Three Worlds, Three Trajectories : Mid-Year Outlook

Description

Six months in, and the macro picture looks nothing like a quiet year. In this mid-year review, Vincent Chailley, CIO at H2O AM Group & Monaco S.A.M., sits down with Thomas Delabre, Portfolio Manager and macro specialist, to take stock of a first half shaped by the Iran war, the closure of the Strait of Hormuz, and the return of the AI theme with a vengeance. Three worlds, three very different stories - a resilient Europe with no real growth engine, a US walking an increasingly fine line, and an Asia quietly accumulating structural advantages the market is still underestimating. Where do we stand, and what comes next?

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Transcription

Speaker #0
Hi everyone and welcome to this new episode of Think Macro. Today I will exchange, we will discuss with Thomas Delabre, Portfolio Manager at H2O Asset Management and expert on emerging markets on the mid-year outlook. A lot has happened so far, so we will discuss the next six months and more on the economy. Hello, Thomas.
Speaker #1
Hello, Vincent.
Speaker #0
So far this year, we thought at the beginning of the year when discussing this year's outlook that Europe would resist, Asia would perform, and the US was surprisingly resilient. And together with this resilient, we had in mind some fragilities that were appearing in the US economy and we thought okay that may take the economy down and make it slow down over the course of 2026. Now a lot has happened since we had two major shocks to the world economy, a shock that comes from Middle East that took oil prices up so not the shock in itself but the closure of the Strait of Hormuz had a huge impact on oil prices and energy prices in general and us. a new inflation shock that comes on top of tariffs last year. And more recently, we have a third inflation layer shock with artificial intelligence, the boom of investment you have on AI that drives the price of components up as well. So the big question we have from a macro standpoint today is how this triple inflation shock can impact the world, can impact these three regions we discussed last time, with very different outcomes, very different reactions between Europe, the US and Asia. So let's start with Europe. So Europe looks fairly straightforward, is the European low-risk, low-return model. Europe has got plenty of savings, which are in essence, a buffer against any shock and are a buffer against the current shock. But also, Europe has very few means to sort of counterbalance this shock. And you end up with a European continent that seems to take the shock at face value. Growth was expected to be fairly good by European standard, say one, one and a half percent, we thought at the turn of the year is going to be right. Half that, roughly speaking, because of the shock with very few mitigation measures now Maybe more surprising was the reaction of the central bank that, consistent with its inflation mandate, has decided to hike rates and communicate in a fairly hard way on future hikes, fighting inflation and committing to really making sure that there's no second round effect in Europe.
Speaker #1
Yes, indeed. Hi. Hello, Vincent. Indeed, I mean, you know, Europe is Europe. is there is a lack of sexiness from a macro standpoint in Europe, as we know, on the downside, on the upside. I think what you mentioned and what is important to say here is that Europe is entering that oil shock in a very different situation than it was the case in 2022, where inflation was fairly strong.
Speaker #0
So quite different from what the central bank says, right? It is different than 2022.
Speaker #1
Yeah, this is different. But it was... From, you know, from our reading, indeed, the reaction function of the central bank should be slightly different than it was the case. And the ECB should not enter into, you know, a long tightening cycle, as it was the case in 2022, as the Fed was, by the way. So the ECB hiked last week, we know, by 25 basis points. The market is still pricing around 30 basis points by the end of the year and even more so next year. So what is important? important for us in the in reading that shock is that of course it's first it's inflationary but second to the second order this is recessionary for the economy for the purchasing power by eroding you know the purchasing power of consumers and so from that standpoint you know the central bank should not be overreacting to that move they did i think i guess part of the mandate inflation targeting they had to return to to react for the confidence of the market market in their in their mandate in the credibility even though but so far we don't see much second round effect on salaries and wages in Europe.
Speaker #0
Maybe we could add the fiscal side, right? Back in 2022, you had a lot of fiscal injections or measures to mitigate the shock of the Ukraine war. It's not the case today. So that also should sort of reduce the risk of potential second round effects.
Speaker #1
Yeah, there are a string of factors, as you mentioned. The wages, it's very important for, of course, the central bank to see is that if you do have a spike in wages that mean that you know anticipation expectation of inflation might be disencored and from all point of view this is very unlikely to happen so eventually the the expectation of the market in terms of the pricing of the ecb cycle seems to be overdone uh in opposition that's why it's passing too much yeah the market is pricing too much so from that standpoint It was a good strategy in that crisis we witnessed over the past two months and the repricing of the ECB hikes to counter that and to buy some short-term bonds in Europe. And it's also a multi-scenario from that standpoint if things are getting worse.
Speaker #0
And it's also part of the job of the ECB. It's an inflation mandate. They have to act on that basis. They have to communicate hard. And in doing so, they actually, because they do it well and they are successful in this communication exercise, they actually reduce the risk of second round effects and make it even more recessionary than the shock itself. So they actually go our way, the way that ends up being positive for bonds, European bonds. And in our portfolios, that's the conclusion we do draw today. on European assets. It's first inflationary, but temporarily, right after, it is recessionary. Growth is going to come down, and too many hikes are priced for that scenario that comes next. So there's a strong opportunity on short-dated European bonds today. And the good news is that it offers also a decent protection for our portfolios versus other positions we may have elsewhere. So... Let's move to the US, which has a fairly more speculative way to leverage itself out of the shock. So in a fairly American way, they are facing a shock probably even bigger than the shock Europe is facing at face value. but they sort of refused the chalk and doubled down with massive AI investments. So far, I mean, to be fair, do offset the shock. They maintain growth in spite of tariffs. That was the surprise we had last year by the end of the year of still decent growth in spite of tariffs today. It's still decent growth in spite of the triple inflation shock and oil and AI coming now. So the question I think we may discuss today is, you know. What's the ability of the U.S. economy to counterbalance that shock? For how long? By how much? And can they really leverage their way out of that inflation shock? I mean, just to start with a number, the revenue squeeze U.S. households are facing, we know it's 80% of the economy consumption, so that's important for the U.S. economy. Today, inflation is running, that's the last number from May, on an annual... annualised visas is running above 8%. headline cpi uh against that salaries are more like three and a half if not a bit less and aggregate labor income on aggregate is slightly above four so that's big i mean that is something we haven't seen outside of recession and such a drag on real revenue of course it's only a month so far but if we are to say it's not going to be easy to take oil prices back down to 60 dollars it's going to take time if we are to say inflation coming from ai it's demand driven you companies are here to invest and they won't stop tomorrow it's likely that this inflation inflationary pressure persists for some time so are we not um you know at the beginning of some very severe pressure on the u.s consumer that could take the economy down yeah
Speaker #1
well it's not only the beginning to be honest i mean if you look at the uh dynamic of this re-income in the u.s it's been coming down for quite a while now not only in the crisis you mean the consumption consumption and the real income in the u.s has been coming down for quite a while inflation is quite sticky eventually even though it came down from the peak into the 22 this there is you know a spike at the moment uh that might be coming down a bit if the oil price is normalizing what is important here is that you you do have some inertia in inflation because you have a triple shock as you mentioned the tariff um the uh the software and the IT. or the AI, the inflation linked to AI, and then the oil prices. So all of those shocks will roll down in a way. This is the case for the tariff shock at the moment, but the inertia is still coming in, and we haven't seen any reaction from the salary standpoint. So from that standpoint, yeah, real income has come down for quite a while in the US. And this is a question. As you mentioned, it's 80% of the GDP in the US consumption. you you need a strong consumption to have a very strong U.S. growth. And to put things into perspective, and I think it's important because there is some perception that the U.S. economy, if you were looking just at, let's say, the equity market and the investment in AI that has been announced over the past 6 to 12 months, you had the impression that you are back into the 2000s where growth was... riding at 4% to 5% on an annual basis. We are around 2%, 1.5%, 1.6% in the first quarter, maybe 2%, maybe slightly above 2%, which is close to par on the potential growth. And when you look at the share of investment in AI in that growth, it's fairly modest so far. The direct impact is 0.3% to 0.5% of GDP out of the 1.5% to 2% we have. So it might be increasing. But this is not the bulk of the investment because consumption is still subdued and there is no driver coming out of consumption at the moment. What is important to notice as well is that this is also a drag on the headline growth because a lot of this investment is imported from Asia. So it has a net negative impact on the GDP growth. Yeah, but I mean,
Speaker #0
now if I may, Thomas, I mean... consumption has been surprisingly resilient. I mean, to be honest, yes, he's been coming down as a trend over the last three years. But yet, recently, you can see that the U.S. consumer in the last six months has consumed well beyond his revenues. Revenues are coming down, yet he's still consuming at a similar pace. You can see that slope of revenues coming down. But spending is remarkably constant, if not actually going up. Today, I would link that to the confidence derived from the theme. So yes, AI is small. The physical contribution, as you said, to GDP is fairly small, 0.3, maybe 0.5% of extra GDP last year and this year. But the confidence it brings in the system through feel-good factor or feel-strong factor as well as... wealth effect from the stock market. We know US consumers are well exposed to. This confidence that comes from these factors led to well above revenue consumption and held the economy. So of course, that means savings continue to come down. But I guess the big question is, how long can that persist? Because by nature, it isn't sustainable. You cannot tap into your savings.
