The Big Conversation
Episode 133: Will the yuan be next?
This week Roger Hirst looks at whether the recent run higher in the dollar will also spread to the Chinese Yuan. So far, it’s been the Euro and the Yen that have seen some of the biggest moves lower versus the US dollar, but will China sit back and allow other regions to take a competitive advantage? The Fed will stay in aggressive tightening mode so long as inflation edges higher. Emerging market currencies have seen significant weakness, and this could pressure China’s policy makers. In the Chatter, we talk to Dewi Johns of Refinitiv Lipper about some of the key fund flows out of the UK.
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Roger [00:00:00] Back on the 20th of April, we asked if the dollar was about to surge. Since then, the dollar index has risen to its highest level since 2002, and the Euro has been eying parity with the dollar. But while the focus has been on the big pairs like the Euro and the Yen, could the next move versus the Chinese Yuan be the one to watch? That's The Big Conversation.
Roger [00:00:24] Although much of the current focus is on the US dollar's move towards parity with the Euro, it really makes little difference to Europeans whether the Euro is at 0.999 or 1.001. Yes, obviously, a weaker Euro will exacerbate the existing issues around rising energy prices, but it's been issues with the deteriorating trade balance that have contributed to the Euro's weakness. Germany's trade balance has recently gone into negative territory for the first time since 1991. German electricity prices have recently surged to another record high on concerns that the annual shutdown for maintenance of the Nord Stream 1 pipeline will become politicized. With risks, the pipeline might not reopen on schedule. Energy infrastructure issues have been persisting for some time. The previous spike took place before Russia invaded Ukraine, and we've discussed weakness in the Yen before. We should expect the Yen to weaken as long as the Bank of Japan remains committed to its yield curve cap of 25 basis points on the ten-year government bond. The US dollar versus the Yen has recently touched its highest level since 1998, which was a period of extreme emerging market currency volatility. Longs on the dollar versus the Yen still have to factor in the asymmetric risk that the Bank of Japan walks away from its yield curve cap. In that scenario, Yen should gap higher against the dollar, while JGB yields should also move higher, pushing up other global yields at the same time. But for now, the Bank of Japan appears committed to their extreme policy, but this remains a significant risk for global markets. Whereas the move in the Euro is largely a byproduct of other forces, such as the energy crisis and the related inflationary shock, emerging markets can be outright vulnerable to a stronger US Dollar. This could add additional pressure after many emerging market assets, especially in the fixed income space, struggled to digest the surge in US benchmark yields during the first half of 2022. The emerging-market bond ETF has dropped below the 2020 low. Within China, many of the fixed income instruments of the indebted property companies have come under continued pressure. The Kraneshares Asia High Yield Bond ETF has made new lows, even as we've seen a rebound in the domestic Chinese equity market. Many emerging market corporates have significant US dollar-denominated debts, and these positions are like having a short dollar position, because these companies will eventually need to pay back their debt in dollars. If the dollar keeps on rising, it increases that debt repayment burden. And this is one of the reasons for the long-term relationship between the US dollar and the ratio of emerging market equities versus the US equity market. Generally, emerging markets have underperformed the S&P 500 when the US dollar is strengthening, when the dollar is weaker. Emerging markets tend to outperform. And this has indeed been the case for much of the last decade. Although in recent months emerging markets have managed to hold their own despite recent US dollar strength. But whilst most of the currency focus has been on the DXY, which is primarily the euro and the yen, broad-based emerging market currencies have been testing the lows again. Many of the commodity-exporting LatAm currencies have also been under pressure. And this is why the Chinese currency becomes a pivotal player. The Chinese authorities let their currency weaken versus the US dollar and other currencies earlier this year. It has recently been in a consolidation phase. If other major exporting blocs like Europe, Japan and Korea are seeing currency weakness again, China's policymakers may not want to be left behind and lose that competitive edge. The next move from China, therefore, could be key for global risk assets. A weaker Yuan could exacerbate the recent move and add more downward pressure, despite many assets now getting into oversold territory. And U.S. authorities may be relatively happy with current events. Unlike previous moves higher in the dollar, which threaten global growth, such as we saw between 2014 and 2016, the Fed has shown little interest in damping down the move this time. A stronger dollar could benefit the US consumer and smaller family-run companies by helping to reduce imported inflation. Additionally, if the stronger dollar takes some of the sting out of the commodity market, that could also help to reduce some of the price pressures. For much of this year, commodities and the dollar have risen together. But that's not the usual long-term