Key Highlights

• Latin America (LatAm) resumes carry interest on FX and fixed income (FI) legs
• Emerging markets (EM) equity rotation could benefit select FI markets
• Domestic and cross-border gilt interests no longer align

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LatAm carry benefiting FX and sovereign flows amid political shifts

EXHIBIT #1: SMOOTHED LATAM FX AND FI HOLDINGS 

_{Source: BNY iFlow}

Our take

The market’s reaction to the first round of Chile’s presidential election suggests a clearer political narrative is taking shape, with investors increasingly distinguishing between outcomes perceived as market friendly and those seen as less supportive. Beyond the specifics of policy platforms, positioning behavior indicates that markets are receptive to reform that could lift trend growth and productivity. Chile is a notable example. Despite lacking the cushion of high nominal or real interest rates, the anticipation of structural improvements generated meaningful inflows into both the currency and sovereign bonds.

A similar dynamic is evident in Argentina, where despite significant volatility, cross-border investors have steadily increased exposure over the past two years, encouraged by reform momentum and improving holdings data. Of course, perceived alignment with the U.S. is helpful, which is also a factor behind Chile’s asset performance.

Combined with the firmly positive real-rate environment in Mexico and Brazil, these developments leave LatAm among the best-positioned regions in both FX and FI. There is also clear recovery from October’s risk-off holdings loss (Exhibit #1).

Forward look

Over the medium term, sustained market performance will depend increasingly on policy results. Argentina offers a clear example: Inflation and fiscal deficits have shown meaningful improvement, even if concerns around currency valuation persist.

Elsewhere in the region, high nominal and real interest rates remain key policy anchors and a source of potential performance divergence within LatAm. Its currencies are likely to stay under pressure, with the Federal Reserve unlikely to pursue aggressive near-term easing. Even so, we retain greater confidence in regional FI, supported by ongoing structural reforms and favorable real-rate differentials.

At the same time, signals from our carry index suggest that demand for higher-yielding currencies is beginning to recover, regardless of the underlying catalyst. Provided broader risk sentiment remains constructive, LatAm currencies could experience a period of tactical strength, although gains may be capped if positioning once again approaches extreme levels.

Rotation risk uneven in overheld EM equities

EXHIBIT #2: MARKETS WHERE EQUITY HOLDINGS GAP VS. FIXED INCOME IS ABOVE 30PP AS SHARE OF ROLLING 12-MONTH AVERAGE

_{Source: BNY iFlow}

Our take

Amid the current risk-off tone led by equities, EM assets may still face pressure. LatAm currencies and FI are generally better positioned due to high real rates, but resilience may be weaker in other regions. We are particularly concerned about markets where equities are strongly overheld on a standalone basis. In the worst-case scenario, these markets could sell off aggressively and trigger FX outflows where unhedged.

A more benign scenario could trigger some rotation into FI. While growth and valuations would still be challenged, many of these markets offer a yield advantage over the U.S., and duration is relatively under-owned. We identified six of 44 markets with data for both assets, where equity holdings on a 12-month rolling basis are more than 30pp higher than FI holdings (Exhibit #2). All six are EM names and represent a notably diverse mix. Three of them – South Korea, Thailand and Indonesia – are in the relatively low-yielding Asia-Pacific (APAC) region, which is somewhat surprising. Egypt is the only frontier name in the group – unsurprising, as equities in such markets often serve as an inflation hedge relative to bonds.

Poland and Colombia complete the set. These two economies are divergent in nominal and real yields, but their equity advantage over FI is the widest. Both have equity holdings at more than 40pp above FI, measured by ratio over the rolling one-year average, pointing to very specific growth and earning stories.

Forward look

Of the six economies, arguably South Korea and Thailand are the only ones with clear funding status. The Polish złoty (PLN) is the only underheld currency, likely due to rate cuts by the National Bank of Poland driven by political developments. Colombia, Indonesia and Egypt are better positioned to benefit if high real yields drive rotation from equities into FI, helping to mitigate capital outflow risk.

Poland and South Korea also face concentration risk. Both countries’ equity markets have benefited from very specific themes this year – European defense and global semiconductor demand – but a marginal lift in investment growth seems unlikely, as the bar is relatively high. We see strong equity outflows from South Korea, though our flow data suggest these positions are hedged, leading to the won (KRW) being overheld.

Colombia, Indonesia and Egypt have traditionally relied on duration to drive portfolio imports. As long as real rates remain anchored, these flows can continue. We would not be surprised if an additional lift emerges from equity rotation, if risk aversion picks up.

Gilt market structure diverging from 2022 as government lays ground for budget

EXHIBIT #3: MONTHLY GILT FLOWS, CROSS-BORDER AND AGGREGATE

_{Source: BNY iFlow}

Our take

Even in ideal market conditions, ongoing uncertainty around the U.K.’s upcoming budget would have strained gilts’ status as a potential safe-haven asset. Price action late last week underscored the risk. Global equity markets struggled – which generally helped European government bond performance – but long-dated gilt yields moved higher amid fears the government is reverting to backloaded measures to generate fiscal headroom, rather than offering immediate relief through income tax increases.

It is not just in emerging markets where fiscal credibility matters for sovereign bond performance. The U.K. and Japan are increasingly under pressure on this front. For the U.K., international investor weakness is particularly problematic. Unlike Japan, foreign holdings of gilts are far higher (around 30% versus 12%). Last week’s outflow by this group was the largest on a weekly basis in more than a year. So far this year, cross-border investor interest has been weak and markedly different from that of domestic investors (Exhibit #3). 

Forward look

Despite the risks of a poor reception to the budget, we continue to highlight material differences from the mini-budget episode in 2022. The budget process and market structure – including the prevalence of liability-driven investments (LDIs), Bank of England (BoE) quantitative tightening, and the current monetary policy setup – are all markedly different.

The current state of the monetary policy cycle is especially important in anchoring domestic demand, which has remained robust since the summer as real rates appear set to improve further. Nonetheless, there are signs of waning momentum among onshore investors.

For structural reasons, passive onshore buyers in gilts will remain in place, but only at the right price or yield level. The current equity environment could even boost demand if the BoE intensifies easing.

However, fiscal discipline remains key for cross-border clients. A gradual decline in foreign participation in the U.K. gilt market will incur a currency cost. In the near term, the persistence of underheld pound (GBP) positions suggests existing positions are not heavily hedged, likely due to higher U.K. yields. Any outflows would have an adverse currency impact as well.

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