Speaker #1
for too long right yeah well it's a difficult question and i don't have the answer i think you know our role here in the way we are analyzing the macro and the markets what we we can you know point out to our listeners is that you have a string of factors markers at the moment in the macro and the financial variable in the us which are you know pointing out two signs of kind of weakening in that that this state is getting less and less steady and stable okay and that's something can break and as you mentioned the confidence is very strong in the stock market and this is helping reducing a consumer tapping in the saving to consume even more despite and to face saving they're not saving anymore or very very few and so they're tapping in their saving to face, you know, the different inflationary shocks. You had some, you know, fiscal impulse thanks to the OBB in the U.S. Lately, it was $140 billion at the moment of the Strait of Hormuz closure. So it's an important flow into the U.S. consumer pocket that have buffered that rise in the oil price at the gas station. But I guess the question here, and this is important for us to mention, that yes, this state is getting more and more fragile. We don't know when, you know, this can be turning from one side to another of the cliff. But clearly we have those. you know, the box ticked that we, you know, we are more careful. Yeah,
Speaker #0
I mean, to be fair, you're right. I mean, the impact of the OBBB is actually now fading, if not over. It was all until end of May, early June. So as we speak today, there's no more positive impact to be expected from that side. So on the fiscal side, there's no more support. We may argue as well that due to these shocks, the Fed will not be easily present. He will know. easily come to the rescue. Hard for them to cut rates in the current context. So it's going to take a while before they're back on that side of the equation. As for savings, there's nothing left in the pocket. Now, the private sector, you may argue, was very strong in the US with all these companies that had made huge profits on the tech sector worldwide. and that are now spending this money. So it probably constitutes a stimulus to the U.S. economy from the private sector. All these hundreds of billions, the big five, the circle big five, are now spending to build these data centers. That's huge money. That's similar to a support, a fiscal support to the U.S. economy, is it not? You may argue that could suffice to... leverage the economy out of the shock.
Speaker #1
It may, you know, entertain the movement or the cycle for quite a while. Then the first question we can ask about this cycle is that, as I said before, a large part of those investments are directed to Asia, imported from Asia. So the main beneficiary, first order, is Asian producers, Taiwan, Korea, and so on. We'll talk about it later. So that's an important thing. The second thing is that there is a rise in investment in AI this year, but part of it is just nominal illusion in the sense that the prices of the inputs for the data center, the chips, and so on.
Speaker #0
You mean costs are rising?
Speaker #1
The costs are rising. I've reasoned quite a lot. So from that standpoint, if you look at just the nominal amount of total investment, let's say maybe 800 billion or maybe more, about 25 to 30%, if we cross-check the numbers with the exports from Asia, are coming from the rise in prices. So the net, I would say the real rise in investment is slightly lower than nominal investment. So from a macro standpoint, it matters because first, the rise in prices is going to Asia, is going to Asian producers and not to American producers. So that's the first thing. So on the steadiness, the durability of that cycle, the question we have is a question, as I think a lot of people have, is that the circularity of this ecosystem in our life. So it's investment in a company owned by another company within an ecosystem, and 80% to 85% of this investment is circular, is generating revenues and profit.
Speaker #0
Remains endogenous, yeah.
Speaker #1
Endogenous. So the question we have is that at some point, that. It might be indeed put into question by investors.
Speaker #0
They're building a new product, but so far it's mostly the staff buying. There's no big final consumer buying these AI products, so at least we're all using it but not paying much for it. Indeed, when you look into the number crunch and the numbers, most of it remains within the system. and something I find interesting and possibly... are worrying on the ability of these companies to monetize the whole thing. These massive investments they have on these $800 billion for this year, above the sort of $500 we had last year, up to maybe $1 trillion next. Is that these 85% you mentioned, 85% of internal money circulating within the system, is fairly stable. I mean, it's been there for about three years. there's no Positive dynamics in such a revolution, you would have expected the number, the ability to sell it to the outside world to increase, not to remain stable. And that sort of hints at really difficulties to monetize that AI production, AI engine they are producing out there. Now, possibly there's more hurdles to it today. You can see as well there are bottlenecks. In the ability to build these data centers, price of electricity, of water, the authorizations they need to build these centers, you mentioned the cost increase which makes... makes it for the big part of the increase in these capex numbers. It's essentially cost-driven. You may mention as well competition. In this big AI revolution, the business plan is drastically changing for the US companies. They're moving from a low-cost, monopolistic business plan. And when you sell... Web advertising or social networks, it doesn't cost you much, and you are pretty much in a monopoly. You don't change the social network that easily. AI is a completely different animal. You need to spend a lot, lot, lot more, 100 times more, for something that is highly competitive and also interchangeable. You can change. AI engine fairly easily. I guess we've all changed already a few times over the last couple of years. So that shows the difficulty for these companies to keep these margins. They will really struggle in this highly competitive world, first to monetize these huge costs, but also over time to keep it. It's one thing to come first to the race, but staying first. staying ahead of others is going to be difficult in the context of high competition. Just one example there. I mean, the deep-seek engine that shaked markets last year is not far behind in terms of efficacy for the user. You're talking 20-30% maybe less efficient than the big US engines. Now, it's also 20-50 times cheaper. depending on the request you have. So you already have half competition in there. So you're already in a world where these companies will struggle. In short, the way we could see that big AI investment boom, the US is putting huge money on the table today with a big bet on the future. But today, it benefits Asia. Now, will it benefit the US in the future? And how many years?
Speaker #1
major questions and from a macro standpoint the answer is not obvious far from it well i think the the most obvious answer is that it will benefit the us of course and but it will benefit if the outcome is as strong as expected it will benefit consumers across the globe so at the end of the day as it was the case with the web so from our standpoint and on analysis is better to be you know, position to the recipients. of those investments, the providers, and the consumer eventually would, you know, and it's true in Europe.
Speaker #0
The two extremes of the chain, the production chain.
