Paradox of acute uncertainty and strong consensus views

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There appears to be a quasi-universal belief that 2017 will be characterised by acute uncertainty, with the list of difficult-to-predict economic and political variables growing exponentially in recent months.

These include the paths which Donald Trump will tread in the US and Theresa May in the UK, the Fed’s reaction function, the future of the eurozone and EU with European elections looming, the perennial question of China’s exchange rate policy and outlook for oil prices.

And yet, there is already it would seem a set of strong consensus views about the direction which economic variables and financial markets will follow in 2017.

US reflationary policies are expected to rule, boosting already decent US economic growth, inflation and US equities, in turn forcing the Fed to adopt a far more hawkish stance than in 2015-2016 and pushing US yields and dollar higher.

At the same time, President-elect Trump’s penchant for protectionism, alongside a strong dollar and higher US yields, are seen as major headwinds for indebted emerging economies reliant on trade and by implication for emerging currencies, bonds and equities. These seemingly include the Mexican Peso and Chinese Renminbi.

Moreover, the consensus forecast is that at the very least EUR/USD will fall below parity, having got close in December.

The perception of acute uncertainty is not totally incompatible with seemingly well-anchored forecasts but they do make uncomfortable bed-fellows.

Some of the uncertainties which have gained prominence can be put to rest, for now at least. At the same time, some of the sure-fire trades currently advocated may struggle to stand the test of time, in my view.

Marine Le Pen is very unlikely to become the next French President, the Italian banking sector will not be allowed to implode and the euro may end the year on a strong note.

Emerging market currencies have showed greater poise in the past few weeks, with a number of central banks showing both the appetite and the room to support their currencies. This should be borne in mind.

 

A growing list of economic and political uncertainties for 2017

Having reviewed the financial press and market developments over the festive season, two potentially contradictory themes stand out. First of all, there appears to be a quasi-universal belief that 2017 will be characterised by acute uncertainty. Opinion polls have been thrown out as largely useless, precedent is being over-looked as an irrelevance and the rule-book on how policy, economics and financial markets interact confined to the bonfire of history. The list of difficult-to-predict economic and political variables has grown exponentially in recent months but a number stand out:

i) The still vague policy-program of a US President with no prior political experience and the United State’s relationship with Russia and China;

ii) The US Federal Reserve’s reaction function to potentially stronger growth and inflation and the future of monetary policy in developed economies, including quantitative easing programs in the eurozone and Japan;

iii) The very uncertain outlook for the UK economy following the British electorate’s vote to leave the EU and the multiplicity of potential resting points for the UK’s relationship with the EU (see The A-Team had a plan, the British government has a nebulous goal, 13 December 2016);

iv) The unpredictability of general and presidential elections in a number of European countries, including in the two largest EU economies – Germany and France;

v) The trifecta of European nationalism, immigration and terrorism;

vi) The Italian banking sector’s vulnerability and implications for the EU’s third largest economy;

vii) China’s exchange rate policy in the face of significant capital outflows;

viii) The short and medium-term impact on the Indian economy of the government’s decision to withdraw a large chunk of cash out of circulation;

ix) The international price of crude oil, which has risen by 25% since late-November following oil-producing countries’ decision to curb production; and

x) Geopolitical tensions in the Middle East.

This list of uncertainties merely highlights the more obvious “known-unknowns” and one needs to factor in the totally unpredictable – the “unknown-unknowns”. In any case, the obvious implication should be that forecasting the path of currency, bond and equity markets is fraught with difficulty in the near-term, let alone the long-term.

Despite uncertainty, consensus view that US reflationary policies will rule

And yet, there is already it would seem a set of strong consensus views about the direction which economic variables and financial markets will follow in 2017. While there is admittedly still a lack of agreement over which policies Donald Trump will prioritise and actually implement once he is inaugurated on 20th January, the broad-based belief is that his policies will have a twin, turbo-charged, impact.

On the one hand the new US administration’s planned financial market deregulation, tax cuts and infrastructural spending are expected to continue driving capital back into the US, boosting already decent US economic growth, inflation and US equities, in turn forcing the Federal Reserve to adopt a far more hawkish stance than in 2015-2016 and pushing US yields and dollar higher. Indeed, for the first time in many years, the US rates market, analysts and FOMC members are broadly in agreement about the appropriate number of policy rates hikes – at least two in 2017 to be precise (see Figure 2). On the other hand, President-elect Trump’s penchant for protectionism, alongside a strong dollar and higher US yields, are seen as major headwinds for indebted emerging economies reliant on trade and by implication for emerging market currencies, bonds and equities.

