Europe
Highlights The world remains mired in a manufacturing recession. As such, it is still too early to put on fresh pro-cyclical trades. Focus on the crosses rather than outright U.S. dollar bets. Two new trade ideas: sell EUR/NOK and buy GBP/JPY. Also consider selling the gold/silver ratio. Feature Currency markets tend to trade into and out of various regimes. This means that to be an effective FX manager, you have to be extremely fluid. For example, interest rate differentials might dominate FX moves during a particular period, pivoting your job to a central bank monitor. Other times, flows dominate, perhaps even equity flows, like when a disruptive technology is developed in a specific market. The outperformance of U.S. equities, specifically technology stocks, is a case in point. Balance-of-payments dynamics usually matter mostly at critical turning points, making them not very useful as timing indicators. The exorbitant privilege of the U.S. dollar we discussed a fortnight ago is also a case in point. But more often than not, being able to identify whether the investment climate is about to become more hostile or not could be the key difference between being a successful FX manager or a relic. There has been no shortage of news for investors to digest over the last few days, from the Brexit imbroglio, to the Fed, to the drone attacks in Saudi Arabia and finally to U.S. President Donald Trump’s possible impeachment. But the most perplexing (and perhaps the most important) has been the German manufacturing flash PMI print for the month of September of 41.4, the lowest in over a decade (Chart I-1). If the country with the “cheapest currency” cannot manage to pull itself out of a manufacturing recession, then the message to the periphery is clearly that they have an impending problem. In short, our contention that the euro was close to a bottom might be offside by a few months, based on the latest manufacturing data release (Chart I-2). Chart I-1A Eurozone Manufacturing Recession Chart I-2The Euro Needs Stronger Growth Which FX Regime? Chart I-3A Recession Will Be Dollar Bullish The performance of the dollar since the 10/2 yield curve inverted is instructive. So far, we are tracking both the 2005 and 1998 roadmaps, meaning the window for cautious optimism on risk assets could still pan out (Chart I-3). Specifically, the dollar tends to rally during recessions but the window before the dollar bull market takes hold can be quite long. In both 2006 and 1998, the dollar eventually catapulted higher, but it took longer than 12 months. Having an accurate recession probability-timing model is therefore crucial for strategy. Historically, domestic flows have been a very timely indicator, since repatriation by residents occurs during episodes of severe capital flight. In 2005, domestic individuals were deploying funds outside the U.S., which suggested patience before positioning for dollar strength. This made sense, since the return on capital was higher outside the U.S. with the EM and commodity bull market in full swing. More often than not, FX markets tend to favor regions with the highest return on capital. These tend to be the most difficult to bet against, but potentially the most potent blindside at turning points. If economic data continues to deteriorate due to much larger endogenous factors, a defensive strategy is clearly warranted. One way to tell will be an emerging divergence between our leading indicators and actual underlying data as is occurring so far in September. On the flip side, any specter of positive news could light a fire under sectors, currencies and countries that have borne the brunt of the slowdown. Both are highly risky bets. For now, we prefer to focus on the crosses rather than outright U.S. dollar bets. Sell EUR/NOK Sometimes, the best ideas are the simplest ones. The Norges bank is the most hawkish G-10 central bank, while the European Central Bank restarted QE at its latest meeting. This is a powerful catalyst for a short EUR/NOK trade: The dollar tends to rally during recessions but the window before the dollar bull market takes hold can be quite long. The slowdown in the euro zone has been concentrated in the manufacturing sector, but the deflationary impulse is starting to shift to other parts of the economy. Euro area overall core CPI continues to blast downwards, which has historically been a bad omen for the euro (Chart I-4). We expect euro zone inflation expectations to eventually rise, in part helped by the recovery in oil prices (Chart I-5), but this will also benefit the Norwegian krone. EUR/NOK has historically tracked the performance of relative stock prices between Europe and Norway, but a gaping wedge opened up in 2018 (Chart I-6). This divergence is unsustainable. In short, it is a bet on oil fields in Norway versus European banks. The ECB’s tiering of reserves might prevent euro zone banks from teetering over the edge, but unless the manufacturing recession ends soon and firms start to borrow to invest, banks will continue to have a demand problem. Meanwhile, the flareup in the Middle East means that oil prices will remain bid in the near term. This should favor Norwegian equities over those in the euro zone, and be negative for EUR/NOK (Chart I-7). 10-year German bunds are yielding -0.57% while the yield pickup on Norwegian bonds is a positive carry of 1.8%, despite liquidity concerns. In their latest policy meeting, Central Bank Governor Øystein Olsen stressed that Norway had much more fiscal room to maneuver in the event of a downturn, meaning the supply of Norwegian paper could increase, easing the liquidity premium. Chart I-4Deflation Remains Predominant In The Eurozone Chart I-5A Rise In Oil Prices Will Help Inflation Expectations Chart I-6Stocks And Currencies: An Unsustainable Divergence Chart I-7Higher Oil is Negative ##br##For EUR/NOK Bottom Line: Sell EUR/NOK at 9.937. Buy GBP/JPY Last week’s Special Report made the case for a cyclical recovery in the U.K., even though structural factors remain a headwind. This week, we are re-attempting to buy cable versus the yen: Most importantly, the Bank of England stood pat at its latest policy meeting while the Bank of Japan is likely to introduce more stimulus or stronger guidance. Real interest rate differentials favor a stronger pound. Most importantly, the Bank of England stood pat at its latest policy meeting while the Bank of Japan is likely to introduce more stimulus or stronger guidance (Chart I-8). Chart i-8A Tactical Bounce In GBP/JPY Is Likely Chart I-9The Benefit Of A Weaker Pound Speculators are very short the pound while they have been covering their short bets on the yen, as the investment environment has become more uncertain. The fall in the pound should begin to improve the U.K.’s balance-of-payment dynamics relative to Japan (Chart I-9). Bottom Line: Buy GBP/JPY at 132.6. Concluding Thoughts We continue to track various indicators for the dollar, from interest rate differentials, balance-of-payment dynamics, valuations, portfolio flows and positioning – and none of them are sending a bullish signal at the moment. Global growth remains in a funk, which has been supercharging dollar bulls. However, long-dollar bets remain susceptible should global growth stabilize. Our strategy is to continue focusing on the crosses until categorical evidence emerges that global growth has bottomed. In our trading portfolio, we continue to favor the NOK, SEK, petrocurrencies and the AUD. So far, these trades have been implemented at the crosses to limit downside risk, should our view on the dollar be offside. We intend to eventually start placing outright dollar bets once evidence emerges that global growth has bottomed and the world has skidded a recession. Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. have been relatively strong: The Markit flash manufacturing PMI rebounded to 51 in September from 50.3. Flash services PMI increased to 50.9. The Chicago Fed national activity index increased to 0.1 from -0.4 in August. The Richmond Fed manufacturing index fell to -9 in September from 1. The Conference Board consumer confidence fell to 125.1 in September from 135.1. On the housing front, home prices grew by 0.4% month-on-month in July. Mortgage applications decreased by 10% for the week ended September 20th, but new home sales increased by 7% month-on-month in August. Initial jobless claims increased to 213,000 for the week ended September 20th. Annualized GDP growth was unchanged at 2% quarter-on-quarter in Q2. Trade deficit of goods was little changed at $72.8 billion. Headline and core PCE increased to 2.4% and 1.9% quarter-on-quarter, respectively in Q2. The DXY index appreciated by 0.6% this week. The recent data from the U.S. have been holding up quite well compared with the rest of the world. Net speculative positions on the greenback remain elevated due to U.S. relative strength. While we see dollar resilience in the near term, declining net foreign purchases of U.S. securities, diminishing interest rate differentials and the plunging bond-to-gold ratio all suggest the path of least resistance for the dollar is down. Report Links: Preserving Capital During Riot Points - September 6, 2019 Has The Currency Landscape Shifted? - August 16, 2019 USD/CNY And Market Turbulence - August 9, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area continue to deteriorate: The Markit flash manufacturing and services PMIs for the euro area both fell to 45.6 and 52, respectively in September. In France, the Markit flash manufacturing PMI fell to 50.3; services PMI decreased to 51.6. In Germany, the manufacturing PMI collapsed to 41.4; services PMI fell to 52.5. German IFO current assessment increased to 98.5 in September. However, the IFO expectations fell to 90.8. Monetary supply (M3) grew by 5.7% year-on-year in August. German Gfk consumer confidence nudged up to 9.9 in October. The EUR/USD fell by 0.8% this week. The recent data from the euro area has unfortunately showed no signs of global growth bottoming. The manufacturing PMI in Germany is now at its lowest level since the Great Financial Crisis. A major concern faced by investors is that weak activity in manufacturing may have already begun to infiltrate the service sectors. That said, the services PMIs in major economies, though falling, still remain in expansionary territory above 50. Report Links: Battle Of The Central Banks - June 21, 2019 EUR/USD And The Neutral Rate Of Interest - June 14, 2019 Take Out Some Insurance - May 3, 2019 Japense Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: National headline inflation fell from 0.5% year-on-year to 0.3% year-on-year in August. Core inflation was unchanged at 0.6% year-on-year. The Markit flash manufacturing PMI fell to 48.9 in September from 49.3. Services PMI also fell to 52.8 from 53.3. The leading index and coincident index were both little changed at 93.7 and 99.7, respectively, in July. The USD/JPY has been flat this week. Japanese exports have been weak, weighed by the global trade war and manufacturing slowdown. However, accordingly to the BoJ, domestic demand has remained firm, and capex also continues to increase. Moreover, the consumption tax hike next month will probably have a marginal impact compared with previous tax hikes. In a speech this week, BoJ Governor Haruhiko Kuroda emphasized that the central bank will ease without hesitation if the economy loses momentum. Report Links: Has The Currency Landscape Shifted? - August 16, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 Battle Of The Central Banks - June 21, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 There is little data from the U.K. this week: Mortgage approvals decreased slightly to 42,576 in August from 43,303 in July. The GBP/USD fell by 1.4% this week. British Prime Minister Boris Johnson has now lost his majority in Westminster after large profile defections from the so-called rebels, thus another election is highly likely by year-end. Besides, a further delay of Brexit is almost certain. We have downgraded the probability for a no-deal Brexit. We remain positive on the pound and are buying GBP/JPY this week. Report Links: United Kingdon: Cyclical Slowdown Or Structural Malaise? - September 20, 2019 Battle Of The Central Banks - June 21, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mixed: The preliminary commonwealth manufacturing PMI fell to 49.4 in September from 50.9 in August. On the other hand, the services PMI rebounded to 52.5 from 49.1, back to above-50 expansionary territory. Consumer confidence increased to 110.1 from 109.3 this week. The AUD/USD fell by 1% this week. Reserve Bank of Australia Governor Philip Lowe commented on Tuesday that the Australian economy is picking up, and is now at a “gentle turning point.” The previous rate cuts have allowed the property markets in big cities like Sydney and Melbourne to regain some strength, but will likely take longer to flow through the whole economy. In terms of monetary policy, Governor Lowe reiterated his commitment to ease monetary conditions when needed, though he did not signal an imminent move for next week. Australia has a large beta to global shifts as a small, open economy. Should the global manufacturing recession come to an end, the positive fundamentals will continue to lift the Australian economy through the rest of the year and into 2020. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been negative: Imports increased by NZ$30 million to NZ$5.69 billion in August, while exports fell by NZ$830 million to NZ$4.13 billion. The total trade deficit widened from NZ$700 million to NZ$1.57 billion. The NZD/USD appreciated by 1% initially, then plunged after the Reserve Bank of New Zealand’s policy meeting, returning flat this week. As widely expected, the RBNZ kept its official cash rate unchanged at 1% this Wednesday while signaling that there is more scope to ease if necessary amid a global slowdown. The market is currently pricing an 80% probability of a rate cut for the next policy meeting in November, reflecting weak business confidence. We are playing the kiwi weakness through the Australian dollar and Swedish krona, which are 1.9% and 1.95% in the money, respectively. Report Links: USD/CNY And Market Turbulence - August 9, 2019 Where To Next For The U.S. Dollar? - June 7, 2019 Not Out Of The Woods Yet - April 5, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been resilient: Bloomberg Nanos confidence increased to 57.4 this week from 56.7. Retail sales increased by 0.4% month-on-month in July, lower than the expectations of a 0.6% monthly growth. The USD/CAD has been flat this week. Oil prices have been on a wild ride this year. Since the drone attack a fortnight ago, Saudi Arabia has claimed that it is recovering faster than expected, beating its own targets. Brent crude oil spot prices have fallen by 6% from their September 16th peak, while Western Canada Select (WCS) oil prices have dropped by 12.3%, dampening the loonie’s upside potential. Report Links: Preserving Capital During Riot Points - September 6, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been mostly negative: The trade balance narrowed to CHF 1.2 billion in August from CHF 2.6 billion in July. Credit Suisse survey expectations came in at -15.4 in September, up from the last reading of -37.5 in August. The USD/CHF has been flat this week. As a small, open economy, Switzerland belongs to those countries with highest foreign trade-to-GDP share. The trade balance in August has been the lowest since January 2018, with lower exports of main goods including chemical and pharmaceutical products. Among trading partners, exports to Germany, Italy, and France all declined, reflecting the recent manufacturing slowdown in Europe. That said, we remain positive on the safe-haven Swiss franc during the risk-off period amid trade war uncertainties, Brexit chaos, Middle-East tensions, and more recently, the Trump Impeachment imbroglio. Report Links: What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 There is scant data from Norway this week: The unemployment rate increased to 3.8% in July, 0.6 percentage points higher than in April, accordingly to the recent Labour Force Survey. The USD/NOK appreciated