Speaker #1
Exactly. So that's a key point. I think to add up to the listing of concern that we may have, you know, is that we are, you know, turning at a tipping point where we see more and more leverage coming. So they have to borrow, they have to come to the market, they have to borrow to build data centers and so on. We know that now the cash flows are not enough to finance investment. So you are entering a phase of the American usual leverage cycle, which is a classic. Maybe it's a beginning, maybe it's mature. Of course, indeed, the leverage so far has been quite low, fairly limited in the US. And we've explained that many times, because during COVID, the state balance sheet, the fiscal, the sovereign, has taken on the private balance sheet, whether it's a consumer or the corporate. rates off. we've we started the cycle in a very lc in a very healthy situation but we start things out so that means that then you're going to be more sensitive to rate hikes to the interest rate and so on and to you know bad loan and so on so we're not saying that we are in a bottleneck at the moment from a less lever leverage
Speaker #0
standpoint but the financing will become an issue as well from the state we we might end up with the overhang of of debt and equity and and supply of capital there in the eye. In the end, I mean, the U.S., in essence, is financing a big tech revolution to the benefits of Asia today, and the rest of the world. Tomorrow, in the meantime, they do bear the huge cost and the big risks that do lie ahead. So that's not a win. The win should not be taken for granted there. Now, on assets, that tells us maybe to conclude on this U.S. part that we remain very cautious on U.S. equities for all the reasons we just described from a macro standpoint. It is really challenging there. We remain also continue to step away from treasuries, so from bonds where it's going to be difficult for the Fed to cut rates before it really slows down. And long bonds continue to be basically sold by investors, and they do move away from these bonds that they see as riskier because because of inflation, because of solvency, and because of the credibility of the US central bank. So we'll also sort of move away from this part of the asset spectrum. And of course, the dollar. The dollar as a consequence of assets. The dollar that has shown that it's probably now linked to assets that are more volatile, riskier, less rewarding as well than in the past. And the dollar, more recently, Because of what happened in the Middle East, that has probably shown that it has lost some of its protection qualities, its defensive safe haven attractiveness it had in the past. So it's basically out of everything U.S. related in our portfolios today, probably even more than was the case at the turn of the year. Now, maybe on a more... Positive note is Asia. Asia, less speculative, more realized, and you're more the expert here on the region. It seems at face value that not only does Asia have the means to absorb the shock with more savings, better ability to absorb it through fiscal measures than the US and even Europe, and that Asia benefits from a strong... macro dynamic because it immediately benefits from the AI investment boom in proportions unseen in Asian history. And I would even add that from what we see that there are quite good at sort of redistributing the gains of this AI boom into the rest of the economy. So it's not to the benefit of a few happy stakeholders. It's really through fiscal measures, through bonuses in companies. It seems that Asia is really doing a good job in translating these profits.
Speaker #1
uh into into real organic growth in the region yeah indeed i mean when you look at asia at the moment clearly this is the main beneficiary and you know to contrast with the u.s and you mentioned about the monetization of those investment in the u.s at the moment asia is monetizing on day one because they are selling product and they are paid and they are not only paid you know on day but they are paying forwards because they are You know, the orders are full. So from that standpoint, you know, this is real money coming in with investment they've made. They have to make more investment in the future. But so it has direct consequences on the macro side from the Asian point of view, you know, on growth, on investment, on consumption. And just anecdotally, we've seen that in the first quarter, Taiwan was running, you know, a normal rate of 14.14%. GDP. GDP growth. Wow, yeah. Of course, it might be, you know, surely it will normalize in the coming quarter, the coming years, because there was initial boom of orders from the US. But we can bet on the fact that because this AI revolution is here to last, this is not our purpose here, this will continue. And so far, Asia has not been challenged in terms of, you know, being the main input. uh in that the main provider the main provider in that chain so uh the the the macro consequences is important uh and it's even more so from a flow standpoint when you look at uh you know the dynamic of flows of course this is resulting in large current account surpluses because the u.s uh companies are buying from products from asia and they buy in dollars and those dollars are returning to Asia in the form of, you know, trade surpluses and so there is a flow of dollars coming out coming in into asia and which is flowing back into the u.s at the moment in form of investment so far it's being recycled so far it's been fully recycled and that explains why those currencies have been quite weak again the dollar because the money which was flowing in was you know returning to the u.s it's a bit like the petrodollars right it's uh exactly what happened in the with the petrodollars in the years 2000 and it's even bigger than... you know, in terms of amount and volume at the moment, it's even bigger than this was at the time. Because if you add up for the current data you have in Taiwan, in Korea, and in Japan, if you add up all the current account surpluses of those three countries and running them for an annualized basis, you're around $500 billion. So those $500 billion are mostly recycled.
Speaker #0
That mirrors the spending from the U.S. almost.
Speaker #1
Exactly. so The U.S. benefits in a way indirectly because this is sent back in the form of investment in treasuries, in U.S. equities. Treasuries is mostly for Taiwan and U.S. equities mainly for Korea. And so far they've been buying this story. What we think will happen is that the balance of flows at the margin or even more so maybe more structurally will change, will shift a bit. That is more of those dollars what we... make all the cheap dollars you know uh the cheap dollars will be recycled more locally in terms of investment i.e what you're going to face is samsung investing into new plants tsmc in taiwan new plants in taiwan and it's in in in korea to to to produce more chips and to invest in rnd and so on and so on so you will have those that's natural move you will have part of it which will be spent locally in local consumption by employees, having nice salaries and good wages, and probably investors will invest more and more locally in their local equity market or bond markets.
Speaker #0
Maybe one point on this, Thomas. I'm a bit surprised to hear you saying that their plan is to invest these big companies to recycle a lot of this money locally because what we see so far, I would say, is probably the opposite. I mean, if you look at the nominal VREAL exports from Asia, most is in the price. They are not producing more or not much more in front of this high demand from the US. They're just selling at. It's a higher price, so basically they are raising margins, which I find is a very strong approach, because basically they are avoiding the risk of overproduction and overcapacity in the future, essentially saying, OK, there's a boom today, but it may not last. So we refuse, as Asian factories, Asian providers, to bear that overcapacity risk. You even had some Taiwanese and Korean companies saying, if you are to want to get that production faster as a U.S. client, then you pay. You pay for the next three, four, five years. You finance the whole thing. And then, okay, then we can produce more. But that's in your hands. And in that sense, it makes, in my view, even more speculative from the U.S. standpoint that bears the whole risk of the whole project when Asia just leave that.
Speaker #1
leaves that in the hands of the us yeah probably from a business standpoint you're right but of course i mean part of that money will be invested reinvested locally into new uh new capacities and r d to yeah one way or the other ahead of the game i'm not saying the full amount and maybe you know they want to regulate i'm here you know if from a macro standpoint i think what matters because we've been studying a bit you know into details the dynamic of flows and it's true that so far Those currencies have been weak because I think the local authorities, like the Japanese authorities, were not that unhappy with the weak currency because, you know, you gain competitiveness. Where, you know, it's becoming a bit more tricky for local authorities like central banks is that you have imported inflation, which is, I mean, there is the oil price increase, but when you have a weak currency, you pay even more. So you have imported inflation. So that's an issue. And imported inflation is rising. You do have also an issue with the fact that because investment in domestic demand is supported by strong growth, unlike in the U.S. domestic demand, well, you have pressure on wages. And this is,
Speaker #0
you know,
Speaker #1
when we talk about Europe and the U.S., here you have risk of second-round effect in Asia, which are very strong. So here you have...
Speaker #0
Even different from what you see in the U.S., indeed.
Speaker #1
Exactly. So here you have to react, and by being more hawkish and too tight in monetary policy, and you have fiscal flows. Because corporate taxes, VAT, is flowing for some of that standpoint. I would say all spectrum ecosystem of the policy mix, as we say, monetary policy and fiscal policy, is benefiting from that.
Speaker #0
You really have that distribution into the whole economy of the benefits of the investment boom, really. Exactly.