In this scenario, Mexico is still viewed as particularly vulnerable, despite the Mexican Peso having already weakened about 17% versus the dollar in 2016 (see Figure 8). Forwards are currently pricing the Peso to depreciate a further 5.5% versus the US dollar in 2017. Moreover, as was the case at the beginning of 2016, the financial community seems in broad agreement that Chinese policy-makers will have no choice but to let the Renminbi weaken further in 2017 in order to slow the fall in central bank FX reserves.

The British electorate’s vote to leave the EU, the rise of European nationalism, the pressing issues of immigration and terrorism and the Italian economy’s vulnerability are the backbone of a view gaining traction that the future of the eurozone/European Union is increasingly precarious. The consensus forecast is that at the very least EUR/USD will fall below parity, having got close in December (see Figure 4).

Of course, the perception of acute uncertainty is not totally incompatible with seemingly well-anchored forecasts of economic and financial variables. The media may be exaggerating the uncertainty which markets face this year (relative to other years) and predictions of a strong dollar, higher US rates, hawkish Fed and weak Renminbi, Mexican Peso and Euro – amongst others – may prove accurate. But they do make uncomfortable bed-fellows.

I stand somewhere in the middle. The surprise outcomes of the British referendum and US presidential elections have led to an exaggerated tendency to expect the unexpected and the status quo to be systematically challenged, in my view. Some of the uncertainties which have gained prominence can be put to rest, for now at least. At the same time, some of the sure-fire trades currently advocated may struggle to stand the test of time.

“Everything stronger in US” forecasts will be challenged

I already argued in Hawkish pendulum may have swung too far (21 December 2016) that analysts and markets may have got ahead of themselves with respect to the path of the US economy and financial markets. My core reasoning is that US inflation may not rise as fast expected, due to lags in the implementation of Trump’s planned fiscal policy loosening and immigration curbs, residual slack in the US labour market and disinflationary impact of higher US yields and a stronger dollar. As a result, the FOMC, which will see important personnel changes in early 2017, may argue that the market has already done some its work and not be as hawkish as expected.

While price action in thinner and typically volatile Christmas markets needs to be taken with a pinch of salt, US front-end yields are trading at levels which prevailed a fortnight ago and are only 3bp higher than in the run-up to the Federal Reserve’s 14th December policy meeting (see Figure 3). At the long-end of the US curve, 10-year yields have fallen about 10bp since 21th December while the US market’s pricing of Fed policy rate hikes in 2017 has fallen to around 55bp from about 61bp.

Eurozone and euro – Not the end

The eurozone and EU face multiple challenges but an imminent break-up of either still seems like a far-fetched scenario. European economic growth has stabilised and the euro has been one of the most stable major currencies in recent years (see Figure 4). Moreover, while nationalism and populist policies continue to gain traction and influence mainstream ruling parties, European nationalist parties on the whole have a long way to go before they command true power, as depicted in Figure 5 (see Black swans and white doves, 8 December 2016).

In France, the extreme right-wing Front National (FN) party, which advocates an exit from the EU, is in the ascendancy and and its leader, Marine Le Pen, could very conceivably make it to the second round of the French presidential elections in May. But the odds of her becoming President are still very low, in my view, with the Republican Party candidate, François Fillon, the more likely victor (see EM currencies, Fed, French elections and UK reflation “lite”, 25 November 2016). Fillon, who advocates for France to remain in a reformed EU, performed strongly in the Republican Party primaries, enjoys the backing of a powerful party and will likely attract some of the more moderate right-wing voters from the FN.

German general elections scheduled for September may well lead to a more divided parliament, making it harder to form a majority coalition government. But it is difficult at this stage to see who will realistically challenge Chancellor Merkel who is striving for a fourth consecutive election victory.

In Italy, the recent resignation of Prime Minister Renzi following his failed referendum and election of a caretaker government has led to much speculation that President Mattarella will have no choice but to bring forward elections currently scheduled for May 2018. The concern, in turn, is that this could bring to power the populist and anti-Europe Five Star Movement led by Beppe Grillo. But the Italian political set-up suggests this is far from a done-deal. Moreover, a hybrid bail-in/bail-out of troubled Italian banks still remains more likely than an outright collapse of the Italian banking sector in my view (see Renzi referendum – storm in a brittle tea cup, 2 December 2016).

