycles. The U.S. stance on trade will not have as much of an impact, and the prospect of the country’s long-term retrenchment from trade globalization has helped redouble EM efforts to push for domestic investment as a primary source of growth, funded by inefficiently allocated domestic savings. There are seasonal aspects to the early Q3 surge, but we believe such flows are a part of a long-term reallocation story, only to be limited by the pace and scale of reforms which will ultimately determine the breadth and depth of the investable universe. Without such changes, U.S. exceptionalism will remain in place by default, with Europe the reluctant core alternative.

Cross-border investors willing to overlook U.K. fiscal risks

EXHIBIT #3: YEAR-TO-DATE HOLDINGS, TOTAL AND CROSS-BORDER FOR U.K. GILTS

_{Source: BNY}

Our take

The U.K. government’s continues to struggle with fiscal credibility. Further industrial action in the publicly funded health sector has been announced, while the Office for Budget Responsibility’s fiscal risks and sustainability report now warns that the country’s debt-to-GDP ratio will likely reach 270% by 2070, and was scathing in its assessments of repeated government inability to grapple with the problem. Given that the U.K. and its assets do not enjoy exorbitant privilege which tends to delay any such reckoning, we find it surprising that cross-border holdings in U.K. assets in general do not look adverse. GBP hedges remain close to the averages seen over the past 12 months, while there has been a surprising surge in holdings of gilts over the past two weeks (Exhibit #3). Similar to what we have seen in long-dated U.S. bonds, it is possible that cross-border investors see adequate compensation for fiscal risks in current yield levels.

Forward look

We believe current positioning in U.K. assets by foreign investors is too benign. Even taking into account higher yields, U.S. Treasurys also benefited from a sharp adjustment in the dollar which further compensated for any idiosyncratic risks. GBP has not seen any such move – even on the crosses where EURGBP’s gains since U.K.-specific risks have come through remain modest. Consequently, we suspect the main trigger will be rate expectations, with the Bank of England looking at resuming rate cuts as there are ongoing signs of inflation (especially wage-based) weakness, albeit at a very slow pace. More dovish monetary policy may help anchor front-end gilt yields, but structural fiscal matters are well beyond the BoE’s control. Although trade and tariffs is one area where the U.K. does not face significant external risks, we anticipate far greater adjustments based on domestic factors as fiscal tests arise in the coming quarter.

Bottom line

The effective extension of trade deal deadlines to August has reassured markets that the upcoming tariff roll-out will not prove as disruptive to markets as in April. Emerging markets on the receiving end of reciprocal tariffs are taking matters in stride, while small-scale and passive reduction of U.S. exposures will continue. Even so, uncertainty itself represents a form of tightening in financial conditions and we expect general risk appetite to stay muted through the coming weeks. 

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