by 0.5% this week. The Norges Bank, the one and only hawkish central bank among the G-10, raised its interest rate by 25 basis points to 1.5% last week. Since last September, the Norges Bank has hiked rates four times in total, resulting in a one-percentage-point increase in rates. The central bank stated that “the Norwegian economy has been solid; Employment has risen; Capacity utilization appears to be somewhat above a normal level; Inflation is close to target.” A higher interest rate would also help take the wind out of skyrocketing house prices and household debt levels. In addition, the central bank lowered its projection path for the krone, stating that the factors it outlined, including weaker activity in the petroleum sector, would probably keep weighing on the krone in the years ahead. Report Links: Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been negative: Consumer confidence fell to 90.6 in September. PPI yearly growth fell from 2% in July to 1.4% in August. Trade balance shifted to a deficit of SEK 5.4 billion in August. USD/SEK has been flat this week. We are closely monitoring the Swedish foreign trade as a leading indicator for global growth. The Swedish trade balance has shifted to a deficit for the first time this year. However, compared to last August, the deficit was narrowed by SEK 2.6 billion. Year to date, the Swedish trade surplus amounted to SEK 27 billion. Notably, the trade in goods with non-EU countries resulted in a surplus of SEK 6.6 billion, while the trade with EU resulted in a deficit of SEK 12 billion. Report Links: Where To Next For The U.S. Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades
Highlights President Trump’s support among Republicans and lack of smoking gun evidence will prevent his removal from office. Trade risk will increase if Trump’s approval benefits from impeachment proceedings and the U.S. economy is resilient. Political risk on the European mainland is falling. However, watch out for Russia and Turkey, and short 10-year versus 2-year gilts. A new election in Spain may not resolve the political deadlock. Book gains on our Hong Kong Hang Seng short. Feature Impeachment proceedings against U.S. President Donald Trump, the brazen Iranian attack on Saudi Arabia, the persistence of trade war risk, and additional weak data from China and Europe all suggest that investors should remain risk averse for now. Specifically, Trump’s impeachment could drive him to seek distractions abroad – abandoning the tactical retreat from aggressive foreign and trade policy that had only just begun. Geopolitical risk outside of the hot spots is falling, especially in Europe. The risk of a no-deal Brexit has collapsed in line with our expectations. Italy and Germany have pleased markets by providing some fiscal stimulus sans populism. In France, President Emmanuel Macron’s popularity is recovering. And – as we discuss in this report – Spain’s election will not add any significant fear factor. In what follows we introduce a new GeoRisk Indicator, review the signal from all of our indicators over the past month, and then focus on Spain. Fear U.S. Politics, Not Impeachment The House Democrats’ decision to impeach Trump gives investors another reason to remain cautious on risk assets. Why not be bullish? It is true that impeachment without smoking gun evidence increases Trump’s chances of reelection, which is market positive relative to a Democratic victory. President Trump is virtually invulnerable to Democratic impeachment measures as long as Republicans continue to support him at a 91% rate (Chart 1). Senators will not defect in these circumstances, so Trump will not be removed from office. Trump is invulnerable to impeachment measures as long as GOP support remains high. Moreover the transcript of his phone conversation with Ukrainian President Volodymyr Zelenskiy did not produce a bombshell: there is no explicit quid pro quo in which President Trump suggests he will withhold military aid to Ukraine in exchange for an investigation into former Vice President Joe Biden’s and his son Hunter’s doings involving Ukraine. Any wrongdoing is therefore debatable, pending further evidence. This includes evidence beyond the “whistleblower’s complaint,” which suggests that the Trump team attempted to stifle the transcript of the aforementioned phone call. The point is that the grassroots GOP and Senate are the final arbiters of the debate. The problem is that scandal and impeachment will still likely feed equity market volatility (Chart 2). The House Democrats could turn up new evidence now that they are fully focused on impeachment and hearing from whistleblowers in the intelligence community. Chart 1GOP Not Yet Willing To Impeach Trump Impeachment also has a negative market impact via the Democratic Party’s primary election. Elizabeth Warren has not dislodged Biden in the early Democratic Primary yet. Chart 2Impeachment Proceedings Likely To Raise Vol If she does, it will have a sizable negative impact on equity markets, as President Trump will still be only slightly favored to win reelection. Under any circumstances, this election will be extremely close, it has significant implications for fiscal policy and regulation, and therefore it will create a lot of uncertainty between now and November 2020. The whistleblower episode has if anything aggravated this uncertainty. As mentioned at the top of the report, if impeachment proceedings ever gain any traction they could drive Trump to seek distractions abroad – abandoning the tactical retreat from aggressive foreign and trade policy that had only just begun. Finally, Trump’s reelection, while more market-friendly than the alternative and likely to trigger a relief rally, is not as bullish as meets the eye. Trump’s policies in the second term will not be as favorable to corporates as in the first term. Unshackled by electoral concerns yet still facing a Democratic House, Trump will not be able to cut taxes but he will be likely to conduct his foreign and trade policy even more aggressively. This is not a market-positive outlook, regardless of whether it is beneficial to U.S. interests over the long run. Bottom Line: President Trump’s approval among Republican voters is the critical data point. Unless they abandon faith, the senate will not turn, and Trump’s support may even go up. But this is not a reason to turn bullish. The coming year will inevitably see a horror show of American political dysfunction that will lead to volatility and potentially escalating conflicts abroad. Introducing … Our Sino-American Trade Risk Indicator This week we introduce a new GeoRisk Indicator for the U.S.-China trade war (Chart 3). The indicator is based on the outperformance of overall developed market equities relative to those same equities that have high exposure to China, and on China’s private credit growth (“total social financing”). As our chart commentary shows, the indicator corresponds with the course of events throughout the trade war. It also correlates fairly well with alternative measures of trade risk, such as the count of key terms in news reports. Chart 3Trade Risk Will Go Up From Here As we go to press, our indicator suggests that trade-war related risk is increasing. Over the past month Trump has staged a tactical retreat on foreign and trade policy in order to control economic risks ahead of the election. Our indicator suggests this is now priced. The problem is that Trump’s re-election risk enables China to drive a harder bargain, which is tentatively confirmed by China’s detainment of a FedEx employee (signaling it can trouble U.S. companies) and its cancellation of a tour of farms in Montana and Nebraska. These were not major events but they suggest China smells Trump’s hesitation and is going on the offensive in the negotiations. Principal negotiators are meeting in early October for a highly significant round of talks. If these result in substantive statements of progress – and evidence that the near-finished draft text from April is being completed – they could set up a summit between Presidents Xi Jinping and Donald Trump in November at the APEC summit in Santiago, Chile. At this point we would need to upgrade our 40% chance that a deal is concluded by November 2020. If the talks do not conclude with positive public outcomes then investors should not take it lightly. The Q4 negotiations are possibly the last attempt at a deal prior to the U.S. election. If there is no word of a Trump-Xi summit, it will confirm our pessimistic outlook on the end game. U.S.