Key Highlights

• ASEAN import stress weighs on flows and positioning
• Equity flows reflect consumer retrenchment
• Duration interest suggests stagflation risk not strong for now

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Balance-of-payments risk a core flow driver outside of North Asia

EXHIBIT #1: MONTHLY AVERAGE HOLDINGS VS. AVERAGE FLOWS, ASEAN CURRENCIES AND AUD

_{Source: BNY, Bloomberg}

Our take

Four weeks into the Iran conflict, markets are steadily appreciating the importance of the Gulf region in exporting energy by-products. From helium to urea, many of these inputs are essential to whole swathes of the APAC economy. While mineral fuels remain the biggest source of regional balance-of-payments stress, the global nature of the current supply shock will likely lead to a wider negative terms-of-trade shock, forcing governments to react accordingly. China’s decision to restrict refined petroleum exports and fertilizers has only compounded the stress, which is already reflected in currency performance.

Core North Asian export-driven economies have sufficient energy resilience over the coming months. Crucially, their reserve coverage levels are high enough to withstand higher import costs over an extended period. High levels of precautionary savings and strong fiscal resources (ex-Japan) represent an additional buffer, to the extent that we don’t see strong FX or fixed income outflows as a major concern for now.

The situation is different for the rest of APAC. Some of the most aggressive government responses along the lines of fuel rationing have been seen in Southeast Asia – President Marcos of the Philippines stated on Tuesday that he couldn’t even rule out planes being grounded due to the lack of jet fuel. Even Australia, despite being a crucial net exporter of natural gas, is facing shortages of refined petroleum, which is impeding a stronger terms-of-trade adjustment. Similarly, Singapore is a major refiner, but the cost of crude oil will significantly damage the industry’s net export earnings.

Forward look

Despite the clear challenges, the only regional currencies that were net sold over the past month are those whose starting position was overheld. Reducing exposures was therefore quite straightforward. MYR, THB and AUD, by contrast, were already significantly underheld, so the marginal benefit of adding to hedges for cross-border investors proved more limited. We are somewhat surprised by the resilience of the PHP, but positioning has played a role.

We expect markets to remain cautious on these currencies, but the swift change in behavior can help build resilience over time and reduce risk premia. For example, Vietnam has announced plans for a long-term transition toward electric vehicles. The energy crises may even alter geopolitical positioning: President Marcos’ overture to China on joint gas exploration marks a change in posture driven by necessity rather than preference. These are only some of the second- or third-order effects of the conflict that will have lasting global implications.

Equities: Consumer discretionary outflows point to dampening demand

EXHIBIT #2: DM AND EM SECTORAL FLOWS OVER THE PAST MONTH

_{Source: BNY, Bloomberg}

Our take

We remain deeply skeptical that developed market (DM) central banks – especially those in Europe – can come close to matching expectations for multiple hikes for the rest of the year. Officials from the Federal Reserve, Bank of England and European Central Bank have all critiqued interest rate pricing in recent sessions, highlighting the high level of uncertainty surrounding energy prices, while seeking to draw a clear distinction between the current state of their economies and the situation in 2022 to 2023. Crucially, household demand is much weaker and looks set to deteriorate further – one of the immediate second-order effects from the conflict. Central banks are resigned to this and issuing pointed stagflation warnings.

With investors scarred by the previous energy shock, we believe expectations will shift quickly toward precautionary savings and a retrenchment in spending as household cash flow falls outright. The most direct impact is through energy costs, but the recent surge in debt servicing costs will likely force through an adjustment in places such as the U.K. and U.S., where household wealth is subject to discounting via mortgage rates. It should come as no surprise that iFlow shows consumer discretionary has been the worst-performing DM sector since the beginning of the conflict, as this is where the cutbacks are immediate in a supply shock.

Forward look

On the positive side, sectors with sufficient pricing power to pass on increases in energy will benefit the most. Utilities is a strong performer in both DM and emerging markets (EM), which are seeing better flows recently. However, there will be major differences depending on region and industry – we would not view the conflict itself as a simple DM vs. EM story. As highlighted in the FX section, balance-of-payments stress is high for EM in APAC and EMEA, so even if equity valuations are proving attractive, we expect hedge ratios to be relatively high until there is a clearer path toward de-escalation and supply chain easing.

Fixed income: Duration interest suggests anchored inflation expectations

EXHIBIT #3: FLOWS INTO 10Y+ PART OF REGIONAL SOVEREIGN DEBT MARKETS

_Source: BNY 

Our take

Asset managers’ long-term behavior is another factor supporting our view that inflation or even stagflation fears are overdone. As governments have pledged to use fiscal policy in a targeted manner, and only when necessary, concerns over a repeat of the 2022–2023 fiscal shock in DM are minimal. Central banks are far more proactive, and practically speaking, fiscal resources are also in far shorter supply. Crucially, inflation breakevens are relatively well contained, which supports recent central bank statements regarding well-anchored, long-term inflation expectations. As a result, real rates have become more attractive after the steepening moves, leading to significant inflows into the long end of DM sovereign debt curves. We note that Friday generated one of the best sessions for the 10y+ part of the U.S. Treasury curve, while European duration has seen consistent purchases over the past three weeks. The gilt market – which has the longest average maturity profile in the G7 – had its best day in September.

Forward look

Assuming that efforts are underway to re-open the Strait of Hormuz amid broader de-escalation, we expect flows into duration to remain strong, supported by the gradual removal of hikes in the front-end of the curve. In contrast, APAC faces greater stress: the starting point for inflation and demand was already low, especially in China, so there is high risk for a steep rise in inflation expectations stemming from higher input and staples costs. Japan in particular is at risk of rapid steepening due to its fiscal position. However,  we do expect the savings base to serve as an offset over time, providing that the fiscal/monetary policy mix remains credible. Further escalation cannot be ruled out, but we believe bond markets are already pricing in an excessively adverse supply/inflation scenario across the curve. This gives DM fixed income investors ample opportunity to capture high real yield.

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