State Street's Risk Appetite Index fell into negative territory in September, hitting its lowest level since the outbreak of the Iran war in March. The reading ended a five-month stretch of risk-seeking behavior among institutional investors.
Equity allocations remain high but edged lower in September. Holdings of bonds excluding short-term Treasurys, by contrast, rose by nearly 1 percentage point, the largest monthly increase in more than five years. Bond allocations are still historically low, but long-term investors have begun responding to higher sovereign yields.
Investors had already stretched their equity exposure, and rising oil prices and tight monetary conditions gave them reason to move to the sidelines. What stands out is that money leaving equities went into bonds rather than cash. Cash allocations slipped slightly and fell below their long-term average. With asset managers' bond holdings close to a 20-year low, rebalancing was needed. That signals that long-dated yields have risen enough to draw investors back, despite concerns over inflation and the fiscal outlook. Foreign demand for Japanese government bonds, in particular, climbed in mid-September to its highest level in seven months. We therefore maintain a positive view on the yen.
We also maintain a positive view on East Asian equities that benefit from the artificial intelligence cycle. With supply constraints persisting, the market is raising its price forecasts for high-bandwidth memory in 2027. Macroeconomic uncertainty has reduced allocations to emerging-market equities, however, and outflows are continuing from Korean stocks and Treasury bonds.
The AI cycle is lifting domestic income in South Korea, but that has not translated into stronger private consumption. Retail sales fell from a year earlier in both July and August, reflecting the negative wealth effect from the stock market correction and higher interest rates on household loans. We expect the Bank of Korea to raise its policy rate in November, on the assumption that it holds the rate in October and revises its inflation forecast upward.
Korea's ultra-long Treasury bonds weakened sharply in the second and third quarters of this year as purchase demand from insurers declined. They have outperformed since late August, however, as demand from public funds and insurers recovered. Despite upward pressure on global rates, ultra-long Treasury yields above the mid-4% range may look attractive to institutional investors. The gap between 10-year and 30-year Treasury yields also has room to narrow further as the government scales back issuance.
The won has held firm against other emerging-market currencies, helped by dollar selling from exporters. We expect the won to weaken gradually against the dollar through the end of the year, however, as domestic investors continue buying overseas stocks.