Speaker #1
And that matters a lot from our point of view. And, you know, when you have, if you... Put the two blocks. You have the sender, which is Asia, the saver, and the recipients, which is the US. Here you have more and more demand. You need to finance more AI investment. So you need a bull market in the bond market, in the equity market with new listing and so on. You need fiscal, and fiscal is not about to be tightened anytime soon. So you need new financing to finance the fiscal deficit coming in from local investors. and from Asia. So this saving is financing the US at the moment. The problem from the receptionist point of view, and this is what we've described for quite a while, is that the question is getting weaker from a standpoint. It's still there, you know, the question, and the machine is still working. But the state, from our point of view, is, I would say,
Speaker #0
less appealing,
Speaker #1
less attractive. because the fiscal deficit... So far,
Speaker #0
Asian money is really invested in U.S. assets, really financing the deficits and the needs of money you have out there. But, I mean, I guess your point is about the fragility of all that and questions being asked from an investment standpoint. There's a point where Asian investors may question the appeal of these investments from a risk standpoint, maybe for the reasons we discussed about the U.S., or from a return standpoint.
Speaker #1
point if we need to struggle to monetize it's just a question of risk reward uh as you mentioned and as we have increasing needs in the u.s you need more marginal buyers it's not about the static you know flow of money that's true about you know 100 billion dollars going from asia to the u.s every year you need more to go because you need more financing for ai and you need more financing for the state for so as uh you know a recipient of those flows you need to be more attractive from all standpoints. the US is getting less attractive on many points. So we think that part of this money at the margin, or, you know, it might be a big amount, so it's going to be less and less invested in the US and more locally. And, you know, it will be invested in domestic. market, equity market, or in local investment. We've seen lately that, you know, the Korean authorities have enticed the National Pension Fund to invest more in the domestic market.
Speaker #0
Which is a strong signal.
Speaker #1
It's a strong signal. I think it's probably a phenomenon that we're going to see a bit worldwide because domestic financing needs in Europe, in the Middle East now,
Speaker #0
are increasing. Rising everywhere.
Speaker #1
So they need to invest locally. So it's a question of sovereign. you know uh risk independence i guess as well so for you we need to understand that we need we don't need a sudden stop in flows from asia to the us or to the rest of the world mainly to the us to
Speaker #0
revert that dynamic you need to have less and less marginal change in the recycling process if they just stop investing 100 of their money into the us just takes that down to 90 you He's already a lot and he's already very supportive for local assets and local currencies. And indeed, yeah, I take your point about that sort of global move, really. The whole world now is in a position where both it's getting skeptical about US assets and the underlying risks, and maybe also on the protection they used to offer, the dollar particularly, as well as in need of more money. locally to finance, you say, national security. Because that's what we're talking about here. And that works both ways and could, in essence, change the nature of flows we've seen going west and west and west again for decades into dollar assets and into the dollar, now reversing one after the other. Maybe Asia is coming last. Maybe on that notion of flow, We've seen as well that funds and particularly you talking about local investors and the massive current account you would expect the currency to be strong in such context right you got a big balance and you got locals that are quite keen to gradually invest more domestically yet the currencies remain strong lately why is that i mean when you dig into the mechanics behind then it's about the other actor in the equation is the foreign investor that had invested in asian stocks And particularly if you take the example of Korea, these foreign funds that had bought these stocks technically had to sell Korean assets. And they, of course, sold the Korean one with it, adding pressure to the one. And the technical reasons is fairly mechanical, very straightforward. Because of the fantastic performance of the Samsung and SK Enix, the big, big caps in the index that exceeded the cap level they had in their own passive management. they had to take that way down as passive managers through the index rebalancing process and in doing so they had to sell one for big amounts now practically this as soon as the performance of these assets normalize i'm not saying go down but just just stop overshooting then that technical pressure stops and it's probably already over because the last three three four weeks have been a lot more stable in terms of price action. So you... I mean, my best guess would be that soon enough, you're going to see that pressure for foreign investors disappears. And you're going to see the power of this massive current account they've created. And gradually, that appetite of local investors for their own assets. And that should take all these currencies up more mechanically, right? Yeah,
Speaker #1
probably. I mean... There are a few other reasons why we think the tide may be turning for Asian currencies. It's also that because of this strong impulse in the domestic growth, as I said, the central banks are biased to be hawkish and high-crates. The Fed, we know, is at the end of the first phase of the loosening cycle. It's in the wait-and-see mode for the moment. you What's going to happen is that the interest rate differential between those currencies and the dollar... Which is the cost of hedging, right? The cost of hedging. So basically, people used to sell those currencies because it was so cheap to sell the currencies. Even though you were investing locally...
Speaker #0
So expensive to hedge the dollar risk.
Speaker #1
Exactly. And it was a way to, for example, at H2O, we've always been using the Asian currencies as a show to finance other... carried position in the portfolio in Latin America or in Central Europe because it was a way, first those currencies were you know structurally cheap because the countries and the authorities were leaning against appreciation and second The carry was very cheap, so it was a good risk we were to short them. But then, because of the change in the bias for the central banks, of course, this will change the interest rate differential for locals and for investors.
Speaker #0
It makes the cost of hedging a lot cheaper.
Speaker #1
Exactly. So that's important because interest rate differential in the currency flow. Yeah,
Speaker #0
we know actual institutions at a certain cost of hedging, when it falls below a given threshold and we're not far from these levels today they tend to a lot more mechanically hedge their dollars until now they had a huge incentive to keep their dollars now that that is changing now yeah with much more hawkish central banks out there in asia so that means i mean in our portfolios if we are to look at what we like and don't like in the region. I mean, we've been fairly positive on equities in the region for now a year or so. That worked pretty well. And we remain constructive on these assets for all the macro reasons we described. Now, on FX, I mean, that's new. It seems that on the back of what's going on on equities, FX is now turning as well and should now, instead of Being a drag on equity performance will come as a support. And that tells us to go overweigh these currencies. So far, it's been for a long time, maybe too many years, a long yen position we had in our portfolios. Now it's being supplemented with positions in the Korean won, in the Taiwanese dollar, even in the Australian dollar, which is part of the big Asia. as well in some portfolios. So that's a big basket of currencies now we do favor in our portfolios. And as you said, it's sort of the first time we really go long. Yeah, if I may add, there is,
Speaker #1
I think, you know, another, you know, positive point for this currency, which is worth mentioning. The yen position we've had for a long time, which is, you know, what was also, you know, a value position, you know, the fact that the BOJ was you know about to you know in a rising cycle for rates but it was also this was also defensive those currencies in norseasia are also cyclical and positive it's a way to benefit from this global cycle yeah in a more uh in a different way through the saver and not the data which is the us the saver so you are i would say on the right side of the equation with the creditors rather than data and in those moments where we start seeing some sign of questioning about the stability of the cycle. I think it's important. The second thing here is that we think that it's more multi-scenario from that standpoint. Why? Because most of the dollars, as I mentioned, are in private hands, i.e. pension funds, corporate, household sometimes, you know, that old dollar count. So from that standpoint, you could argue that what happened is the AI cycle is softening, you know, suddenly. or declining a bit, and those currencies and those economies would be suffering from that. True. But then you would have a situation where those money, which is invested in the US, would be returning to their local markets in Korea and Taiwan, as Japan has been working for years and years. So here we think that it's more multi-scenario than just pure. A pure cyclical investment.
Speaker #0
If I follow you on this, these currencies that have been historically more like offensive currencies, more risk-on currencies, have now gained some safe haven capabilities, if I may say, basically because they hold so much of these US assets. if there's a shock out there, which as we discussed, may happen with the current massive AI investment boom, then That would trigger repatriation and that would make these currencies stronger, not weaker like in the past. And in that sense, that's another argument, right, in this list of supportive argument for holding a position in those currencies. Maybe we may say that the dollar is gradually being replaced progressively as a safe haven, as a currency, defensive currency. progressively being replaced by Asian currencies, possibly. So on that note, thank you, Thomas, for that long and interesting discussion. Thank you all for listening to this Think Macro, episode of Think Macro, and speak soon on another episode.
