After the crisis, what will the global recovery look like and what’s the impact for Foreign Exchange markets?

27 August 2020

Neil ParkerFX Markets Strategist

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Market Strategist Neil Parker looks ahead to what H2 2020 may have in store.

The second quarter GDP (Gross Domestic Product) numbers released have showed the extent of the downturn experienced by major economies. In most cases these have been broadly in line with expectations. The UK has suffered one of the worst downturns in Q2, but that after much of the services sector remained closed throughout. The bounce back in GDP in most economies got underway in late Q2, but the effects of months of shutdown has left Europe over 15% smaller in GDP, the US around 11% smaller, and the UK over 22% smaller than in Q4 2019. Recoveries may look v-shaped in nature, but the reality is that the recoveries will take multiple quarters/years to regain the pre-crisis highs, and there will be lasting damage to labour markets and businesses that is yet to be fully uncovered. So specifically what is there to look forward to for each major economy?

United Kingdom – upturn ahead, but will it be upset by Brexit trade talks?

Although the UK’s H1 performance was the worst in Europe (with the exception of Spain), Q3 numbers are already looking better. Data and surveys indicate that the UK is set to bounce back strongly, with retail enjoying a healthy recovery, the housing market enjoying a revival, and the Chancellor’s ‘Eat out to help out’ scheme set to support the beleaguered hospitality sector. Anecdotal evidence from UK coastal regions, and some retailers of outdoor equipment, suggests that the UK staycation has proven popular, which could again benefit the UK’s recovery. This is all wrapped up into the PMI (Purchasing Managers’ Index) figures which have shown a jump in activity, and, so far, suggest an outperformance versus the US and Euroland.

There is a challenge to the UK’s recovery that will increase in importance as we head through Q3 and into Q4. That is what the outturn of discussions between the UK & EU on trade will be? As we stand, it looks to be between a fairly basic free trade agreement on goods, or no-deal, which would mean WTO (World Trade Organisation) terms would apply from the 1st January 2021. There remain significant differences between the two sides in negotiations, and despite some positive commentary from the UK about the possibility of a deal, the time frame for agreement is rapidly eroding. Moreover, the two outturns will have widely different effects on the value of sterling, in my view. A free trade deal now would be broadly constructive for sterling, whereas no-deal would prove destructive, since it would mean widespread upheaval for firms importing from, and exporting to, the European continent.

There is also the risk that, as government support schemes are wound down, the number of insolvencies will increase, which could worsen the outlook for the UK economy in the short term. What took a few months to destroy will likely take many quarters to rebuild. We are potentially looking at a much altered economic reality, even once economies are able to deal with the coronavirus more effectively. The onward march of digitalisation, and renewed interest in automation, could mean significant permanent changes to labour markets, and further issues for government to deal with.

United States – November Presidential election in focus with Trump well behind in the polls

The US Presidential election is set to take place on the 3rd November. At the moment the aggregate of recent polls puts Joe Biden as a comfortable winner of both the popular and electoral college votes. The same polls put Hillary Clinton comfortably ahead in 2016 at this point, but not as far ahead as they suggest Biden is. There are still questions surrounding the Presidential election. Has Biden reached peak popularity? Will Trump be able to rekindle the 2016 recovery that saw him win in key states such as Florida, Michigan and the other rust belt states? Will the performance of the US economy, or the US government’s response to the COVID-19 be as much of a factor by November, especially if US infection rates continue to fall? Will it be a decisive election, or will the result be contested (like we saw in 2000)? How will the debates alter the thinking of US voters? 

The first half of the year was predictably poor in terms of economic performance, though not as bad as in Euroland or the UK. The renewed increase in new cases of coronavirus in June, through to the peak in late July, may have set back the US economy in terms of its rebound, for a few weeks at least. The US fiscal and monetary authorities were swift to provide initial support to the US economy, markets, businesses and individuals. However, in recent months although additional fiscal stimulus measures have been proposed they have not been agreed. Furthermore, the Federal Reserve has stopped adding additional funds into the US economy, after an initial splurge of almost $3 trillion.

The Q3 data on economic output may see the US underperforming the likes of the UK and Europe, and that data will be delivered just a few days prior to the election itself. The US economy is likely to have shrunk by around 4% in 2020, with growth in 2021 likely to return the US economy close to where it was at the end of 2019. However, the recovery may put the US some way behind the rest of the major economies. Indeed, the persistent damage that the elevated level of unemployment may do to consumption and investment in the US may be a hot topic well beyond the Presidential elections.

What is certain is that the coronavirus will have left a lasting mark on US government debt, and monetary policy, which will take many years to begin to reverse. US interest rates are likely to remain at rock bottom for the next 2-3 years at least, and one should not completely write off the prospect of negative interest rates.

