Key Highlights

• FX markets target EM balance of payments stress
• Equity outflows remain a function of positioning
• EMEA bond markets must anchor real rates

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FX: Balance of payments vs. carry in INR and TRY

EXHIBIT #1: WEEKLY SMOOTHED FX FLOWS YTD – INR AND TRY

_{Source: BNY, Bloomberg}

Our take

We had anticipated FX carry trades to face significant selling pressure as inflation risk begins to erode real rates. Our iFlow Carry indicates that selling increasingly dominates irrespective of holdings status: 11 of 13 emerging market (EM) FX high-yielders were net sold over the past week, as markets clearly pushed for risk reduction, though flow magnitudes were generally light. The worst performers, however, were TRY and INR, which were not at the forefront of holdings stress. TRY is currently at around 50% above its rolling 1y average, while INR is largely aligned with recent history. TRY is also anchored by very high nominal rates and enjoyed one of the best runs in EM carry year-to-date.

Rather than positioning stress, we believe the market is revisiting fundamental exposures and looking at where balance of payments could quickly deteriorate due to energy exposures. Both Türkiye and India have struggled in the past with current accounts: rather than the supply shock in 2022 to 2023, the damage to balance of payments was strongest between 2011 and 2014, when Brent crude prices were consistently above $100/bbl. This was the only time in recent history where India’s current account deficit surpassed 5% of GDP, while Türkiye’s hit nearly 9% of GDP.

Forward look

Immediately extrapolating a severe balance of payments shock from current events is excessive, so positioning has played a role in amplifying general risk reduction for net energy importers. Ultimately real rates and fiscal restraint matter: if the energy balance deteriorates, an offset is needed through the demand channel. Türkiye has already announced mitigating adjustments to its automotive fuel pricing mechanism, but it is imperative that efforts elsewhere to bring down inflation continue due to an extremely high base. India has already obtained some relief through the Russian oil channel, while the government has announced domestic rationing in addition to securing supplies from outside the conflict region. Depending on the duration of the current supply shock, we believe the market will expect strong fiscal credibility and monetary restraint to help anchor real rates, complemented by sparing FX intervention.

Equities: EM APAC semiconductor flows struggle to stabilize

EXHIBIT #2: WEEKLY SMOOTHED EQUITY FLOWS YTD – SOUTH KOREA AND TAIWAN

_{Source: BNY, Bloomberg}

Our take

Since the start of the Middle East conflict, we have noted that the aggressive moves in South Korea and broader Asia-Pacific markets are almost exclusively attributable to excess positioning. Even after repeated “limit-down” days, South Korea remains the best-performing major equity market globally, although recent volatility will likely depress risk-adjusted returns for asset allocators. Taiwanese market volatility has not been as extreme, but there are similar vulnerabilities.

External investment lies in a handful of companies leveraged to the global AI capital expenditure (capex) theme. Evidently, the tightening risk in global financial conditions will have an impact on such investment plans, and iFlow data suggest that more recent cross-border flows have had lower FX hedge ratios, which also lower liquidation thresholds for foreign investors.

South Korea remains the most-sold equity market in iFlow since the conflict began, but our data also indicate foreign investors are now seeing some value in the market.

Forward look

Although South Korea and Taiwan are heavily exposed to energy imports, domestic reserves are ample, and we doubt that energy supply itself is a direct trigger of the selloff. When the market is moving toward extreme risk aversion, assets with extreme valuations face the highest level of capitulation risk, and subsequent VaR shock often leads to overcompensation.

Without taking a view on valuations, the biggest question is when financial conditions will tighten enough to cause a significant slowdown in the broader AI theme. The focus on near-term energy supply has limited scrutiny on the return on investment case for AI-based capex, but risk management relating to the theme – in both public and private markets – is clearly increasing.

Fixed income: Fiscal dominance risks in EM loom large by choice

EXHIBIT #3: WEEKLY SMOOTHED FI FLOWS YTD – HUNGARY AND SOUTH AFRICA

_Source: BNY 

Our take

While high-carry FX markets have maintained resilience stronger than anticipated, debt markets are a different story. Spillover into EM should not be a surprise given the relatively aggressive moves in developed market duration, especially in markets where holdings are already elevated and perception of fiscal dominance is high. Consequently, outside of countries directly affected by the conflict, Eastern European and African debt is highly exposed.

Hungary and South Africa were poorly performing markets over the past week, and there is no sign of a recovery. Real rates in both countries remain high, and recently South Africa has even committed itself to stronger fiscal rules. However, the burden of proof appears to be on finance ministries to act sparingly in the current environment, and the immediate debt outflows already raise the costs of acting.

Forward look

For now, it appears that market concerns over Hungary have proven correct. The government is the first in the EU to announce an energy price cap, and on Tuesday, the central bank even announced the direct use of FX reserves to cover energy import needs and “shield the HUF,” while committing to maintaining “cautious” monetary policy. There are exogenous factors in play for Hungary’s energy supply, and the sharp decline in inflation numbers will help anchor real rates. However, we think it is a question of prior form that is leading to market hesitation over performance. Hungary’s support for households was particularly aggressive during the 2022 to 2023 energy crisis, but the artificial suppression of real rates will be far more damaging to duration.

In contrast, we believe there is scope for investors to position for outperformance in South African government bonds as flows stabilize. Finance Minister Enoch Godongwana admitted that South Africa is a “price taker” in energy markets but crucially, government buffers are sufficient to maintain their debt-consolidation plans. It is telling that Godongwana emphasizes using resources for this purpose rather than energy subsidies. Barring a more sustained shock that severely restricts growth, we believe the ongoing re-rating process for South Africa will continue.

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