Speaker #1
Thank you, Vincent.
Speaker #0
Thank you, Thomas.

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Transcription

Speaker #0
Hi everyone and welcome to this new episode of Think Macro. Today I will exchange, we will discuss with Thomas Delabre, Portfolio Manager at H2O Asset Management and expert on emerging markets on the mid-year outlook. A lot has happened so far, so we will discuss the next six months and more on the economy. Hello, Thomas.
Speaker #1
Hello, Vincent.
Speaker #0
So far this year, we thought at the beginning of the year when discussing this year's outlook that Europe would resist, Asia would perform, and the US was surprisingly resilient. And together with this resilient, we had in mind some fragilities that were appearing in the US economy and we thought okay that may take the economy down and make it slow down over the course of 2026. Now a lot has happened since we had two major shocks to the world economy, a shock that comes from Middle East that took oil prices up so not the shock in itself but the closure of the Strait of Hormuz had a huge impact on oil prices and energy prices in general and us. a new inflation shock that comes on top of tariffs last year. And more recently, we have a third inflation layer shock with artificial intelligence, the boom of investment you have on AI that drives the price of components up as well. So the big question we have from a macro standpoint today is how this triple inflation shock can impact the world, can impact these three regions we discussed last time, with very different outcomes, very different reactions between Europe, the US and Asia. So let's start with Europe. So Europe looks fairly straightforward, is the European low-risk, low-return model. Europe has got plenty of savings, which are in essence, a buffer against any shock and are a buffer against the current shock. But also, Europe has very few means to sort of counterbalance this shock. And you end up with a European continent that seems to take the shock at face value. Growth was expected to be fairly good by European standard, say one, one and a half percent, we thought at the turn of the year is going to be right. Half that, roughly speaking, because of the shock with very few mitigation measures now Maybe more surprising was the reaction of the central bank that, consistent with its inflation mandate, has decided to hike rates and communicate in a fairly hard way on future hikes, fighting inflation and committing to really making sure that there's no second round effect in Europe.
Speaker #1
Yes, indeed. Hi. Hello, Vincent. Indeed, I mean, you know, Europe is Europe. is there is a lack of sexiness from a macro standpoint in Europe, as we know, on the downside, on the upside. I think what you mentioned and what is important to say here is that Europe is entering that oil shock in a very different situation than it was the case in 2022, where inflation was fairly strong.
Speaker #0
So quite different from what the central bank says, right? It is different than 2022.
Speaker #1
Yeah, this is different. But it was... From, you know, from our reading, indeed, the reaction function of the central bank should be slightly different than it was the case. And the ECB should not enter into, you know, a long tightening cycle, as it was the case in 2022, as the Fed was, by the way. So the ECB hiked last week, we know, by 25 basis points. The market is still pricing around 30 basis points by the end of the year and even more so next year. So what is important? important for us in the in reading that shock is that of course it's first it's inflationary but second to the second order this is recessionary for the economy for the purchasing power by eroding you know the purchasing power of consumers and so from that standpoint you know the central bank should not be overreacting to that move they did i think i guess part of the mandate inflation targeting they had to return to to react for the confidence of the market market in their in their mandate in the credibility even though but so far we don't see much second round effect on salaries and wages in Europe.
Speaker #0
Maybe we could add the fiscal side, right? Back in 2022, you had a lot of fiscal injections or measures to mitigate the shock of the Ukraine war. It's not the case today. So that also should sort of reduce the risk of potential second round effects.
Speaker #1
Yeah, there are a string of factors, as you mentioned. The wages, it's very important for, of course, the central bank to see is that if you do have a spike in wages that mean that you know anticipation expectation of inflation might be disencored and from all point of view this is very unlikely to happen so eventually the the expectation of the market in terms of the pricing of the ecb cycle seems to be overdone uh in opposition that's why it's passing too much yeah the market is pricing too much so from that standpoint It was a good strategy in that crisis we witnessed over the past two months and the repricing of the ECB hikes to counter that and to buy some short-term bonds in Europe. And it's also a multi-scenario from that standpoint if things are getting worse.
Speaker #0
And it's also part of the job of the ECB. It's an inflation mandate. They have to act on that basis. They have to communicate hard. And in doing so, they actually, because they do it well and they are successful in this communication exercise, they actually reduce the risk of second round effects and make it even more recessionary than the shock itself. So they actually go our way, the way that ends up being positive for bonds, European bonds. And in our portfolios, that's the conclusion we do draw today. on European assets. It's first inflationary, but temporarily, right after, it is recessionary. Growth is going to come down, and too many hikes are priced for that scenario that comes next. So there's a strong opportunity on short-dated European bonds today. And the good news is that it offers also a decent protection for our portfolios versus other positions we may have elsewhere. So... Let's move to the US, which has a fairly more speculative way to leverage itself out of the shock. So in a fairly American way, they are facing a shock probably even bigger than the shock Europe is facing at face value. but they sort of refused the chalk and doubled down with massive AI investments. So far, I mean, to be fair, do offset the shock. They maintain growth in spite of tariffs. That was the surprise we had last year by the end of the year of still decent growth in spite of tariffs today. It's still decent growth in spite of the triple inflation shock and oil and AI coming now. So the question I think we may discuss today is, you know. What's the ability of the U.S. economy to counterbalance that shock? For how long? By how much? And can they really leverage their way out of that inflation shock? I mean, just to start with a number, the revenue squeeze U.S. households are facing, we know it's 80% of the economy consumption, so that's important for the U.S. economy. Today, inflation is running, that's the last number from May, on an annual... annualised visas is running above 8%. headline cpi uh against that salaries are more like three and a half if not a bit less and aggregate labor income on aggregate is slightly above four so that's big i mean that is something we haven't seen outside of recession and such a drag on real revenue of course it's only a month so far but if we are to say it's not going to be easy to take oil prices back down to 60 dollars it's going to take time if we are to say inflation coming from ai it's demand driven you companies are here to invest and they won't stop tomorrow it's likely that this inflation inflationary pressure persists for some time so are we not um you know at the beginning of some very severe pressure on the u.s consumer that could take the economy down yeah
Speaker #1
well it's not only the beginning to be honest i mean if you look at the uh dynamic of this re-income in the u.s it's been coming down for quite a while now not only in the crisis you mean the consumption consumption and the real income in the u.s has been coming down for quite a while inflation is quite sticky eventually even though it came down from the peak into the 22 this there is you know a spike at the moment uh that might be coming down a bit if the oil price is normalizing what is important here is that you you do have some inertia in inflation because you have a triple shock as you mentioned the tariff um the uh the software and the IT. or the AI, the inflation linked to AI, and then the oil prices. So all of those shocks will roll down in a way. This is the case for the tariff shock at the moment, but the inertia is still coming in, and we haven't seen any reaction from the salary standpoint. So from that standpoint, yeah, real income has come down for quite a while in the US. And this is a question. As you mentioned, it's 80% of the GDP in the US consumption. you you need a strong consumption to have a very strong U.S. growth. And to put things into perspective, and I think it's important because there is some perception that the U.S. economy, if you were looking just at, let's say, the equity market and the investment in AI that has been announced over the past 6 to 12 months, you had the impression that you are back into the 2000s where growth was... riding at 4% to 5% on an annual basis. We are around 2%, 1.5%, 1.6% in the first quarter, maybe 2%, maybe slightly above 2%, which is close to par on the potential growth. And when you look at the share of investment in AI in that growth, it's fairly modest so far. The direct impact is 0.3% to 0.5% of GDP out of the 1.5% to 2% we have. So it might be increasing. But this is not the bulk of the investment because consumption is still subdued and there is no driver coming out of consumption at the moment. What is important to notice as well is that this is also a drag on the headline growth because a lot of this investment is imported from Asia. So it has a net negative impact on the GDP growth. Yeah, but I mean,
Speaker #0
now if I may, Thomas, I mean... consumption has been surprisingly resilient. I mean, to be honest, yes, he's been coming down as a trend over the last three years. But yet, recently, you can see that the U.S. consumer in the last six months has consumed well beyond his revenues. Revenues are coming down, yet he's still consuming at a similar pace. You can see that slope of revenues coming down. But spending is remarkably constant, if not actually going up. Today, I would link that to the confidence derived from the theme. So yes, AI is small. The physical contribution, as you said, to GDP is fairly small, 0.3, maybe 0.5% of extra GDP last year and this year. But the confidence it brings in the system through feel-good factor or feel-strong factor as well as... wealth effect from the stock market. We know US consumers are well exposed to. This confidence that comes from these factors led to well above revenue consumption and held the economy. So of course, that means savings continue to come down. But I guess the big question is, how long can that persist? Because by nature, it isn't sustainable. You cannot tap into your savings.
