Key Highlights

• ZAR hedging needed but difficult to counter solid fundamentals
• JPY buying needed to offset JGB weakness
• EM miners a firm expression of the metals trade

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Equity-driven rebalancing: South African assets continue surge, but ZAR could be difficult to sell

EXHIBIT #1: CURRENCY DIRECTIONAL FLOW ESTIMATE FOR EQUITY-BASED REBALANCING

_{Source: BNY, iBloomberg}

Our take

January has proven eventful on multiple fronts, but ultimately risk appetite is ending January on a high note. Risk premia related to the U.S. may be reflected in dollar performance, but this is not taking place to the detriment of U.S. equities. Even U.S. data are soft enough to keep a lid on curve steepening and any additional fiscal dominance fears coming through. As assets perform well, the general trend is for additional selling in underlying currencies by cross-border investors for hedging purposes. This has generally been the trend iFlow has observed through January. The largest marginal flows have been skewed toward outflows, with BRL, INR and AUD leading the way. These flows were more than enough to offset equity market gains, leading to limited signals in favor of currency purchases for rebalancing purposes.

In contrast, inflows into majors were generally light and led by JPY, CNY and EUR, which indicates the market is currently partial to high-savings economies that are appreciating, but not aggressively so.

Forward look

Based on our criteria – where currency flows are not strong enough to offset asset performance, or even aligned with the direction of asset flows – there is only one clear-cut signal in equity markets: ZAR. This is no surprise. The rally in precious metals prices has led to surge flows into South African equities, and the Johannesburg Stock Exchange (JSE) is already up over 10% in local currency terms. Normally, this should generate strong incentives to hedge, but South Africa is a rare case, where over the past year, the country’s fiscal credibility has strengthened due to the coalition government’s policies, particularly the adoption of a lower inflation target. Consequently, markets have been adding to ZAR exposure, and carry trades remain popular – leading to a high selling requirement for the currency, as asset allocators are likely very overweight in South African assets. Given our experience last year, when ZAR resisted several months of strong selling signals at month-end rebalancing, we would be cautious about pursuing this view aggressively.

Fixed income-driven rebalancing: AUD and JPY require purchases due to fixed income weakness

EXHIBIT #2: CURRENCY DIRECTIONAL FLOW ESTIMATE FOR FIXED INCOME-BASED REBALANCING

_{Source: BNY iFlow, Bloomberg}

Our take

Compared to equities, fixed income performance has driven rebalancing in the opposite direction. Fiscal dominance fears have led to some steepening in global curves, but progress is uneven. There are several economies where data is weak enough to prompt yields to move in the opposite direction. Ultimately, we have only identified a net buying need in AUD, marginally, and JPY, ostensibly for different reasons.

Although Australia is a strong candidate to be the first G10 economy to switch from rate cuts to hikes, the bulk of the move took place around Q4 last year, as markets began to price in  a major policy pivot. Ultimately, the net change in in the Australian Commonwealth government bond (ACGB) curve was minimal through January, but the AUD struggled with flows as hedging remained high. Such preference will remain in place until there is clear daylight between RBA and Fed benchmark rates. Consequently, the heavy AUD outflows, combined with softer fixed income performance, have contributed to purchase risk (Exhibit #2).

The biggest rebalancing signal across all asset classes is in the JPY, where significant purchases are needed after a record selloff in Japanese government bonds (JGBs). Due to concerns over fiscal and monetary credibility, JPY purchases were lackluster on the month, so the rebalancing need is strong.

Forward look

Despite the need for more JPY purchases, we doubt markets will take a strong view until after the election. Notwithstanding near-term intervention risk, which already contributed to improved JPY performance, we believe JPY flows will only return in earnest once fiscal policy under the next Diet can be assessed. The Bank of Japan also appears to have sufficient support to continue tightening policy, which will help sustain JPY flow and holdings through the hedging channel. Our data indicate that cross-border JGB flow is still firm, suggesting that foreign investors may be finding value in current JGB yields, while relying on the FX authorities of Japan and the U.S. to limit future currency losses. Either way, the JGB moves in January require a material offset, and we see adding to JPY as the most efficient solution, especially if intervention remains onside.

Asset allocation: Mining stocks continue to ride rally in precious metals

EXHIBIT #3: SMOOTHED MONTHLY FLOW, METALS AND MINERS (GICS® LEVEL 3) IN EM EMEA AND EM LATIN AMERICA

_Source: BNY 

Our take

We continue to dispute the notion that there is a material “sell U.S.” trade going through markets, though the dollar continues to bear the brunt of any adjustment. Nonetheless, we don’t see current levels of hedging of U.S. assets as extreme by historical standards, especially relative to strong asset performance. Fiscal premia are clearly a dominant market driver, and we remain wary of spillover effects from the JGB market into other economies’ sovereign bond markets. However, this is not a U.S.-specific story. The best gauge of global fiscal dominance risk remains in the precious metals markets, with ancillary flow into assets exposed to industrial metals.

Recently, we observed that, due to the rise in silver, Peru has become the best-performing asset market globally when measured by cumulative flows into equities, bonds and the exchange rate. Over the past few sessions, we note that after an indifferent start to the year, equities of emerging economies in EMEA and Latin America are also benefiting from metals-related flows (Exhibit #3).

Forward look

South Africa is the dominant metals and mining producer in the EMEA region, so we expect flows into this industry (GICS Level 3) to largely target the JSE.

In contrast, LatAm has far more diverse metals exposure, both by output (industrial and precious) and by the markets involved. Over the past few months, we’ve seen broader alignment in sectoral flows across the region. iFlow indicates that, for the metals and mining industry (GICS Level 3), holdings in emerging markets are strongly outperforming their developed market counterparts. Due to the disproportionate share of these companies’ capitalization on local exchanges (e.g., materials accounts for 49% of the MSCI Peru and 32% of South Africa), these flows have a direct impact on financial conditions in the underlying economies.

Peru remains an outlier in seeing all assets outperform, and we don’t expect such “over-allocation” to extend. FX hedging may need to pick up, especially if stronger currencies start to soften inflation and USD valuations also hit extremes.

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