Key Highlights

• APAC FX: reluctance to build on an already overheld position
• China and Japan equity positioning is stagnant as South Korea and Taiwan carry the load
• Cross-border investors still aren’t sold on APAC real rates

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FX: Only KRW and JPY seeing any holdings lift

EXHIBIT #1: WEEKLY SCORED HOLDINGS VS. FLOWS AS OF MAY 8, APAC FUNDERS ONLY

_Source: BNY

Our take

The search for diversification continues amid resurging tensions over Iran and fears over equity concentration risk, and the market is once again revisiting APAC FX. China’s producer price growth has finally moved back into positive territory. A process that we felt would occur in any case has been accelerated by the conflict, and CNY ended last week as the best-bought currency in EM APAC, even though the net gain was marginal. If it hadn’t been for intervention risk, it would have probably outperformed JPY (Exhibit #1).

There are two ways to interpret the impact of high PPI on the rest of the region. An adverse result would be China exporting inflation at a time of global supply stress, further weakening balance of payments in the region and driving outflows. On a more positive note – as import prices are currently the clear driver of producer prices, and a higher real effective exchange rate (REER) is inevitable – there might be room to shift the burden of adjustment more on the nominal effective exchange rate (NEER), where CNY clearly has room to run. This would also open up space for peers to pursue further nominal exchange rate gains, and a regional shift could even attract diversification flow out of the U.S.

Forward look

Based on current flow figures, it appears markets fear the adverse scenario more in the near term. We’ve previously noted that given China’s dominant market shares in manufacturing globally, there is a strong incentive to pass input costs through and opt for margin expansion for an entire corporate sector starved of earnings growth over the past few years due to disinflation. Meanwhile, outflows suggest the market will only hold currencies (or be unhedged in underlying markets) where there is a clear idiosyncratic narrative, whether AI-driven growth (South Korea), or more assertive intervention (Japan). Even the SGD, a regional safe haven because of its ratings, is now approaching underheld for the first time in recent memory, as import costs erode balance of payments. We continue to see CNY appreciation, but not at a pace that will provide relief for other APAC currencies. If anything, regional central banks will need to increase vigilance on pass-through from CNY, JPY and USD.

Equities: APAC combined equity lift restricted to South Korea and Taiwan

EXHIBIT #2: CNY AND JPY GAINS AREN’T HELPING THE EQUITY CASE

_{Source: BNY}

Our take

KOSPI had another volatile session Tuesday on fears of conflict re-escalation and some “private comments” by the presidential policy chief regarding an AI “citizen dividend.” Whatever the reason for the drop, this is going to be the “new-normal” for that market due to high levels of realized two-way volatility and extreme concentration. That the index itself is starting to behave like a semiconductor stock is no exaggeration, especially if daily gains and losses are being generated by a very small subset of names. Yet, the way this select group is starting to distort asset allocation and index investors is becoming increasingly visible. This much is evident in iFlow’s equity holdings figures. China and Japan retain large capitalizations, and the size of their economies has ensured large absolute levels of holdings in our equity allocations. However, we note that growth in all APAC holdings has come from the non-China EM APAC segment, i.e. South Korea and Taiwan (Exhibit #2). 

Forward look

APAC equity benchmarks are now being driven in the same way as U.S. capitalization growth, where an increasingly small group of stocks hold sway. On the other hand, fundamentals are entirely different as AI-related outlays in Asia-Pacific (EM and DM) do not account for 70% of GDP growth in the first quarter or more, as observed in the U.S. Stripping out the AI-led export contributions from South Korea and Taiwan, there’s sufficient domestic demand capacity to drive earnings growth independent of the U.S. capex cycle. This is where reflation in China or its own spending and investment initiatives can support a rotation in equity leadership, and we expect major behavioral changes in APAC equity indices and investment trends over time.

Fixed Income: Same inflation exposures, but very different appetite at the long end

EXHIBIT #3: MONTHLY SMOOTHED FLOWS YTD, APAC AND EUROPEAN SOVEREIGN DEBT, >10Y MATURITIES ONLY

_Source: BNY 

Our take

For the savings-heavy regions of Europe and APAC, fixed income flows have become highly divergent, underscoring the weakness in APAC real rate prospects. The entire region is entering a phase of stronger price growth due to supply and cyclical reasons, though except for Japan, yields have not been able to react in kind due to passive domestic flow. Despite higher inflation attributable to multiple factors, the 10y Chinese Government Bond (CGB) yield is materially lower than pre-conflict levels. Any steepening was bought into – lack of investment options, especially outbound, continues to suppress yields and keep CGBs more attractive to cross-border investors. Anticipating further CNY strength alone isn’t sufficient risk/reward, particularly relative to high-carry commodity exporters that continue to dominate EM fixed income allocations. There are similar pressures across APAC, whereas price discovery is better in Europe due to freedom of capital movement for domestic and cross-border investors alike.

Forward look

In contrast to equities, South Korea and Taiwan barely register in cross-border fixed income flows, and we expect holdings in the entire APAC region to remain dominated by interest in Japanese Government Bonds (JGBs) and CGBs to a lesser extent. For both markets, highly erratic flow patterns have been the biggest challenge this year. JGB and CGB interest started the year on a strong note, but interest faltered after early February (the point of near-convergence vs. European flow magnitude) as data and valuations continued to undermine interest. CGBs have particularly struggled throughout the course of the conflict as the real rate story undermined any potential safety interest, and the recent rise in inflation has not seen commensurate gains in long-dated yields, which will continue to limit inflows. Meanwhile, the JGB market is now being affected by intervention and difficulties of balancing monetary and fiscal policy. For now, there is very little sign that intervention to strengthen the JPY is having a marginal impact on external demand for JGBs. Domestic investors are benefiting from higher yields, but the balance of flow isn’t sufficient to support the currency alone.

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