Speaker #1
for too long right yeah well it's a difficult question and i don't have the answer i think you know our role here in the way we are analyzing the macro and the markets what we we can you know point out to our listeners is that you have a string of factors markers at the moment in the macro and the financial variable in the us which are you know pointing out two signs of kind of weakening in that that this state is getting less and less steady and stable okay and that's something can break and as you mentioned the confidence is very strong in the stock market and this is helping reducing a consumer tapping in the saving to consume even more despite and to face saving they're not saving anymore or very very few and so they're tapping in their saving to face, you know, the different inflationary shocks. You had some, you know, fiscal impulse thanks to the OBB in the U.S. Lately, it was $140 billion at the moment of the Strait of Hormuz closure. So it's an important flow into the U.S. consumer pocket that have buffered that rise in the oil price at the gas station. But I guess the question here, and this is important for us to mention, that yes, this state is getting more and more fragile. We don't know when, you know, this can be turning from one side to another of the cliff. But clearly we have those. you know, the box ticked that we, you know, we are more careful. Yeah,
Speaker #0
I mean, to be fair, you're right. I mean, the impact of the OBBB is actually now fading, if not over. It was all until end of May, early June. So as we speak today, there's no more positive impact to be expected from that side. So on the fiscal side, there's no more support. We may argue as well that due to these shocks, the Fed will not be easily present. He will know. easily come to the rescue. Hard for them to cut rates in the current context. So it's going to take a while before they're back on that side of the equation. As for savings, there's nothing left in the pocket. Now, the private sector, you may argue, was very strong in the US with all these companies that had made huge profits on the tech sector worldwide. and that are now spending this money. So it probably constitutes a stimulus to the U.S. economy from the private sector. All these hundreds of billions, the big five, the circle big five, are now spending to build these data centers. That's huge money. That's similar to a support, a fiscal support to the U.S. economy, is it not? You may argue that could suffice to... leverage the economy out of the shock.
Speaker #1
It may, you know, entertain the movement or the cycle for quite a while. Then the first question we can ask about this cycle is that, as I said before, a large part of those investments are directed to Asia, imported from Asia. So the main beneficiary, first order, is Asian producers, Taiwan, Korea, and so on. We'll talk about it later. So that's an important thing. The second thing is that there is a rise in investment in AI this year, but part of it is just nominal illusion in the sense that the prices of the inputs for the data center, the chips, and so on.
Speaker #0
You mean costs are rising?
Speaker #1
The costs are rising. I've reasoned quite a lot. So from that standpoint, if you look at just the nominal amount of total investment, let's say maybe 800 billion or maybe more, about 25 to 30%, if we cross-check the numbers with the exports from Asia, are coming from the rise in prices. So the net, I would say the real rise in investment is slightly lower than nominal investment. So from a macro standpoint, it matters because first, the rise in prices is going to Asia, is going to Asian producers and not to American producers. So that's the first thing. So on the steadiness, the durability of that cycle, the question we have is a question, as I think a lot of people have, is that the circularity of this ecosystem in our life. So it's investment in a company owned by another company within an ecosystem, and 80% to 85% of this investment is circular, is generating revenues and profit.
Speaker #0
Remains endogenous, yeah.
Speaker #1
Endogenous. So the question we have is that at some point, that. It might be indeed put into question by investors.
Speaker #0
They're building a new product, but so far it's mostly the staff buying. There's no big final consumer buying these AI products, so at least we're all using it but not paying much for it. Indeed, when you look into the number crunch and the numbers, most of it remains within the system. and something I find interesting and possibly... are worrying on the ability of these companies to monetize the whole thing. These massive investments they have on these $800 billion for this year, above the sort of $500 we had last year, up to maybe $1 trillion next. Is that these 85% you mentioned, 85% of internal money circulating within the system, is fairly stable. I mean, it's been there for about three years. there's no Positive dynamics in such a revolution, you would have expected the number, the ability to sell it to the outside world to increase, not to remain stable. And that sort of hints at really difficulties to monetize that AI production, AI engine they are producing out there. Now, possibly there's more hurdles to it today. You can see as well there are bottlenecks. In the ability to build these data centers, price of electricity, of water, the authorizations they need to build these centers, you mentioned the cost increase which makes... makes it for the big part of the increase in these capex numbers. It's essentially cost-driven. You may mention as well competition. In this big AI revolution, the business plan is drastically changing for the US companies. They're moving from a low-cost, monopolistic business plan. And when you sell... Web advertising or social networks, it doesn't cost you much, and you are pretty much in a monopoly. You don't change the social network that easily. AI is a completely different animal. You need to spend a lot, lot, lot more, 100 times more, for something that is highly competitive and also interchangeable. You can change. AI engine fairly easily. I guess we've all changed already a few times over the last couple of years. So that shows the difficulty for these companies to keep these margins. They will really struggle in this highly competitive world, first to monetize these huge costs, but also over time to keep it. It's one thing to come first to the race, but staying first. staying ahead of others is going to be difficult in the context of high competition. Just one example there. I mean, the deep-seek engine that shaked markets last year is not far behind in terms of efficacy for the user. You're talking 20-30% maybe less efficient than the big US engines. Now, it's also 20-50 times cheaper. depending on the request you have. So you already have half competition in there. So you're already in a world where these companies will struggle. In short, the way we could see that big AI investment boom, the US is putting huge money on the table today with a big bet on the future. But today, it benefits Asia. Now, will it benefit the US in the future? And how many years?
Speaker #1
major questions and from a macro standpoint the answer is not obvious far from it well i think the the most obvious answer is that it will benefit the us of course and but it will benefit if the outcome is as strong as expected it will benefit consumers across the globe so at the end of the day as it was the case with the web so from our standpoint and on analysis is better to be you know, position to the recipients. of those investments, the providers, and the consumer eventually would, you know, and it's true in Europe.
Speaker #0
The two extremes of the chain, the production chain.