-China trade talks are unlikely to produce a durable agreement. Ultimately we do not believe that the U.S.-China trade talks will produce a conclusive and durable agreement that substantially removes trade war risk and uncertainty. This is especially the case if financial market and economic pressure – amid global monetary policy easing – is not pressing enough to force policymakers to compromise. But we will watch closely for any signs that Trump’s tactical retreat is surviving the impeachment proceedings and eliciting reciprocation from China, as this would point to a more sanguine outlook. Bottom Line: As long as the president’s approval rating benefits from the Democratic Party’s impeachment proceedings, and the U.S. economy is resilient, as we expect, Trump can avoid any capitulation to a shallow deal with China. Trade risk could go up from here. By the same token, impeachment proceedings could eventually force Trump to change tactics yet again and stake out a much more aggressive posture in foreign affairs. If impeachment gains traction, or a bear market develops, he could become more aggressive than at any stage in his presidency – and this aggression could be directed at China (or Iran, North Korea, Venezuela, or another country). The risk to our view is that China accepts Trump’s trade position in order to win a reprieve for its economy and the two sides agree to a deal at the APEC summit. European Risk Falls, While Russian And Turkish Risk Can Hardly Fall Further Elsewhere our measures of geopolitical risk indicate a decrease in tensions for a number of developed and emerging markets (see Appendix). In Germany, risk can rise a bit from current levels but is mostly contained – this is not the case in the United Kingdom beyond the very short run. In Russia and Turkey, risk can hardly fall further. Take, for starters, Germany, where political risk declined after Chancellor Angela Merkel’s ruling coalition agreed to a 50 billion euro fiscal spending package to battle climate change. This agreement confirms our assessment that while German politics are fundamentally stable, the administration will be reactive rather than proactive in applying stimulus. Europe will have to wait for a global crisis, or a new German government, for a true “game changer” in German fiscal policy. Perhaps the Green Party, which is surging in polls and as such drove Merkel into this climate spending, will enable such a development. But it is too early to say. Meanwhile Merkel’s lame duck years and external factors will prevent political risk from subsiding completely. We see the odds of U.S. car tariffs at no higher than 30%, at least as long as Sino-American tensions persist. By contrast, the United Kingdom’s political risks are not contained despite a marked improvement this month. The Supreme Court’s decision on September 25 to nullify Prime Minister Boris Johnson’s prorogation of parliament drove another nail into the coffin of his threat to pull the country out of the EU without a deal. This was a gambit to extract concessions from the EU that has utterly flopped.1 Since it was the most credible threat of a no-deal exit that is likely to be mounted, its failure should mark a step down in political risk for the U.K. and its neighbors. However, paradoxically, our GeoRisk indicator failed to corroborate the pound’s steep slide throughout the summer and now, as no-deal is closed off, it has stopped falling. The reason is that the pound’s rate of depreciation remained relatively flat over the summer, while U.K. manufacturing PMI – one of the explanatory variables in our indicator – dropped off much faster as global manufacturing plummeted. As a result, our indicator registered this as a decrease in political risk. The world feared recession more than it feared a no-deal Brexit – and this turned out to be the right call by the market. But the situation will reverse if global growth improves and new British elections are scheduled, since the latter could well revive the no-deal exit risk, especially if the Tories are returned with thin majority under a coalition. The truth is that the Brexit saga is far from over and the U.K. faces an election, a possible left-wing government, and ultimately resilient populism once it becomes clear that neither leaving nor staying in the EU will resolve the middle class’s angst. Our long GBP-USD recommendation is necessarily tactical and we will turn sellers at $1.30. In emerging markets, Russia and Turkey have seen political risk fall so low that it is hard to see it falling any further without some political development causing an increase. Based on our latest assessment, Turkey is almost assured to see a spike in risk in the near future. This could happen because of the formation of a domestic political alliance against President Recep Erdogan or because of the increase in external risks centering on the fragile U.S.-Turkey deal on Syria. Tensions with Iran could also produce oil price shocks that weaken the economy and embolden the opposition. As for Russia, our base case is that Russia will continue to focus internal domestic problems to the neglect of foreign objectives, which helps geopolitical risk stay low. With U.S. politics in turmoil and a possible conflict with Iran on the horizon, Moscow has no reason to attract hostile attention to itself. Nevertheless Moscow has proved unpredictable and aggressive throughout the Putin era, it has no real loyalty to Trump yet could fall victim to the Democrats’ wrath, and it has an incentive to fan the flames in the Middle East and Asia Pacific. So to expect geopolitical risk to fall much further is to tempt the fates. Bottom Line: European political risk is falling, but Merkel’s lame duck status and trade war make German risk likely to rise from here despite stable political fundamentals. The United Kingdom still faces generationally elevated political risk despite the happy conclusion of the no-deal risk this summer. Go short 10-year versus 2-year gilts. Russia should remain quiet for now, but Turkey is almost guaranteed to experience a rise in political risk. Spain: Election Could Surprise But Risks Are Low Spanish voters will head to the polls on November 10 for the fourth time in four years after political leaders failed to reach a deal to form a permanent government. The Spanish Socialist Workers’ Party (PSOE) has served as a caretaker government after winning 123 out of 350 seats in the snap election in April. A new Spanish election will not resolve the current political deadlock. Prime Minister and PSOE leader Pedro Sanchez failed to be confirmed in July, and has since attempted to make a governing deal with the left-wing, anti-establishment party Podemos. However, PSOE is not looking for a full coalition but merely external support to continue governing in the minority. Hence it is only offering Podemos non-ministerial agencies (rather than high-level cabinet positions) in negotiations, leaving Podemos and other parties ready for an election. The outcome of the upcoming election may not differ much from the April election. The Spanish voter is not demanding change. Unemployment and underemployment have been decreasing, and wage growth has been positive since 2014 (Chart 4). In opinion polls, support for the various parties has not shifted significantly (Chart 5, top panel). PSOE is still leading by a considerable gap. Chart 4Spanish Voter Is Not Demanding Change However, the election will increase uncertainty at an inconvenient time, and it could produce surprises. PSOE’s support has slightly decreased since late July, when negotiations with Podemos started falling apart. Chart 5Not Much Change In Polls... Even if PSOE and Podemos form