BlueBay AM: Greenback surges to the top as corona spreads

February 21, 2020

Mark Dowding, CIO at BlueBay Asset Management, has issued his latest market insight in which he discusses domestic demand in the Eurozone, the likely outperformance of the UK economy post-Brexit and US growth.

US growth continues to strengthen with the theme of exceptionalism trumping viral concerns.

With fears relating to the coronavirus continuing to spread, global bond yields remained well supported over the past week, notwithstanding robust US economic data on consumer and business confidence, housing activity and producer prices.

Minutes from the Federal Reserve continued to point to policy being ‘on hold’, and although the probability of Bernie Sanders winning the Democrat nomination continued to rise following a poor debate – which dented Bloomberg’s rise in the polls – US equities have continued to forge record highs, belying fears of possible downside risks to the global economy.

US growth exceptionalism has been a renewed theme in the past few weeks and on the back of this, it has been striking to see the dollar strengthen against most global currencies.

Hard to fight fundamentals

With Japanese economic data surprising to the downside and widespread anecdotal evidence of business life in Japan (and elsewhere in Asia) being impacted on corona fears (a trip I had planned to Tokyo in March has been cancelled), it is interesting to see that the yen is no longer behaving like a safe haven and with the virus spreading in Singapore and Korea, Asian currencies as a whole have also traded weaker.

FX volatility has recently been at record lows, but long-held trading ranges appear to have been broken in recent days. Although it is possible that the US Administration may want to intervene to avert further dollar strength, it is hard to fight fundamentals and for now there seems little reason why we should see an imminent reversal in this trend.

In the eurozone, weaker PMI reports may highlight the vulnerability of the regional economy to a downturn in Chinese demand and the fallacy of what we believe to be an outdated German economic model, given the short-sightedness of policymakers who have viewed a bloated current account surplus as something to feel proud of.

Domestic demand in the Eurozone is more robust, but for now it is difficult to see the economy registering any growth in the first half of 2020. We doubt that the ECB will (be able to) react to this and although calls for fiscal easing are only likely to grow, in Berlin this narrative continues to fall on deaf ears.

Perceived triumph could thwart trade

The likely outperformance of the UK economy post-Brexit may well prove a major irritation to eurozone policymakers. Yet further fiscal expansion is expected in the March budget as Johnson tries to model himself as Europe’s answer to Donald Trump. This has the potential to lift demand over the next few months.

Rising economic optimism following the ‘Boris bounce’ may lead to a sense of vindication amongst Brexiteers – though we are concerned that this could create the pretext for difficult trade negotiations in the course of the next few months.

Once Brussels gets the mandate to commence negotiations next week, we won’t be surprised if initial skirmishes produce some hawkish headlines.

The UK is already attacking the EU’s reluctance to give the UK the same deal as afforded to Canada – despite this seeming to be an option that Brussels put on the table back in 2016.

Meanwhile, with the UK looking like it is currently winning out of Brexit – this could see EU policymakers go on the attack by making threats to industries like financial services if rights in areas like fishing are not guaranteed. Certainly the idea that the UK could outperform in the wake of Brexit is anathema to policymakers on the Continent.

As any extension to the December deadline needs to be agreed by the end of June, so we would not be surprised for fears of a hard Brexit at year-end to increase in the next couple of months before a position of pragmatism and compromise is found (isn’t that the Trump way in ‘The Art of the Deal’?).

We retain a short stance on the pound and have reduced the short position we have maintained in UK Gilts, following a period when Gilts have recently underperformed other markets as it becomes clear that fiscal easing is more likely than monetary easing under the government.

Constructive on credit

Elsewhere, credit markets continue to take their lead from equities. Spreads remain supported by the grab for yield in the eurozone and the perception that central banks will continue to deliver liquidity, creating a Federal Reserve and ECB put under market valuations.

Emerging market credit also continues to trade constructively, away from idiosyncratic weak names (Lebanon became a candidate for imminent restructuring during the past week).

In high yield, upside has been stymied by a large portion of the index trading at a price above the level at which bonds can be called.

Looking ahead

We continue to monitor high-frequency data coming out of China, in order to discern signs that economic activity may be returning to normal.

Certainly a number of these indicators have bounced quite materially in the past few days as factories re-open. However, they remain well below levels which would normally be seen and anecdotal evidence points to very widespread ongoing economic disruption in both the manufacturing and service sectors.

Economic contraction in China in Q1 appears inevitable (regardless of what official data may print).

The bigger question is whether what follows will be more of a ‘V’ shaped, or a ‘U’ shaped rebound – or even an elongated ‘L’ shape if corona casts its economic shadow over the whole of the year.

It remains difficult to be too precise in seeking to answer this. However, the Chinese PMI data will be interesting to observe at the end of next week and more broadly it will be interesting to see how the fear of the virus is impacting activity more broadly across Asia – particularly if there is further spread away from Hubei province.

This said, unless there is a move to pandemic and widespread infection in the US, it is tempting to believe that the current status quo may hold and the US may continue to power ahead.

As for FX moves, you could say that in a corona scenario the greenback is destined to stay at the top (of the bottle).