Speaker #1
Exactly. So that's a key point. I think to add up to the listing of concern that we may have, you know, is that we are, you know, turning at a tipping point where we see more and more leverage coming. So they have to borrow, they have to come to the market, they have to borrow to build data centers and so on. We know that now the cash flows are not enough to finance investment. So you are entering a phase of the American usual leverage cycle, which is a classic. Maybe it's a beginning, maybe it's mature. Of course, indeed, the leverage so far has been quite low, fairly limited in the US. And we've explained that many times, because during COVID, the state balance sheet, the fiscal, the sovereign, has taken on the private balance sheet, whether it's a consumer or the corporate. rates off. we've we started the cycle in a very lc in a very healthy situation but we start things out so that means that then you're going to be more sensitive to rate hikes to the interest rate and so on and to you know bad loan and so on so we're not saying that we are in a bottleneck at the moment from a less lever leverage
Speaker #0
standpoint but the financing will become an issue as well from the state we we might end up with the overhang of of debt and equity and and supply of capital there in the eye. In the end, I mean, the U.S., in essence, is financing a big tech revolution to the benefits of Asia today, and the rest of the world. Tomorrow, in the meantime, they do bear the huge cost and the big risks that do lie ahead. So that's not a win. The win should not be taken for granted there. Now, on assets, that tells us maybe to conclude on this U.S. part that we remain very cautious on U.S. equities for all the reasons we just described from a macro standpoint. It is really challenging there. We remain also continue to step away from treasuries, so from bonds where it's going to be difficult for the Fed to cut rates before it really slows down. And long bonds continue to be basically sold by investors, and they do move away from these bonds that they see as riskier because because of inflation, because of solvency, and because of the credibility of the US central bank. So we'll also sort of move away from this part of the asset spectrum. And of course, the dollar. The dollar as a consequence of assets. The dollar that has shown that it's probably now linked to assets that are more volatile, riskier, less rewarding as well than in the past. And the dollar, more recently, Because of what happened in the Middle East, that has probably shown that it has lost some of its protection qualities, its defensive safe haven attractiveness it had in the past. So it's basically out of everything U.S. related in our portfolios today, probably even more than was the case at the turn of the year. Now, maybe on a more... Positive note is Asia. Asia, less speculative, more realized, and you're more the expert here on the region. It seems at face value that not only does Asia have the means to absorb the shock with more savings, better ability to absorb it through fiscal measures than the US and even Europe, and that Asia benefits from a strong... macro dynamic because it immediately benefits from the AI investment boom in proportions unseen in Asian history. And I would even add that from what we see that there are quite good at sort of redistributing the gains of this AI boom into the rest of the economy. So it's not to the benefit of a few happy stakeholders. It's really through fiscal measures, through bonuses in companies. It seems that Asia is really doing a good job in translating these profits.
Speaker #1
uh into into real organic growth in the region yeah indeed i mean when you look at asia at the moment clearly this is the main beneficiary and you know to contrast with the u.s and you mentioned about the monetization of those investment in the u.s at the moment asia is monetizing on day one because they are selling product and they are paid and they are not only paid you know on day but they are paying forwards because they are You know, the orders are full. So from that standpoint, you know, this is real money coming in with investment they've made. They have to make more investment in the future. But so it has direct consequences on the macro side from the Asian point of view, you know, on growth, on investment, on consumption. And just anecdotally, we've seen that in the first quarter, Taiwan was running, you know, a normal rate of 14.14%. GDP. GDP growth. Wow, yeah. Of course, it might be, you know, surely it will normalize in the coming quarter, the coming years, because there was initial boom of orders from the US. But we can bet on the fact that because this AI revolution is here to last, this is not our purpose here, this will continue. And so far, Asia has not been challenged in terms of, you know, being the main input. uh in that the main provider the main provider in that chain so uh the the the macro consequences is important uh and it's even more so from a flow standpoint when you look at uh you know the dynamic of flows of course this is resulting in large current account surpluses because the u.s uh companies are buying from products from asia and they buy in dollars and those dollars are returning to Asia in the form of, you know, trade surpluses and so there is a flow of dollars coming out coming in into asia and which is flowing back into the u.s at the moment in form of investment so far it's being recycled so far it's been fully recycled and that explains why those currencies have been quite weak again the dollar because the money which was flowing in was you know returning to the u.s it's a bit like the petrodollars right it's uh exactly what happened in the with the petrodollars in the years 2000 and it's even bigger than... you know, in terms of amount and volume at the moment, it's even bigger than this was at the time. Because if you add up for the current data you have in Taiwan, in Korea, and in Japan, if you add up all the current account surpluses of those three countries and running them for an annualized basis, you're around $500 billion. So those $500 billion are mostly recycled.
Speaker #0
That mirrors the spending from the U.S. almost.
Speaker #1
Exactly. so The U.S. benefits in a way indirectly because this is sent back in the form of investment in treasuries, in U.S. equities. Treasuries is mostly for Taiwan and U.S. equities mainly for Korea. And so far they've been buying this story. What we think will happen is that the balance of flows at the margin or even more so maybe more structurally will change, will shift a bit. That is more of those dollars what we... make all the cheap dollars you know uh the cheap dollars will be recycled more locally in terms of investment i.e what you're going to face is samsung investing into new plants tsmc in taiwan new plants in taiwan and it's in in in korea to to to produce more chips and to invest in rnd and so on and so on so you will have those that's natural move you will have part of it which will be spent locally in local consumption by employees, having nice salaries and good wages, and probably investors will invest more and more locally in their local equity market or bond markets.
Speaker #0
Maybe one point on this, Thomas. I'm a bit surprised to hear you saying that their plan is to invest these big companies to recycle a lot of this money locally because what we see so far, I would say, is probably the opposite. I mean, if you look at the nominal VREAL exports from Asia, most is in the price. They are not producing more or not much more in front of this high demand from the US. They're just selling at. It's a higher price, so basically they are raising margins, which I find is a very strong approach, because basically they are avoiding the risk of overproduction and overcapacity in the future, essentially saying, OK, there's a boom today, but it may not last. So we refuse, as Asian factories, Asian providers, to bear that overcapacity risk. You even had some Taiwanese and Korean companies saying, if you are to want to get that production faster as a U.S. client, then you pay. You pay for the next three, four, five years. You finance the whole thing. And then, okay, then we can produce more. But that's in your hands. And in that sense, it makes, in my view, even more speculative from the U.S. standpoint that bears the whole risk of the whole project when Asia just leave that.
Speaker #1
leaves that in the hands of the us yeah probably from a business standpoint you're right but of course i mean part of that money will be invested reinvested locally into new uh new capacities and r d to yeah one way or the other ahead of the game i'm not saying the full amount and maybe you know they want to regulate i'm here you know if from a macro standpoint i think what matters because we've been studying a bit you know into details the dynamic of flows and it's true that so far Those currencies have been weak because I think the local authorities, like the Japanese authorities, were not that unhappy with the weak currency because, you know, you gain competitiveness. Where, you know, it's becoming a bit more tricky for local authorities like central banks is that you have imported inflation, which is, I mean, there is the oil price increase, but when you have a weak currency, you pay even more. So you have imported inflation. So that's an issue. And imported inflation is rising. You do have also an issue with the fact that because investment in domestic demand is supported by strong growth, unlike in the U.S. domestic demand, well, you have pressure on wages. And this is,
Speaker #0
you know,
Speaker #1
when we talk about Europe and the U.S., here you have risk of second-round effect in Asia, which are very strong. So here you have...
Speaker #0
Even different from what you see in the U.S., indeed.
Speaker #1
Exactly. So here you have to react, and by being more hawkish and too tight in monetary policy, and you have fiscal flows. Because corporate taxes, VAT, is flowing for some of that standpoint. I would say all spectrum ecosystem of the policy mix, as we say, monetary policy and fiscal policy, is benefiting from that.
Speaker #0
You really have that distribution into the whole economy of the benefits of the investment boom, really. Exactly.
