Key Highlights

• Real rates limit carry sell-off for now
• Equity holdings buffer remains strong in EM APAC
• Complacency risk present in LatAm bonds

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INR and RON now underheld but FX carry sales not uniform

EXHIBIT #1: WEEKLY SCORED FLOW VS. CURRENT HOLDINGS, EM CARRY CURRENCIES

_{Source: BNY, Bloomberg}

Our take

There are still very few signs of de-escalation in the Middle East conflict, but risk appetite is holding up remarkably well. This is most apparent in equity markets, where the repricing of global energy prices has yet to result in a significant correction, whether through the margin channel or the demand channel. The same dynamic is visible in FX markets: Of the 12 Emerging Market (EM) currencies that we characterize as high-yielding – and for which we have sufficient data density – only INR and RON have moved into underheld territory based on the latest available data. All 12 were overheld before the conflict began. 

Forward look

The single most important factor behind FX carry resilience, in our view, is real rates. Inflation is now expected to rise globally, but EM central banks have generally established sufficient policy credibility in recent years such that few are expected to ease policy aggressively into a supply shock, even if growth faces significant challenges in the near term. A further constraint is the potential pushback on Fed rate cuts. Bank Indonesia’s decision on Tuesday illustrates the point: IDR is currently most at risk of joining INR and RON in underheld territory. The bank framed its decision around “strengthening external resilience,” with “stabilization of the exchange rate” through intervention and “attract[ing] foreign portfolio investment” as key policy anchors. Markets are likely to expect most EM central banks to follow this path, which explains why most high-yielders remain net bought.

TRY is currently facing the strongest selling pressure, even with very high nominal rates, suggesting growing concern on the fiscal front – particularly if subsidies become increasingly burdensome as the conflict continues. We expect central banks to signal to fiscal authorities that market tolerance for large-scale energy price intervention is extremely limited, goes some way to explaining why austerity or rationing measures are prevalent across emerging and frontier economies.

Equities: EM APAC remains best-held region despite recent turbulence

EXHIBIT #2: CURRENT HOLDINGS IN EQUITIES BY REGION

_{Source: BNY, Bloomberg}

Our take

Some of the biggest equity market swings over the past two weeks have taken place in APAC. The boundary between EM and Developed Market Asia is often blurred, but equity markets with elevated pre-conflict exposure to tech or the global AI complex were most at risk of a significant correction. We believe supply risks remain for the affected industries.

It is not simply a matter of energy. For semiconductors, “helium risk” is swiftly moving up the agenda due to disruption in Qatari natural gas supplies. The gas is used in semiconductor manufacturing, and regional exposures is significant.

Fitch notes that South Korea sourced nearly 65% of its helium imports from Qatar last year, and Japan on Monday was compelled to publicly disclose its reserves level. Nonetheless, EM APAC remains the best-held equity market region globally, while developed economies in the region are also better-held than their global peers. Holdings have already come off extremes, while the dollar’s recovery has improved valuations for external investors.

Forward look

We are broadly sympathetic to the case for increased APAC holdings as asset exposures to U.S. investments were relatively light even before the recent adjustment. The prospect of improved Chinese demand due to base effects and additional stimulus is another idiosyncratic factor that can underpin the region, though growth targets at the recent National People’s Congress have not surprised to the upside.

We also expect by savings-heavy economies in the region to introduce new measures to stabilize their currencies and incentivize investment over U.S. equities.

However, in the near term, we believe hedge ratios will need to be high. Rising energy costs will damage Asia’s balance of payments, while rising front-end global yields will also dampen repatriation interest for traditional funders. For now, gains in total asset exposure to APAC – especially in FX and equities – will probably be more subdued than at the start of the year.

Fixed income: Limited reduction in LatAm bonds but no appetite for shorts

EXHIBIT #3: SCORED HOLDINGS AND SHORT UTILIZATION IN LATAM SOVEREIGN BONDS

_Source: BNY 

Our take

Even though LatAm is arguably the least economically exposed region to the current conflict, markets have not shied away from adjusting policy expectations. In the run-up to this week’s Selic Rate decision in Brazil, the initial consensus of a 50bp cut swiftly shifted to 25bp – even from a high 15% starting point. The removal of rate cuts from Turkey’s central bank path the week prior followed a similar process, though Turkey faces far greater risk of a negative terms-of-trade shock, warranting a firmer policy stance.

We have highlighted that well-held equity markets were most at risk of a large correction from risk aversion, and in some cases those moves were realized. This has not, however, been the case in LatAm fixed income – the best-held segment in global sovereigns – and current evidence suggests that hedging interest is limited.

Forward look

As highlighted, LatAm is currently the only region without any underheld currency. Fixed income holdings have declined by less than 2pp, which is not significant and simply reflects a global repricing of inflation risk. In absolute terms, current holdings remain around 14% above the rolling 12-month average and are slightly higher year to date. Most surprising is that short utilization for the region’s debt has been falling.

Coupled with the absence of additional FX hedging, this suggests there is close to no “insurance” being placed on total return portfolios in LatAm, where cross-border fixed income positions anchor the portfolio account. We acknowledge that high nominal and real carry do increase the hedging cost, and there is a case for positive terms-of-trade adjustment due to the conflict, especially for net energy exporters. However, we believe the lack of movement in hedges reflects the view that there will be close to no direct tightening in financial conditions through the dollar or U.S. rate channel, which will significantly affect Latin American asset holdings. While this is our base case for now, lack of positioning for the opposite is increasing asymmetry and will render LatAm assets – especially fixed income – highly exposed to a sharp pullback if alternative scenarios for the Fed or broader financial conditions are realized.

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