a governing pact, their combined popular support is not significantly higher than the combined support for the three main conservative parties. These are the Popular Party, Ciudadanos, and Vox (Chart 5, bottom panel) – which recently showed they can work together by making a governing deal to rule the regional government in Madrid. Chart 6…But Lower Turnout Could Hurt The Left The Socialist Party hopes to capture borderline voters from Ciudadanos, namely those who are skeptical towards the party’s right-wing populist shift and hardening stance regarding Catalonia. However, even capturing as many as half of Ciudadanos’ voters would place PSOE support at ~37% – far short of what is needed to form a single-party majority government. Another factor that can hurt PSOE is voter turnout. Spanish voters have been less and less interested in supporting any party at all since the April election. A decrease in turnout would hurt left-wing parties the most, given that voters blame Podemos and PSOE more than PP and Ciudadanos for the failure to form a government (Chart 6). The most likely outcomes are the status quo, or a PSOE-Podemos alliance. But a conservative victory cannot be ruled out. In the former two cases, the implication is slightly more positive fiscal accommodation that is beneficial in the short-term, but at the risk of a loss of reform momentum that has long-term negative implications. To put this into context, Spanish politics remains domestic-oriented, not a threat to European integration. Voters in Spain are some of the most Europhile on the continent, both in terms of the currency and EU membership (Chart 7). Spain is a primary beneficiary of EU budget allocations, along with Italy. Even Spain’s extreme right-wing party Vox is not considered to be “hard euroskeptic.” Within Spain, however, political polarization is a problem. Inequality and social immobility are a concern, if not as extreme as in Italy, the U.K., or the United States. Moreover the Catalan separatist crisis is divisive. While a new Catalonian election is not scheduled until 2022, the pro-independence coalition of the Republican Left of Catalonia and Catalonia Yes has been gaining momentum in the polls, and Ciudadanos’s support plummeted since the party hardened its stance on Catalonia earlier this year (Chart 8). Catalonia is by no means going independent – support for independence in the region peaked in 2013 – but it remains a driving factor in Spanish politics. Chart 7Spaniards Love Europe Chart 8Catalonia Is A Divisive Issue In the very short term, election paralysis introduces fiscal policy crosswinds. On one hand, regional governments may be forced to cut spending. The regions were expecting to receive EUR 5 billion more than last year, which was promised to be spent in part on healthcare and education. Until a stable (or at least caretaker) government can approve a 2019 budget, the regions will base their 2019 budgets on last year’s numbers, meaning they will have to cut any projected increases in spending. Yet on the other hand, the budget deficit will widen as taxes fail to be collected. In late 2018 Spain approved increases in pensions, civil servants’ salaries, and minimum wage by decree, but any corresponding revenue increases that were to be implemented in the 2019 budget will fail to materialize until government is in place, putting upward pressure on the deficit. Beyond the election the trend should be slightly greater fiscal thrust due to the continental slowdown. Spain has some fiscal room to play with – its budget deficit is projected to decrease to 2% in 2019 and 1.1% in 2020.2 The more conservative estimate by the European Commission forecasts the 2019 and 2020 deficits to be 2.3% and 2%, respectively (Chart 9). This means that Spain can provide roughly 10-15 billion euros worth of additional stimulus in 2020 without so much as hinting at triggering Excessive Deficit Procedures, a welcome change after nearly a decade of austerity. The risk is that Spain’s structural reform momentum could be lost with negative long-term consequences. In 2012 Spain undertook painful labor and pension reforms that underpinned its impressive economic recovery. The economy continues to grow faster than the average among its peers, unemployment has fallen by 12% in the past six years, and export competitiveness has had one of the sharpest recoveries in Europe since 2008 (Chart 10). This recovery has now begun to slow down, and the current political deadlock means that reforms could be rolled back farther than the market prefers. Chart 9Spain Has Some Fiscal Room This is more likely to be avoided if a surprise occurs and the conservatives come back into power, although that would also mean less accommodative near-term policies. Chart 10Recovery Starting To Slow Bottom Line: Our geopolitical risk indicator is signaling subdued levels of risk for Spain. This is fitting as the election may not change anything and at any rate the country will remain in an uneasy equilibrium. Politics are fundamentally more stable than in the populist-afflicted developed countries – the U.S., U.K., and Italy. However, an outcome that produces a left-wing government will lead to greater short-term fiscal accommodation at the expense of Spain’s recent outstanding progress on structural reforms. Housekeeping We are booking gains on our Hong Kong Hang Seng short. Unrest is not yet over, but is about to peak as we approach October 1, the National Day of the People’s Republic of China, and Beijing will look to avoid an aggressive intervention. Ekaterina Shtrevensky, Research Analyst ekaterinas@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 The Supreme Court deemed Johnson’s government’s prorogation of parliament an unlawful frustration of parliament’s role as sovereign lawgiver and government overseer without reasonable justification. The court was larger than usual, with 11 judges, and they ruled unanimously against the prorogation. We had expected the vote at least to be narrow – given the historic uses of prorogation, the fact that parliament still had time to act prior to October 31 Brexit Day, and the prime minister’s historical authority over foreign affairs and treaties. But the Supreme Court has risen to fill the power vacuum created by parliament’s paralysis amid the Brexit saga; it has “quashed” what might have become a neo-Stuart precedent that prime ministers can curtail parliament’s role at important junctures. The pragmatic, near-term consequence is the reduction in the political and economic risks of a no-deal exit; but the long-term consequence may be the rise of the judiciary to greater prominence within Britain’s ever-evolving constitutional system. 2 Please see “Stability Programme Update 2019-2022, Kingdom of Spain,” available at www.ec.europa.eu. U.K.: GeoRisk Indicator France: GeoRisk Indicator Germany: GeoRisk Indicator Spain: GeoRisk Indicator Italy: GeoRisk Indicator Russia: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea: GeoRisk Indicator What's On The Geopolitical Radar? Section III: Geopolitical Calendar
PM Johnson had already mostly lost control of the Brexit process once Parliament decided to take the matter in its own hands. His gambit to prorogue Parliament in order to regain controlled has now backfired as the Supreme Court unanimously ruled against him.…
The U.K. has created 4.2 million new jobs over the past decade, nudging the employment-to-population ratio to the highest level in almost 50 years. Positively, full-time job creation has outpaced part-time and female participation rates are soaring. Despite…
A big driver for retail sales in the U.K. are tourist arrivals and the weaker pound is likely to keep attracting an influx of visitors. The U.K. commands many of the world’s leading brands that will benefit from a cheap currency. The household deleveraging…
Germany’s most important energy source is still oil which accounts for over a third of its primary energy use. Moreover, 98 percent of Germany’s consumption of oil depends on imports. Most of Germany’s oil consumption is for transport. In the short term, oil…
