MARKET VIEWS

Trump and the US Dollar

November 2016

Previously we had felt the US Dollar was set to rally because of higher growth and monetary policy divergence relative to the rest of the world as the Fed’s tightening bias evolves. Now, our position is further supported by the incoming Trump administration and its proposed policies of tax reform and infrastructure investment will provide a significant boost to the US economy. We have upgraded our US GDP growth forecast by 0.7ppt to 2.7%y/y in 2017 and our US 10 yr yield forecast to 3.25% by end-2017, with the balance of risks to the upside. We expect the dollar to outperform all other currencies in the medium term and refer you to our medium term forecasts in chart 1, and our recent performance figures in chart 3.

Chart 1

The opportunity

The Trump administration’s economic plan centres on a fiscally expansive programme of tax reform and infrastructure investment. On tax reforms they propose a simplification of the tax code, fewer income tax bands, a reduction in corporate tax to 15% from 35%, a one off 10% tax on the repatriation of foreign earnings and eliminating double taxation on the foreign component of US corporate profits. These reforms would provide a stimulus of almost $10 trillion over the next decade. A public investment programme of $1 trillion over 4 years is envisaged.

While a fully implemented plan would add 1.5ppt to GDP next year, we believe it is more realistic to assume only a portion of the package will pass through Congress. Therefore we project the impact will be 0.7ppt and we have increased our US GDP forecast to an above trend rate of 2.7%y/y for 2017.

As the economic programme is enacted, in part or in whole, consumption will increase and US firms will repatriate foreign earnings; companies may relocate headquarters and operations back to the US owing to the more favourable corporate tax rate. The jobless rate will fall further and given the economy is close to full capacity, inflation will rise. Consequently the Fed will need to be additionally vigilant in 2017. After a 25bp hike in December, we expect 50bp of tightening next year with a possibility of more hikes.

While outstanding debt in the US will increase as the budget deficit widens, this is not necessarily a negative factor if international investors are willing to buy US government bonds. We project US 10 yr yields to be 3.25% by the end of next year, making returns to US debt considerably more attractive than the bonds of other developed nations.

A risk to our view is that beyond 2017, the strength of the dollar and higher bond yields will significantly tighten financial conditions, limiting growth due to weak exports and capital expenditure growth, and the administration expresses concerns about the strengthening of the US Dollar.

In summary, the proposed economic plan of the new administration will lead to a sharp pick up in US GDP growth and inflation, with risks tilted to the upside, as we expect an increasingly hawkish Fed. This contrasts to the rest of the world, where economic growth is below trend, inflation is subdued and monetary policy is accommodative. We reaffirm our dollar bullish view and look for more gains in the months ahead as monetary policy and growth projections between the US and the rest of the world diverge. (see chart 2)

Chart 2

The opportunity

Chart 3

The opportunity

Brexit and Sterling

October 2016

The UK’s relationship with the EU has altered permanently since June when the UK voted to leave the EU. In light of the weekend announcement by Prime Minister Theresa May of a March 2017 deadline to trigger Article 50 and commence the exit process, we reaffirm our negative outlook for the UK economy and why we believe Sterling will fall through 1.19 in 6 months and is unlikely to appreciate for some considerable time.

The Prime Minister has now set a date by which the exit process must commence. Her speech at the Conservative Party Conference suggests the UK is emphasizing immigration control over unfettered access to the Single Market. The Home Secretary has said she will look to make it more difficult for British firms to hire foreign workers, something we view as a negative for the economy, if taken at face value.

In an earlier article we identified the capital account and an expected reduction in portfolio and investment flows as the most significant structural vulnerabilities facing the UK over the medium term, should it vote to leave the EU.

There is still little detail or certainty about the form the UK’s relations with the EU will take since the formal negotiation process has yet to start. This is hampering firms’ ability to plan for the future. A significant number of large companies have announced spending and investment freezes, profit warnings and possible HQ relocations due to the referendum result. Cross border bank flows also face uncertainty given comments from European officials that the EU is unwilling to permit the UK to passport financial services to other EU countries without accepting the free movement of people.

Since late June, survey and sentiment data has been volatile. The UK Composite PMI for July printed the lowest reading in 7 years, but recovered in August. However, the trend indicates weakness ahead for GDP growth (see chart 1). While high frequency economic data has yet to show a decisive weakening, we foresee that as corporate spending, investment delays/reductions take effect, it will feed into the hard data and we expect this will happen over the coming months.

Chart 1

The opportunity

Since late June, survey and sentiment data has been volatile. The UK Composite PMI for July printed the lowest reading in 7 years, but recovered in August. However, the trend indicates weakness ahead for GDP growth (see chart 1). While high frequency economic data has yet to show a decisive weakening, we foresee that as corporate spending, investment delays/reductions take effect, it will feed into the hard data and we expect this will happen over the coming months.

Considering these cyclical and structural factors we forecast that GBP/USD will decline in the medium term. Sterling will be unable to appreciate meaningfully until the issues associated with Brexit have been worked through, which may take a number of years. We look for 1.19 in 6 months with downside risks, possibly targeting the all time lows below 1.10, in the longer term (see chart 2).