trend. Normally, a stronger US dollar would have a dampening effect on commodities. That has often also had a dampening effect on global growth, as it did between 2014 and 2016, when a surging dollar led to a global industrial profits recession. Today, price is more important than growth, so a stronger dollar has far more benefits today than it did in 2015. And a stronger US dollar today may be a more acceptable way to tighten financial conditions compared to higher bond yields or wider credit spreads. High yields in particular have already had a major influence on driving other asset prices lower. Inflation, however, is not yet under control. The latest release will be after we film this episode, but 1.1% month on month, if that materializes, is an unacceptable level for the Fed. And inflation is a lagging data point. So we might need more economic weakness before we get a real lid on inflation. And markets are not yet priced for that level of a growth slowdown. Of course, the US dollar is getting stretched on most metrics and the euro has already attempted a bounce off that psychologically important parity level. But things continue to move quickly and the Fed remains on a path not seen for 40 years, one in which they continue to target price even as growth has begun to roll over. And the Bank of Japan appear determined to cap yields, and the Eurozone and Europe as a whole will continue to struggle to find alternative energy sources for much of the foreseeable future. Even though the dollar is stretched against both, the dynamics for the US dollar remain relatively favorable. Therefore, what will China do? Most likely they will go with the flow. If China's currency weakens further, then other Asian currencies will follow suit. The US dollar versus the Korean Won has already broken out. When the Korean Won weakened significantly, it's often at the time when the VIX surges, because a weaker Korean Won reflects a worsening outlook for global growth. In April, we suggested calls on the dollar as a hedge for risk assets, but currency options are a lot more expensive today. Perhaps the big move is still for volatility of volatility in the equity market. The VIX, is at fair value with implied volatility at similar levels to actual market volatility. But volatility of volatility has fallen significantly because this has so far been an orderly decline in the equity market. If China lets its currency go again, we might get a disorderly move in the dollar and a more emphatic decline in the equity market that could be marked by a surge in both the VIX and the volatility of the VIX that has so far been absent in this market. In the next section, I talked to LSEG's Dewi John to look at some of the trends in fund flows and how recent activity has, if anything, been counterintuitive to the performance of the market.
Roger [00:07:15] Fund flows was one of the key elements that investors really like to look at to understand kind of what's really driving markets. Can you just maybe explain what it is that you're looking at and why it is that these sort of fund flows and flows in general are such an important barometer for markets?
Dewi [00:07:28] Well, Lipper has been providing fund analytics, performance and flow data for about half a century. Now I'm focused on the U.K. market, but we're also obviously this takes place in the context of global markets, and it's really giving us a good insight into investor sentiments, both in terms of longer-term, but also there's a lot of noise in the market at the moment. I'm looking at one month after another and going, you know, a lot of this makes no sense and it only becomes clear in the longer period.
Roger [00:07:57] And which you mentioned, the U.K., which are the funds that you particularly focus on in terms of getting your information and the sources that you have?
Dewi [00:08:04] Predominantly mutual funds and ETFs, which is where the most of the fund's assets are. We also look at pension funds and insurance funds and some hedge funds. But really the main focus for me is mutual funds and ETFs.
Roger [00:08:18] And those are, is it the flows in the U.K. context, or is it the flows from U.K. companies that you're focused on?
Dewi [00:08:23] It's not looking at domicile, because a lot of what U.K. investors take on are obviously domiciled either in Ireland or in Luxembourg, so we're really looking at currency of record being sterling and registered for sale in the U.K. and that gives you really there's nothing exact about this, but it gives you the best picture of what U.K. investors are buying.
Roger [00:08:45] So going into the context now of the actual flows themselves, maybe if we split up the sort of the history in recent history into two parts, sort of the 18 months up to March and then post March.
Dewi [00:08:56] The bestselling asset class over 21 was bonds, despite the fact that performance last year with this has been none too impressive. My best guess with that is what we've seen there is institutional investors basically top up their accounts as the values of the fixed income portfolios have fallen. Over 21 up to March as well, and possibly a little bit further beyond, the best selling asset class or has been within equities, has been global equities. And for UK investors, what we've seen them do is abandon domestic equities and get into global.
Roger [00:09:39] So this is, this is the UK kind of all types of UK investors are basically saying we want out of the UK domestic equity market, we're going to go out into the broader world. Do you think that's because they were overweight in the first place and it's been dealing with that overweight?