Highlights The U.K. economy has been holding up fairly well, despite the overhang of political uncertainty. However, even before the actual withdrawal of the U.K. from the E.U. has occurred, Brexit has left a lasting mark on the U.K. economy through elevated uncertainty, severe weakness in business investment spending, and anemic productivity. The net result is an economy with lower trend growth, a structurally weaker exchange rate, and relatively high domestic inflation. Brexit will be delayed beyond October 31. No-deal Brexit is an overstated risk unless an early election strengthens Boris Johnson’s hand. That is unlikely. The investment outlook for the British pound and U.K. gilts is highly binary: a “smooth” Brexit is bullish for the pound and bearish for gilts, while no-deal Brexit would push both the pound and gilt yields even lower. Feature Ever since the United Kingdom voted in 2016 to exit the European Union, the outlook for the economy and financial assets has been tied to the binary outcome of whether or not an exit would be orderly. This has been a tremendous source of uncertainty, putting the Bank of England (BoE) in one of the most inconvenient positions ever faced by a central bank. In this week’s report, we look to address a few high-level questions. First, has the slowdown in the U.K. economy been run of the mill, given the global manufacturing recession? Or has it been unduly protracted given heightened political uncertainty? If the latter, what are the prospects of a rebound should anything other than a “no-deal” Brexit prevail? Finally, has there been irreparable damage already done to the economy because of delayed investment, with longer-term ramifications irrespective of the relationship outcome with the E.U.? An Employment Boom The U.K. is currently experiencing the best jobs recovery since the Second World War. 4.2 million new jobs have been created over the past decade, nudging the employment-to-population ratio to the highest level in almost 50 years. What is remarkable is that this recovery looks even more impressive than that of the U.S., where labor market conditions have been very robust. For example, in the U.S., the employment rate stands at 60.9%, just a nudge below the U.K. but still nearly four percentage points below its pre-crisis peak (Chart 1). Compared to the eurozone, the outperformance of the U.K. labor market has been very evident. Despite this recovery, the pickup in wages has been the most tepid since the Boer War. The quality of jobs has also been stellar – full-time job creation has outpaced part-time and female participation rates are soaring. The jobs bonanza has also been broad across regions and industries. Yes, the manufacturing sector has seen some measure of volatility, but aside from the East Midland region, unemployment rates continue to converge downward across the United Kingdom (Chart 2) Chart 1An Employment Boom Chart 2Recovery Is Broad-Based Despite this recovery, the pickup in wages has been the most tepid since the Boer War. In a July speech, the BoE’s chief economist, Andy Haldane, rightly noted that the lost decade of pay has been an equal-opportunity disaster across the major U.K. regions. From the 1950s until the Great Recession, real pay in the U.K. grew by about 2% per annum. Since the Great Recession, real pay has stagnated at a rate of -0.4% per year (Chart 3).1 Chart 3Wages Stagnated Until Recently There have been a few reasons for this. First, there has been strong growth in self-employment, zero-hours contracts and agency work. So even though the share of full-time work has been rising during the post-crisis period, it remains well below its pre-crisis highs. This has increased the fluidity of the labor market, lowering the cost of doing business in the process. Compensation of self-employed or zero-hours contract workers lies significantly below their permanent counterparts. The silver lining is that this phenomenon is not specific to the U.K., but is happening worldwide, especially in Europe where structural reform has disentangled rigidities in the labor market. The key question going forward is whether the nascent rise in wages will continue. Over a cyclical horizon, our contention is that should positive employment trends continue, the U.K. could begin to experience significantly stronger wage pressures. There are four fundamental reasons for this: Job offers continue to outpace the number of seekers. Depending on the measure used, there are 20%-40% more jobs than there are applicants (Chart 4). This impasse cannot easily be resolved by a higher employment rate (it is at a secular high) or lower unemployment. The BoE estimates NAIRU in the U.K. is at 4.4%, which means that the unemployment rate is firmly below its structural level. Business surveys continue to suggest that a shortage of skilled labor is among the top problems firms are facing. The Phillips curve in the U.K. has flattened in the last few years, but wage growth has started to inflect higher of late. Like many other countries, the Phillips curve in the U.K. is kinked, whereby the convexity of wage growth increases as the unemployment gap closes. The velocity of circulation in the jobs market, also known as the job-to-job flow, has picked up. This has historically been positive for wage growth (Chart 5). This is also mirrored by the quits rate, which has been accelerating since 2012. Chart 4Wage Pressures Should Mount Chart 5Velocity Of U.K. Employment Rising At the moment, the transmission mechanism from a tight labor market to higher wages is being impeded by political uncertainty, which will continue to cast a near-term shadow on longer-term hiring plans. For example, for all the talk of the U.K. being a financial center, attrition in banking and insurance employment remains entrenched (Chart 6). The U.K. continues to attract a significant amount of financial business, especially in the foreign exchange market, but there was a clear hit to volumes in 2016, the year the Brexit referendum was held (Chart 7). Meanwhile, for the manufacturing sector, it will take a while to rekindle animal spirits and re-attract foreign direct investment. Chart 6Attrition In Manufacturing And Finance Employment Chart 7The U.K. Is An Important Financial Center That said, the U.K. economy remains mostly driven by services, meaning wages will still face some measure of upward pressure. Service sector wage growth has been robust and unless the manufacturing recession grows deeper and starts to infect other sectors of the U.K. economy, the path of least resistance for wages remains up. Bottom Line: The U.K. economy has been holding up fairly well, despite the overhang of political uncertainty. Virtuous Circle Of Spending While the U.K. income pie could grow, a lack of confidence is nonetheless constraining spending. Chart 8 shows that U.K. consumer confidence has negatively diverged from trends in both the U.S. and the euro area. There have been a few offsetting factors at play suggesting that once the clouds of Brexit uncertainty lift, spending could re-accelerate higher. The transmission mechanism from a tight labor market to higher wages is being impeded by political uncertainty, which will continue to cast a near-term shadow. A big driver for retail sales in the U.K. is tourist arrivals and the weaker pound is likely to keep attracting an influx of visitors (Chart 9). Chart 8Confidence Will Be Key For ##br##Any Recovery Chart 9The Cheap Pound Will Encourage ##br##Foreign Shoppers The U.K. commands many of the world’s leading brands that will benefit from a cheap currency. The household deleveraging process is well advanced, and the tentative recovery in borrowing and mortgage applications is helping to cushion the fall in U.K. house prices. This is underpinned by the fact that mortgage-borrowing costs in the U.K. have collapsed along with yields (Chart 10). That said, any rise is borrowing will be mitigated by the fact that household debt-to-GDP in the U.K. remains higher than in many other developed economies. Chart 10Low Rates Should Help Housing Chart 11Cost-Push Inflation Inflation expectations are blasting upward, partly in