Chart 2

The opportunity

The Outlook for Sterling if the UK votes to leave the European Union

April 2016

On the 23rd of June voters in the UK will be asked "Should the United Kingdom remain a member of the European Union or leave the European Union?" A referendum to exit the EU has never taken place in any Member State before now.

Such an exit is not our base case. We expect the UK will remain in the EU in some form. But, with a meaningful percentage of undecided voters and polls indicating the "Remain" versus "Leave" camps are within 5 points of each other, either outcome is possible.

Below we address the implications for Sterling in the event the UK does exit the EU.

Membership of the EU gives the UK the right to the free movement of goods, people, services and capital. Such rights have significant economic benefits. A vote to exit would not immediately result in withdrawal from the EU or curtailment of these rights; such a transition could take up to 2 years during which time the UK would negotiate its withdrawal from and subsequent relationship with the EU.

Post exit scenarios range from the UK having full access to the EU, as it does now, to being excluded entirely. The former is very unlikely and in all scenarios the UK’s relationship with the EU is permanently and irrevocably weakened.

We believe that the most significant structural vulnerability of the UK economy is its capital account. The UK is the third largest recipient of inward foreign investment in the world after the US and China, see chart 1.

Chart 1
The opportunity

A large majority of investors cite the UK’s membership of the EU as one of the main reasons the UK is an attractive destination for capital. Half of this stock originates from within the EU (see chart 2), making it even more vulnerable to change. Post exit such investors would be expected to cut back on direct investment and reduce or reverse such portfolio inflows.

Chart 2
The opportunity

Another concern is the potential reduction in cross-border bank flows between the EU and the UK. If there was a rise in bank transaction costs following an exit, this could trigger cross-border deleveraging and some repatriation of EU bank flows. Currently, EU banks account for around 50% of total UK foreign bank claims.

On a cyclical basis, following a vote to leave the EU and with the prospect of a long period of negotiation, we expect consumer and business confidence and the outlook for GDP growth in the UK will decline. Consequently, the Bank of England would seek to lower rates to support the economy. We would expect the UK trade deficit to initially shrink following exit as a fall in consumer demand and business spending causes a decline in imports; however, any improvement in the current account balance will be more than offset by capital outflows.

Today, with the UK as an EU linked economy, Sterling benefits from a dual-existence, not only because of the flexibility of an independent monetary policy but also because of the stability associated with being a member the EU.

Structurally, upon leaving the EU, Sterling would need to ‘re-emerge’ as a standalone currency. Such a ‘re-emergence’ would normally be associated with higher inflation and an increase in risk premia on UK assets.

Based on cyclical and structural factors a vote to leave the EU will cause Sterling to depreciate significantly over the medium term and longer term versus the Euro and all major currencies.

Oil and Currency Outlook

March 2016

Fundamental Backdrop

Economically speaking, the oil market is an oligopoly with a good measure of collusion, meaning a small group of sellers collude to maximise profits. Economic theory states that in a free market the lowest marginal cost producer sets the price, but the oligopoly price is higher than the marginal cost of production as there is little competition and therefore producers can earn monopolistic type profits.

But high oil prices, a continual reduction in the cost of extraction and advances in drilling technology in the early part of this decade brought US shale oil producers to the market.This lead to a significant supply increase. While US shale oil production was close to 1.5Mbpd in 2010 ,it was around 5.5Mbpd by mid 2015. The impact was not immediately obvious as oil prices remained high due to supply constraints mainly in North Africa in the wake of the Arab Spring.

However, and unusually, the oil cartel is also the lowest cost producer and much better positioned to endure low prices. Aware that their profits were being diluted and also that shale companies had much higher production costs ($30-$60/bbl), OPEC increased supply from Q3 2014 with the intention of driving prices lower to make it uneconomical for shale companies to remain in business. In effect, they are switching to more competitive pricing to eliminate competition with the option to revert to monopolistic pricing in future in order to earn excess profits again.

The strategy appears to be succeeding (see chart 1). In early 2015 US shale oil production peaked. Declines have been relatively modest as pumping from the lowest cost wells has been economically viable in the short term for many shale firms which require cash to service their debt. But in recent months the fall in shale oil production has accelerated as benchmark crude oil prices reached a new low, global production surplus hit 1.5Mbpd and live rig counts are now at 2009 levels.

Chart 1
The opportunity

We expect the trend of declining shale oil production will continue in the months ahead as the lowest cost wells are exhausted and extraction costs increase. We forecast oil to finish 2016 around $50/bbl as the fall in supply of US shale oil restores balance to global energy markets.

Currency Implications

While many factors influence currency, oil is a particularly significant driver of the Russian Rouble, Canadian Dollar, Mexican Peso and Norwegian Krone (see chart 2). Investors should take this into account when formulating decisions with regard to these so called 'petro currencies'.

Chart 2
The opportunity

Continuing declines in US shale production will be a sign that oil is set to rally towards our target and that any sell-offs will be short lived. The stability of the oil price will be a positive factor for these currencies during the second half of the year and will limit much of the weakness they would otherwise be expected to experience against the US Dollar as the Federal Reserve tightens monetary policy (see forecasts below). We expect they will outperform relative to lower yielding currencies which have lower exposure to the oil sector.

Chart 3
The opportunity