Key Highlights

• Short interest rising in bunds, not the DAX
• Foreign participation fades again in China
• U.S. still in love with buying the dip

Fading perfection pricing in Germany

EXHIBIT #1: CHANGE IN SHORT INTEREST, BUNDS AND GERMAN EQUITIES SINCE JANUARY 1, 2025

^{Source: BNY}

Re-pricing of fiscal impulse and European defense autonomy has been the biggest investment theme in Q1 this year. The speed at which Germany tore up decades of fiscal and strategic convention caught global investors by surprise. Based on our data, non-Eurozone investors have been under-allocated in Eurozone stocks. As a result, their portfolio performance has lagged behind Eurozone asset managers. Coupled with the underperformance in U.S. equities, investors with global mandates will be under pressure to increase European allocations. However, our data also point to the re-emergence of tactical interest to inject some risk premia into German assets, especially fixed income.

Our take

We are sympathetic to the view that European assets are priced for perfection and the “everything rally” will be challenged. Export exposures remain high, which renders a strong euro incompatible with earnings. On the political front, difficulties forming a new German government will also delay implementation of fiscal plans. Based on our securities short utilization data, investors favor a move lower in bunds rather than equities. Higher bund yields across the curve can be considered “healthy” as trend growth repriced higher after the fiscal push, but the less healthy aspects of fiscal spending may come to the fore.

Forward look

The head of the Ifo Institute, Dr. Clemens Füst, highlighted that although sentiment in Germany has improved, poor execution of fiscal plans could exacerbate stagflation, especially if public funds move too aggressively into sectors with ongoing supply challenges such as construction. The ECB’s March refusal to commit to further easing supports the view that price risks are building. Corporates are in a better position to protect margins, while the lack of cross-border ownership of German equities should also support holdings. Tariffs represent a further risk to growth and inflation returning to target. Bear steepening is a clear risk now in Germany and across the Eurozone, and we expect short utilization to recover back the highs seen in early February.

China less “un-investable” to foreign investors

EXHIBIT #2: CROSS-BORDER FLOWS AND HOLDINGS IN CHINESE EQUITIES

^{Source: BNY}

Cross-border investors will continue to play catch-up in Europe, but our data do not show similar efforts with respect to the China AI/tech rally. Chinese equities look set to end the month as the best-performing emerging market name, but our data show that surge flow was ephemeral and month-end re-allocations will be light. Given quarter-end rebalancing needs after the strong performance of the index through the past few weeks, the risk is strong profit-taking or a sharp rise in USDCNY hedging ahead of the April 2 tariff announcements.

Our take

In our view, much of the market continues to see China as “un-investable,” though this is mostly due to structural and geopolitical factors (such as sanctions risk), rather than valuations or the macro growth and earnings outlook. For this reason, even though international participation in the recent China rally is even lower compared to the defense-based repricing of Europe, we do not see the same reallocation pressure coming through. Re-introducing China into investment mandates will be a long process, though existing holdings will likely stay put.

Forward look

Our data point to a weak start for cross-border flows into Chinese equities in Q2. Even discounting subjective factors limiting allocations, we agree that the demand and corporate earnings outlook remains soft for Chinese equities. This is a challenge the government itself acknowledges. With retail participation from Greater China and APAC names forming the bulk of recent gains in the Shanghai and Hong Kong indices, the risk of a valuations-based unwind is high as both domestic and international institutional investors fail to follow through. However, the latter groups are now re-establishing China as a theme and if the growth and earnings cases begin to surprise to the upside, a more durable rally is possible upon data confirmation.

Long U.S. equities, but not bonds

EXHIBIT #3: U.S. CONSUMER SENTIMENT VS. 10-YEAR U.S. YIELDS

^{Source: Bloomberg, BNY}

The drop in soft data in the U.S. continues to worry investors, as future expectations from the U.S. Conference Board falling to 12-year lows. The U.S. growth outlook has dropped considerably, mainly because of tariff uncertainty, leaving companies and consumers waiting to spend. The lack of a reaction by bonds stands out against March washouts in U.S. stocks. U.S. bond yields have not yet responded to confidence weakness. The role of rates in tracking confidence has been significant since the end of the Covid-19 pandemic. Whether this has fully changed will be a risk to consider for April.

Our take

Bonds will require either much higher yields or a clear hit to growth to shift investor holdings. Our positioning in bonds and stocks shows little shift in appetite for holding bonds against stocks. The level of U.S. yields is a more important driver for fixed income buying, whereas growth seems to be the key for equities. Fed policy remains important in setting the tone for yields in the U.S., but we see a risk of this shifting – when investors see the Fed having to cut in a hurry.

Forward look

The Q2 outlook for fixed income allocations against equities will pivot on growth. Higher expectations of a U.S. recession risk following the implementation of tariffs on April 2 has not been sufficient to drive bonds. Cash continues to be a part of the asset mix and that won’t change until the Fed cuts rates to a level that leads investors to search for better yields. The bounce back in risk mood for U.S. equities plays a role as well – with many willing to put cash to work should the hit from tariffs prove less onerous than feared. U.S. equities could see a modest rally to get U.S. holdings back to their longer-term averages – 2-3% from here.

Bottom line

Investors who missed the key trades in Q1 will not passively jump on in Q2. The European equity theme is more durable, but our flows point to the risk of greater volatility in European sovereigns and Chinese equities, while FX hedging will pick up in the dollar’s favor, even before Fed considerations. As for the U.S. markets, equities remain the favorite asset class of retail investors and that could tip the scales for institutional investors should tariffs prove less painful. Markets look more likely to trade ranges rather than chase returns in the month ahead.