response to the weaker currency. What is remarkable is that the pound has plummeted by a lot more than is warranted on a fundamental PPP basis. This will bring about imported inflation (Chart 11). Bottom Line: The big risk to the U.K. economy is that it enters into stagflation. A BoE survey pins the loss to output in the event of a no-deal Brexit at around 3% of GDP, but these are estimates since the bulk of the economic adjustment might occur through the exchange rate. The range of estimates for the economic impact of a no-deal (Table 1), perhaps not coincidentally, mirrors the range of Britain’s recessions in the 20th century (Chart 12). This puts the BoE in a particularly uncomfortable “wait and see” mode. For example, if a hard exit leads to a fall in the pound and a rise in inflation expectations, it is not clear the BoE’s Monetary Policy Committee would cut rates if it were to meet its inflation mandate. Table 1Wide Range Of Estimates For Impact ##br##Of No-Deal Brexit Chart 12Past British Recessions Offer Guidelines ##br##For No-Deal Impact Brexit Uncertainty Has Already Caused Lasting Damage To U.K. Growth A major drag on U.K. economic growth over the past three years has been the collapse in business confidence and associated contraction in capital spending (Chart 13). Since the 2016 Brexit vote, business investment has been substantially weaker than at similar points in previous U.K. business cycles – by a cumulative 26%, according to the BoE (Chart 14). While some of the softness seen in 2019 can also be attributable to slowing global economic growth and uncertainty related to the U.S.-China trade war, U.K. capital spending has been far weaker than that of other advanced economies (Chart 15). Since the 2016 Brexit vote, business investment has been substantially weaker than at similar points in previous U.K. business cycles – by a cumulative 26%. This is a critical point to consider when judging the long-run damage that has already been inflicted on the U.K. economy just from the uncertainty of Brexit. The best way to evaluate this damage is through the lens of capital spending, the growth of which is highly correlated to changes in productivity and potential economic growth (Chart 16). Chart 13Gloomy U.K. Businesses Have Stopped Investing Chart 14Massive Underperformance Of U.K. Capex Compared To History ... Chart 15...And Compared To ##br##Global Peers Chart 16A Lasting Hit To The U.K. Economy From Brexit Uncertainty An important research paper published by the BoE last month – co-authored by two current members of the BoE Monetary Policy Committee, Ben Broadbent and Silvana Tenreyro – discusses the linkages between Brexit uncertainty, capital spending and U.K. productivity.2 The authors concluded that the economic effects of the Brexit referendum result can be categorized as a response to an anticipated, persistent decline in productivity growth for the tradeable sectors of the U.K. economy. In that framework, the following chain of events would occur after the “news” of weaker expected productivity (i.e. the Brexit referendum result) is announced: Chart 17A Misallocation of Resources An immediate and permanent fall in the relative price of non-tradeable output relative to tradeable output, i.e. the real exchange rate. Resources shift to the tradeable sector to take advantage of the higher relative price, leading to an increase in output and a rise in exports. Productivity growth in the tradeable sector then falls, as heralded by the “news” of the Brexit vote, leading to a shift in economic resources back towards the higher productivity non-tradeable sectors. U.K. interest rates fall relative to the world, as financial markets discount the expected relatively slower path of U.K. productivity. Aggregate business investment growth slows, but overall employment growth remains resilient. This is exactly how the U.K. economy has evolved since the 2016 Brexit vote: The BoE’s trade-weighted index for the pound has fallen in both nominal and real terms. The export share of U.K. real GDP rose from 27% to 30%, while the investment share of real GDP declined from 10% to 9% (Chart 17, top panel). Annual employment growth in U.K. services (non-tradeable) fell from 2.1% to zero by the end of 2018, but has since begun to recover; manufacturing (tradeable) employment growth initially increased from 0.5% to 2.7% within a year of the Brexit vote, before slowing back to 0% in 2018, and is also starting to move higher (Chart 17, third panel). Productivity growth has declined from 1.9% to nil, even as wage growth has accelerated due to the steady pace of labor demand at a time of low unemployment (Chart 17, bottom panel). On a sectoral level, the worst growth rates of realized productivity growth are occurring in tradeable industries like metal products and financial services, while the highest productivity growth is seen in non-tradeable industries like professional services and retail (Chart 18).3 Chart 18Latest U.K. Productivity Growth Rates, By Industry Summing it all up, according to the analytic framework of the BoE research paper, the Brexit referendum result essentially created a signal, manifested by the plunge in the British pound, for the misallocation of U.K. resources away from higher-productivity non-tradeable industries to lower productivity tradeable sectors. If true, we would also expect to see the following: Chart 19Inflationary Consequences of Brexit Uncertainty Much higher inflation rates in more domestically-focused measures like services and wages. Faster growth in unit labor cost as a result of the gap between accelerating wages and stagnant productivity. Structurally higher inflation expectations. Lower real interest rates in the U.K. than in other advanced economies. Prolonged weakness in the exchange rate. Again, all of this has come to fruition in the U.K. (Chart 19): Services CPI inflation is now at 2.2%, compared to only 1.7% for overall CPI inflation. Unit labor costs growth has accelerated from below zero before the Brexit referendum to a 2%-3% range since the end of 2016. The real 10-year gilt yield (deflated by the 10-year CPI swap rate) is now -3.1%, compared to a 0% real yield on 10-year U.S. Treasurys. The trade-weighted British pound remains close to its post-Brexit referendum lows. It is clear that the Brexit uncertainty has resulted in a structurally weaker, and more inflationary, U.K. economy – an outcome that may not be quickly reversed in the event a no-deal Brexit is avoided. This has important implications for the future monetary policy decisions of the BoE and the investment outlook for the pound and U.K. gilts. Bottom Line: Even before the actual withdrawal of the U.K. from the E.U. has occurred, Brexit has left a lasting mark on the U.K. economy through elevated uncertainty, severe weakness in business investment spending and anemic productivity. The net result is an economy with lower trend growth, a structurally weak exchange rate, and relatively high domestic inflation. Political Uncertainty Prevails Chart 20Public Opposes No-Deal Brexit Even after considering the cyclical and structural state of the U.K. economy, as we have done in this report, the near-term outlook is still entirely dependent on the Brexit outcome. The state of Brexit is more uncertain than ever due to the Supreme Court case against the government’s suspension of Parliament and Prime Minister Boris Johnson’s refusal to obey an order by Parliament to seek an extension to the October 31 exit deadline. What is not in doubt is that parliament opposes a disorderly, no-deal Brexit. And the best polling suggests that public opinion opposes a no-deal Brexit as well (Chart 20). Members soundly rejected Prime Minister Boris Johnson’s negotiation strategy in September – they prohibited both a no-deal Brexit and voted against holding an early election on two separate occasions (Chart 21). Johnson lost his coalition majority and yet cannot go to new elections, leaving him hamstrung until Parliament returns. What is likely regardless of the outcome is a substantial increase in fiscal spending, The United Kingdom is not a