Speaker #1
And that matters a lot from our point of view. And, you know, when you have, if you... Put the two blocks. You have the sender, which is Asia, the saver, and the recipients, which is the US. Here you have more and more demand. You need to finance more AI investment. So you need a bull market in the bond market, in the equity market with new listing and so on. You need fiscal, and fiscal is not about to be tightened anytime soon. So you need new financing to finance the fiscal deficit coming in from local investors. and from Asia. So this saving is financing the US at the moment. The problem from the receptionist point of view, and this is what we've described for quite a while, is that the question is getting weaker from a standpoint. It's still there, you know, the question, and the machine is still working. But the state, from our point of view, is, I would say,
Speaker #0
less appealing,
Speaker #1
less attractive. because the fiscal deficit... So far,
Speaker #0
Asian money is really invested in U.S. assets, really financing the deficits and the needs of money you have out there. But, I mean, I guess your point is about the fragility of all that and questions being asked from an investment standpoint. There's a point where Asian investors may question the appeal of these investments from a risk standpoint, maybe for the reasons we discussed about the U.S., or from a return standpoint.
Speaker #1
point if we need to struggle to monetize it's just a question of risk reward uh as you mentioned and as we have increasing needs in the u.s you need more marginal buyers it's not about the static you know flow of money that's true about you know 100 billion dollars going from asia to the u.s every year you need more to go because you need more financing for ai and you need more financing for the state for so as uh you know a recipient of those flows you need to be more attractive from all standpoints. the US is getting less attractive on many points. So we think that part of this money at the margin, or, you know, it might be a big amount, so it's going to be less and less invested in the US and more locally. And, you know, it will be invested in domestic. market, equity market, or in local investment. We've seen lately that, you know, the Korean authorities have enticed the National Pension Fund to invest more in the domestic market.
Speaker #0
Which is a strong signal.
Speaker #1
It's a strong signal. I think it's probably a phenomenon that we're going to see a bit worldwide because domestic financing needs in Europe, in the Middle East now,
Speaker #0
are increasing. Rising everywhere.
Speaker #1
So they need to invest locally. So it's a question of sovereign. you know uh risk independence i guess as well so for you we need to understand that we need we don't need a sudden stop in flows from asia to the us or to the rest of the world mainly to the us to
Speaker #0
revert that dynamic you need to have less and less marginal change in the recycling process if they just stop investing 100 of their money into the us just takes that down to 90 you He's already a lot and he's already very supportive for local assets and local currencies. And indeed, yeah, I take your point about that sort of global move, really. The whole world now is in a position where both it's getting skeptical about US assets and the underlying risks, and maybe also on the protection they used to offer, the dollar particularly, as well as in need of more money. locally to finance, you say, national security. Because that's what we're talking about here. And that works both ways and could, in essence, change the nature of flows we've seen going west and west and west again for decades into dollar assets and into the dollar, now reversing one after the other. Maybe Asia is coming last. Maybe on that notion of flow, We've seen as well that funds and particularly you talking about local investors and the massive current account you would expect the currency to be strong in such context right you got a big balance and you got locals that are quite keen to gradually invest more domestically yet the currencies remain strong lately why is that i mean when you dig into the mechanics behind then it's about the other actor in the equation is the foreign investor that had invested in asian stocks And particularly if you take the example of Korea, these foreign funds that had bought these stocks technically had to sell Korean assets. And they, of course, sold the Korean one with it, adding pressure to the one. And the technical reasons is fairly mechanical, very straightforward. Because of the fantastic performance of the Samsung and SK Enix, the big, big caps in the index that exceeded the cap level they had in their own passive management. they had to take that way down as passive managers through the index rebalancing process and in doing so they had to sell one for big amounts now practically this as soon as the performance of these assets normalize i'm not saying go down but just just stop overshooting then that technical pressure stops and it's probably already over because the last three three four weeks have been a lot more stable in terms of price action. So you... I mean, my best guess would be that soon enough, you're going to see that pressure for foreign investors disappears. And you're going to see the power of this massive current account they've created. And gradually, that appetite of local investors for their own assets. And that should take all these currencies up more mechanically, right? Yeah,
Speaker #1
probably. I mean... There are a few other reasons why we think the tide may be turning for Asian currencies. It's also that because of this strong impulse in the domestic growth, as I said, the central banks are biased to be hawkish and high-crates. The Fed, we know, is at the end of the first phase of the loosening cycle. It's in the wait-and-see mode for the moment. you What's going to happen is that the interest rate differential between those currencies and the dollar... Which is the cost of hedging, right? The cost of hedging. So basically, people used to sell those currencies because it was so cheap to sell the currencies. Even though you were investing locally...
Speaker #0
So expensive to hedge the dollar risk.
Speaker #1
Exactly. And it was a way to, for example, at H2O, we've always been using the Asian currencies as a show to finance other... carried position in the portfolio in Latin America or in Central Europe because it was a way, first those currencies were you know structurally cheap because the countries and the authorities were leaning against appreciation and second The carry was very cheap, so it was a good risk we were to short them. But then, because of the change in the bias for the central banks, of course, this will change the interest rate differential for locals and for investors.
Speaker #0
It makes the cost of hedging a lot cheaper.
Speaker #1
Exactly. So that's important because interest rate differential in the currency flow. Yeah,
Speaker #0
we know actual institutions at a certain cost of hedging, when it falls below a given threshold and we're not far from these levels today they tend to a lot more mechanically hedge their dollars until now they had a huge incentive to keep their dollars now that that is changing now yeah with much more hawkish central banks out there in asia so that means i mean in our portfolios if we are to look at what we like and don't like in the region. I mean, we've been fairly positive on equities in the region for now a year or so. That worked pretty well. And we remain constructive on these assets for all the macro reasons we described. Now, on FX, I mean, that's new. It seems that on the back of what's going on on equities, FX is now turning as well and should now, instead of Being a drag on equity performance will come as a support. And that tells us to go overweigh these currencies. So far, it's been for a long time, maybe too many years, a long yen position we had in our portfolios. Now it's being supplemented with positions in the Korean won, in the Taiwanese dollar, even in the Australian dollar, which is part of the big Asia. as well in some portfolios. So that's a big basket of currencies now we do favor in our portfolios. And as you said, it's sort of the first time we really go long. Yeah, if I may add, there is,
Speaker #1
I think, you know, another, you know, positive point for this currency, which is worth mentioning. The yen position we've had for a long time, which is, you know, what was also, you know, a value position, you know, the fact that the BOJ was you know about to you know in a rising cycle for rates but it was also this was also defensive those currencies in norseasia are also cyclical and positive it's a way to benefit from this global cycle yeah in a more uh in a different way through the saver and not the data which is the us the saver so you are i would say on the right side of the equation with the creditors rather than data and in those moments where we start seeing some sign of questioning about the stability of the cycle. I think it's important. The second thing here is that we think that it's more multi-scenario from that standpoint. Why? Because most of the dollars, as I mentioned, are in private hands, i.e. pension funds, corporate, household sometimes, you know, that old dollar count. So from that standpoint, you could argue that what happened is the AI cycle is softening, you know, suddenly. or declining a bit, and those currencies and those economies would be suffering from that. True. But then you would have a situation where those money, which is invested in the US, would be returning to their local markets in Korea and Taiwan, as Japan has been working for years and years. So here we think that it's more multi-scenario than just pure. A pure cyclical investment.
Speaker #0
If I follow you on this, these currencies that have been historically more like offensive currencies, more risk-on currencies, have now gained some safe haven capabilities, if I may say, basically because they hold so much of these US assets. if there's a shock out there, which as we discussed, may happen with the current massive AI investment boom, then That would trigger repatriation and that would make these currencies stronger, not weaker like in the past. And in that sense, that's another argument, right, in this list of supportive argument for holding a position in those currencies. Maybe we may say that the dollar is gradually being replaced progressively as a safe haven, as a currency, defensive currency. progressively being replaced by Asian currencies, possibly. So on that note, thank you, Thomas, for that long and interesting discussion. Thank you all for listening to this Think Macro, episode of Think Macro, and speak soon on another episode.
Speaker #1
Thank you, Vincent.
Speaker #0
Thank you, Thomas.

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