Euroland – A game changing support package from the European Commission, but will the peace and harmony last?

Euroland suffered significantly at the outset of the coronavirus outbreak, with first Italy, then France and Spain all seeing the rates of infections climbing alarmingly, and even Germany, who commentators thought did a good job of controlling the spread, still saw more than 195k cases by the end of Q2. Italy and Spain were the worst affected, seeing economic output down by more than a sixth and a fifth respectively. The damage wrought to Euroland economies from a prolonged lockdown, and the limitations placed on individual governments to respond to the crisis with fiscal loosening, prompted the European Union, led by the governments of Germany and France, to outline an ambitious plan of grants and loans to support those countries/economies most affected by the pandemic.

The agreement to provide €750bn in loans and grants to the worst hit countries of the European Union still came with a fight, with many countries wanting to change the mix of grants to loans, in favour of a larger proportion of loans. In the end, the compromise still meant that the likes of Italy and Spain were given the largest proportion of grants, and the support measures took the European Union into an era of even greater fiscal cooperation. The support measures were wrapped up in a Multi-annual Financial Framework, which included a commitment from the EU to borrow €750bn from the financial markets. The agreement meant that borrowing would continue up to the end of 2026, and that the debt would be extinguished by no later than 2058. 

The initial signals from Q3 were good, with PMIs signalling a strong expansion in the manufacturing and services sectors, although preliminary August figures recorded a sharp pull back, confidence indicators have generally improved, and consumer spending measures also reported a sharp rebound, after the declines of early Q2. However, the spike in case numbers in Germany, France, Spain and Holland will be of concern to authorities. This may slow or postpone further measures to unlock the Euroland economy, and the German Chancellor Angela Merkel announced only recently that Germany plans to extend its furlough scheme to 24 months. If there is a slower start to the recovery, because of the spike in COVID-19 cases, that could affect the fiscal and monetary response from authorities and additionally the performance of the euro. Much like the UK and US, the Euroland economy is likely to take at least six quarters to recover the drop in economic output seen from the coronavirus crisis, but that could be delayed by a number of quarters by repeated spikes in infections. The strain on public finances is yet to be fully realised. When it is, will this push the case for even greater cooperation, or will this be the moment when the peace, harmony and unity amongst European countries begins to fracture?  

The Foreign Exchange (FX) markets – Is the USD heading for more weakness?

Firstly, let’s put the recent USD weakness into context. On a dollar index basis it has fallen from a three-year high of 102.99 in March, to a two-year low of 92.13 in August. That in percentage terms is a 10.5% move. During the financial crisis and its aftermath we saw the USD index at a high of 89.62 (March ‘09) to an initial low of 78.33 in June of the same year (eventual low for the year was 74.17). That was an initial move of over 12.5% and eventually a total sell off of more than 17%. So whilst the dollar has weakened significantly, it has not weakened by as much as during the financial crisis, and it has started from a much higher base. Indeed, looking at EUR/USD, over the past couple of years it has been higher than $1.25 (currently around $1.18) and for GBP/USD it has not yet hit the heights of the 12th December 2019 highs that occurred in the aftermath of the UK election exit poll.

So is the USD in for more weakness? Clearly part of the sell-off around the USD has been the monetary and fiscal response to the coronavirus pandemic. These have totalled nearly $3 trillion each, and there is still the chance that the US government spends more money in support of the economy, given the second wave of coronavirus infections and the negative effect this has had on the US’s recovery. Politics may well dominate economics over the next few months, and any closing of the polls between Biden and Trump could create greater uncertainty for FX markets. That tends to be good for the US dollar against other majors, and so we could see the likes of the EUR and GBP struggle to make fresh highs from here.

For the GBP specifically, there are some risks associated with the UK/EU trade deal, and likely more risks of a weakening rather than a strengthening. If the probability of no deal increases, then I’d expect to see the pound come under additional pressure, whereas a deal, no matter how rudimentary, would offer the GBP some relief.

As for the EUR, will it be able to capitalise on the recent USD weakness, or has it shown its limitations in recent months/years? After the financial crisis EUR/USD rose to a post crisis high of $1.4940 (June 2011), but there are no suggestions, looking at the spread of forecasts from strategists across the financial markets, that the EUR is set to even get close to such levels over the course of the next 12 months. In my view the global economy would have to demonstrate a persistent, uninterrupted, improvement in activity to warrant significant additional gains in risk based currencies against the USD. Meanwhile, it could also come in for some short term pressure if the UK/EU talks break up with no agreement. Does the EUR look undervalued at current levels? On a trade weighted basis the EUR is approaching its highs for the past six years, even with the limited improvement against the USD.

A final question. If the major central banks are wedded to a policy of ultra-loose monetary policy for the coming years, what will this mean for emerging economies, their currencies and markets?

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