Dewi [00:09:52] Up until the end of last year, it's been a performance issue very much. I mean, UK equities have underperformed for a very long period. They've been a pariah asset class since the Brexit referendum, if not before. This year is quite surprising because obviously UK equities, particularly UK blue chips have strongly outperformed other global markets really until June. And we've seen international investors start to dip their toes back into UK blue chips. But that hasn't it doesn't seem to have made any difference for UK investors. We've seen two billions worth of outflows so far in UK equities by UK investors in June alone and that was quite unusual. So that's a heavy flow.
Roger [00:10:38] If someone had asked me recently where you'd have thought there'd be the flows going in, it would be value areas, value indices, places like Australia places like the UK, which is big on mining, big on, you know, the oil companies which had done well. Yet even when the outperformance was there, you still saw net sellers of that.
Dewi [00:10:54] Yes, absolutely. With the UK market. And as I said, international investors are taking a nibble out of the UK market now. But by no means this year have they gone, "oh look, value-driven performance, energy stocks, fantastic, let's go in there and fill our boots", which you might expect. It really hasn't happened. It's been incremental, whereas UK investors have largely gone 'no' as they've done for years previously.
Roger [00:11:19] So it could potentially open up, I mean, assuming that, you know, we stay in this world of value over growth and obviously there's so many moving parts of that. But if we stay in a world which is largely expectation, value outperforms, it could be an interesting place for people to go because it's been basically sounds like one-way traffic is selling even when that value factor has been outperforming?
Dewi [00:11:36] Yeah. Yeah, very much the case. Over the past month we've seen growth rally a little bit and it's outperformed value but that's no by no means a done deal. So the market's doing a lot of flip- flopping at the moment. As I said, I'm surprised that international investors in particular and UK investors to a degree, just tactically to take advantage of this, haven't responded in more decisively than we've seen.
Roger [00:12:05] And do you feel that you're seeing these sort of moves within the equity space, there has been a sense recently that investors got very, very bearish in terms of their sort of tone, but some of the position surveys suggest that people have actually held on to equities, they haven't rotated en masse out of equities. They've got very, very negative on equities. Are you seeing anything like that over the last couple of months, three months, where you're seeing people hanging on equities or what has to be some serious liquidations going through?
Dewi [00:12:31] Well, you're right to identify March as something of a turning point, because globally things do turn very bearish in both bonds and equities from March, whereas prior to that you'd seen a gradual reduction, but then it goes boom and both bars become negative.
Roger [00:12:48] And you're able to get any sense at all when you look across the whole board, that are there any differences to what institutions may be sort of more retail type funds are doing, do you get to get that granularity as well?
Dewi [00:12:58] It's quite hard to tell because you can get an institutional share class on a retail platform and that's divvied up between investors. So it's not as easy as it was 10, 20 years ago to go, this is an institutional share class that is being bought by retail investors, other than, as I said, just speaking to people in the market and getting the sense of where the particular interests are.
Roger [00:13:20] And then, I guess finally within all of this, as we, we're not really looking forward because obviously we're looking at fund flows, but do you get a sense from the client base of any apprehension at the moment, any sort of feeling that, you know, we've had inflation, we're talking about growth, potential recession. Do you see from the client base any sort of feeling that this is going to be tricky six months ahead of us?
Dewi [00:13:39] I think looking at month-on-month flows, the lack of a clear trend there as as I said, you look longer term and things fall out, but May figures for instance, May data I just said earlier, that that was a US month. Everybody was taking up US assets, whether it was bond or equity, you know, safe haven. That's not the case. In June, I saw people taking a nibble out of short-term bonds and linkers last month. Again, not the case this month, it's where you think they would be. What's taking off in June is emerging market debt, and that could well be a trend going forward because emerging market central banks in some instances, particularly with local currency, seem to have moved further and certainly earlier than domestic markets. But you know what will happen in July? I genuinely have no idea at the moment. There's a lot of noise.
Roger [00:14:39] So it sounds like in some ways in the way that we've got this great uncertainty from inflation, will that remain sticky from here or will it reduce, we've got uncertainty on growth and potentially recession that's being reflected in this uncertainty in the flows we've seen in the last couple of months.
Dewi [00:14:51] Yeah, very definitely, no clear trends at the moment, certainly over the short term.
Roger [00:14:55] Great. Well, thanks very much for those insights and those kind of views and what's going on in the flows market.
Roger [00:15:01] And if you have any questions about this episode, the financial markets or the economy, please put them in the comments section or send them to fmt@LSEG.com