seventeenth-century Stuart monarchy – Parliament is the supreme political body in the constitution and its decrees cannot be permanently ignored or disobeyed. Whenever Parliament reconvenes, likely October 14, it will have the ability to ensure that the Brexit deadline is extended. The E.U. is likely to grant an extension because it is in the E.U.’s interest to delay or cancel Brexit and demonstrate to all members that leaving the bloc is neither desirable nor practical. The result will then be an election. Chart 21Boris Johnson’s Negotiation Strategy Failed Chart 22A Hung Parliament Is The Likely Outcome Election polls show the Conservative Party breaking out, the Liberal Democrats overtaking Labour, and the Brexit Party maintaining an edge (Chart 22). Translating these polls to parliamentary seats is not straightforward because the first-past-the-post electoral system means that a smaller party can steal crucial votes from the most popular party leaving the second- or third-most popular party to win the seat. The key point is that the Brexit Party is a single-issue party and the Tories under Johnson are now monopolizing that same issue. If this dynamic persists, the Lib Dems pose a greater threat of splitting Labour’s votes than the Brexit Party does of splitting Conservative votes. The result is that it is still possible for the Conservatives to gain a majority, even though it seems unlikely given that they need 325-plus seats and have fallen to 288 seats after purging unruly members and losing leadership in Scotland. A hung Parliament is a more likely outcome. A hung Parliament will prolong the indecision and uncertainty – but will also be likely to remain united against a no-deal Brexit. An opposition coalition government will prevent a no-deal Brexit. Even a single-party Tory majority is not a disastrous outcome, as it would increase Johnson’s leverage with the E.U. and increase the likelihood that the E.U. would offer some concessions to get a withdrawal agreement passed, resulting in a Brexit deal and an orderly exit (Specifically, a Northern Irish limitation to the backstop, or a sunset clause or withdrawal mechanism for the same). Such a deal is in Johnson’s best interests so that he does not preside over a recession from the moment he returns to office. All of these outcomes point toward either an exit deal or a new chapter in which parliament seeks a new referendum. Chart 23Expect An Increase In Fiscal Spending The worst outcome for the markets would be a weak Tory coalition majority that cannot agree on Ireland or pass an exit deal, as this could lead to paralysis, as it did with Theresa May, at a time when the prime minister is committed to delivering an exit come hell or high water. This is the scenario in which no-deal once again becomes a genuine risk. Subjectively we have estimated that the risk of no-deal is around 30%, but this is currently falling, not rising, as a result of parliament’s strong majorities against that outcome in September – and only an election can change that. It is fruitless trying to predict the U.K.’s future political landscape without knowing the conclusion of the Brexit saga. What is likely regardless of the outcome is a substantial increase in fiscal spending, reversing the “austerity” of the aftermath of the Great Recession. This trend is already apparent from Johnson’s current attempt to present a generous social spending package at the Tory party conference this fall – which would, if vindicated by a new election, represent a turnaround in Conservative fiscal policy (Chart 23). More fiscal spending will be needed to counteract the negative impact of a disorderly Brexit, or to placate the middle class once it becomes clear that leaving the E.U. is not a panacea for the UK’s problems, or to fulfill the agenda of an opposition government when it comes to power. In the event that a no-deal Brexit occurs, the U.K. will not only face a tumultuous economic aftermath, but the constitutional struggles among the three kingdoms will reignite due to the negative impact in Northern Ireland and the likely revival of Scottish independence efforts. Bottom Line: The U.K. is not a dictatorship and the prime minister cannot refuse to obey Parliament’s will. Parliament has voted clearly to delay a no-deal Brexit and will continue to do so. A disorderly exit remains a risk because an eventual election could return the Tories to power. But in this case, the E.U. will be more likely to offer a concession that enables Parliament to pass a withdrawal bill. The odds of no deal are no higher than 30%. The structural takeaway, regardless of the outcome, is that fiscal spending will rise. Investment Conclusions The episodes surrounding the collapse of the pound in 1992 carry important lessons for today.4 Crucially, most of the adjustment in the pound happened quickly, but a key difference from today is that an exit from the European Exchange Rate Mechanism was unanticipated, unlike Brexit. Foreign exchange markets are extremely fluid and adjust to expectations quite quickly. Peak to trough, cable has already fallen by circa 30% suggesting the bulk of the downward adjustment is done. Chart 24A Binary Brexit Outcome for Gilts The British currency is free floating, meaning there are less “hidden sins” compared to the fixed exchange rate period. That said, the fair value of the pound has structurally weakened. Our bias is that if there is a hard Brexit, the pound could easily drop to the 1.10-1.15 zone. Part of this move will be an undershoot. In the case of a soft Brexit (or no Brexit), the pound should converge toward the mid-point of its historical real effective exchange rate range, which would pin it 15%-20% higher, or at around 1.50. From a risk-reward perspective, this looks attractive. For U.K. gilts, the direction of yields is also dependent on the Brexit outcome, as there is essentially no change in policy rates discounted in the U.K. Overnight Index Swap (OIS) curve (Chart 24). A “smooth” Brexit would allow the BoE to return its focus to fighting elevated U.K. inflation expectations. That would likely result in both higher gilt yields and a flattening of the gilt yield curve, as the market prices in future BoE rate hikes, and lower longer-term inflation expectations. A rising cable will also temper inflation expectations. Neither gilts nor U.K. inflation-linked bonds would perform well in this scenario.. A “no deal” Brexit, on the other hand, would prompt the BoE to cut interest rates in order to offset the potential hit to business and consumer confidence. This could occur even if inflation expectations remain high or rise further on pound weakness. That would mean lower gilt yields and a steepening of the gilt curve. Going overweight gilts but also long inflation-linked bonds would be the best way to position for this outcome. The scenarios for fiscal easing outlined earlier would also influence the shape of the gilt curve, resulting in some degree of bearish steepening as the gilt curve prices in both larger deficits and higher future inflation, all else equal. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Matt Gertken, Geopolitical Strategist mattg@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com Footnotes 1 Andrew G Haldane, “Climbing the Jobs Ladder,” Bank of England, July 23, 2019 2 Bank of England External MPC Unit Discussion Paper No. 51, “The Brexit vote, productivity growth and macroeconomic adjustments in the United Kingdom”, August 2019 3 London’s role as a major global financial center makes the U.K. financial services industry a “tradeable” sector, in that a significant share of its output is “traded” to non-U.K. users. 4 Mathias Zurlinden, “The Vulnerability of Pegged Exchange Rates: The British Pound in the ERM,” Economic Research, Vol. 75, No. 5 (September/October 1993). Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades
The cut in the ECB’s deposit facility rate from -0.4% to -0.5% was in line with market consensus, as was the resumption of quantitative easing. Investors did not foresee that the ECB would embark on open-ended bond purchases however, with the plan quickly…