So while the euro may remain under pressure near-term, it is conceivable that it will end the year stronger, if not against the dollar at least in nominal effective exchange rate (NEER) terms.

Emerging markets – Written off prematurely?

It is easy to forget that emerging market equities and currencies were in the ascendancy last summer (see Figure 6), propelled by a pick-up in global growth, loose global monetary policy and in some cases attractive valuations. However, since Donald Trump’s surprise election victory, emerging markets have been caught in a seemingly perfect storm of a stronger dollar, the prospect of tighter global monetary policy and threat of protectionist US policies.

There is no doubt that EM economies and asset prices face a number of exogenous challenges, as well as obstacles of their own making, including political upheaval in Turkey, corruption scandals in Malaysia and Brazil, major product recalls in South Korea and India’s decision to withdraw 86% of the cash in circulation. Moreover, the strong appreciation of the Brazilian Real, Russian Rouble and South African Rand in 2016 will weigh on export competitiveness (see Figure 8). Chinese policy-makers are experiencing first-hand the challenges posed by capital account liberalisation, with outflows from China combined with a more modest current account surplus keeping the Renminbi under pressure.

But a GDP-weighted basket of EM currencies, excluding the CNY, has appreciated about 0.7% versus a stronger US dollar since end-November, according to my estimates (see Figure 7). This modest appreciation has been driven by solid gains in the Russian Rouble, South African Rand and Brazilian Real which benefit from both high yields and stronger international commodity prices (see Figure 9).

 

Moreover, in economies experiencing balance of payment pressures – including Turkey, Mexico and China (capital outflows) and Saudi Arabia (collapse in current account surplus) – central banks have provided some currency support. Central bank FX reserves fell in November in Turkey, China and Saudi Arabia, even accounting for estimated currency-valuation effects (the Dollar’s appreciation against other major reserve currencies), providing (admittedly imperfect) evidence of intervention in the FX market (see Figure 10)[1]. There is anecdotal evidence that FX intervention continued in December.

Finally, central banks in Turkey and Mexico have hiked their policy rates 50bp and 100bp, respectively, since November. The Mexican Peso has been broadly stable versus the Dollar since 24 November, the Renminbi has depreciated only 0.6%, the Saudi Riyal peg to the dollar has held and the Turkish Lira’s slide has slowed somewhat.

If capital outflows from EM economies extend near-term, the question then becomes which central banks have both the incentive and the tools to support their currencies, via FX intervention, higher policy rates or even capital controls. While each central bank will evaluate the cost-benefits of stabilising their currency and using up FX reserves, I would argue that emerging market central banks in aggregate have the firepower to defend their currencies in the FX market.

Excluding China, the US dollar-value of central bank FX reserves in emerging economies rose about $60bn between end-2015 and end-November 2016 to about $4.47bn, based on my estimates (FX-valuation effects were negligible during that period – see Figure 11).

The $-value of FX reserves was flat or rose in all major economies bar China, Saudi Arabia, Nigeria and Hungary (see Figure 13) and in Non-Japan Asia (excluding China) rose about $80bn in the year to November 2016 or about 4%, according to my estimates.

Admittedly, this modest increase in EM FX reserves may have been at least partly whipped out in December if central banks continued to counter currency-depreciation pressures by intervening in the FX market. Moreover, the $-value of Chinese central bank FX reserves likely fell a further $300bn or so last year (it was down $280bn in January-November 2016 – see Figure 12). Even so, 2016 was likely a far more benign year for EM central bank FX reserves than 2015, when the USD-value of reserves fell about 8%, or 5% accounting for a stronger dollar, as depicted in Figure 14.

Central bank FX reserves are significant in Taiwan, however they are measured, in Saudi Arabia, Hong Kong and Singapore when expressed as a percentage of GDP and in China, Russia and Brazil when expressed as months of imports (see Figure 15). Conversely, FX reserves are particularly small in Egypt, Hungary and Mexico, which clearly limits the room for FX intervention. Pressure on Egypt’s dwindling FX reserves prompted the central bank to devalue the Egyptian Pound in early November.

Olivier Desbarres

Olivier Desbarres currently works as an independent commentator on G10 and Emerging Markets. He has over 15 years’ experience with two of the world’s largest investment banks as an emerging markets economist, rates and currency strategist.


[1] The USD-value of central banks’ FX reserves can fluctuate due to, amongst other things, currency and gold price valuation effects, repayments of external debt and interventions in the FX market (buying or selling of foreign currency).

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