There have been some speed bumps along the way, but the European Recovery Fund should be approved in Q4. The so-called “rule of law” findings are likely to delay its passage but in the end, we suspect Germany and the larger powers will agree to dilute the language by enough to get Hungary and Poland to sign on but not by too much that support from the “frugal” countries is eroded. As it always to be in Europe, policymakers will walk a tightrope until a compromise is finally reached. And despite the dilution of the “rule of law,” this is yet another step towards a more unified Europe.
Much ink has been spilled over whether the ECB will take any action to prevent excessive euro strength. At the most recent policy meeting in September, ECB President Lagarde initially took a nonchalant attitude to the strong euro, which at the time was testing the $1.20 area. Other ECB officials quickly asserted that the ECB does take the exchange rate into account when setting policy, signaling a level of greater concern. Lagarde later walked back her remarks. That said, jawboning cannot turn the tide by itself. Underlying monetary policy stances and economic growth differentials are still the primary drivers for exchange rates and in that regard, we think the eurozone has an advantage over the US, at least for now. The easing by the ECB mentioned above is already priced in, we believe, so it would take a dovish surprise to put the euro in the backfoot.
The ongoing COVID crisis and the expiration of some government support programs will both weigh on Q4 economic activity. Chancellor Sunak is under great pressure to extend the government’s job furlough program, which expires at the end of October. He is trying to come up with ways to modify the scheme, but most alternatives being discussed would still likely lead to the loss of millions of UK jobs. Sunak’s reluctance to continue spending is understandable, as debt has already risen above 100% of GDP. However, the hard political realities argue for more stimulus, not less. But the Johnson government has been strongly criticized for their restrained approach during the first wave of the virus, which may make it biased towards stronger preemptive action this time around.
A no deal Brexit is also a downside risk. As of this writing, talks are entering their final phase and clinching a deal remains difficult. The long-standing fishing dispute has come up again as one of the main obstacles for an agreement. We find it difficult to imagine that this issue will prove decisive given the small shares of the UK and French economies it represents. State aid and the UK’s Internal Market Bill, which are still unresolved, seem like much more difficult obstacles to overcome. If enough progress is made in all these areas, the best-case scenario sees the two sides enter the so-called “tunnel” where the final language is hammered out in private.
The October 15-16 EU summit is widely regarded as a potential deadline. However, we suspect talks can be extended beyond this if a deal is within reach. Instead, many believe early November is the true deadline in order to have enough time to prepare for the December 31 transition. The December 10-11 EU summit may see the finalized agreement or an announcement of a no-deal Brexit. The outcome is binary and we put the odds at basically 50-50.
No wonder the Bank of England (BOE) is widely expected to increase its asset purchases in Q4. We look for the BOE to add stimulus at its November 5 meeting, when new macro forecasts are released in its quarterly Monetary Policy Report. The debate about negative rates continue to rage but we do not see that happening in Q4. Indeed, we view that option as a last-ditch option, even though the BOE appears to be setting the table for such an outcome. Much of the UK curve remains in negative territory as a result of negative rate talk.
Sterling remains subject to mood swings regarding Brexit talks. With such a binary outcome, it’s no wonder that sterling volatility (both actual and implied) has risen steadily since July. With talks entering their final stage, investors should be prepared for a protracted period of even higher headline-based volatility. And Brexit risks come just as the UK economy is facing greater headwinds. We expect sterling to benefit from the weak dollar backdrop but it is likely to underperform the euro. As such, the EUR/GBP cross is likely to trade with an upward bias.
There is an element of political uncertainty but nothing that should impact markets. There is increased speculation that new Prime Minister Suga will call snap elections in late 2020 or early 2021 to consolidate his hold on power. Fresh elections are not due until October 2021, and the ruling liberal democratic party (LDP) is widely expected to win. Ahead of any elections, we expect Suga and his cabinet to deliver another round of fiscal stimulus in order to help cement its popularity.
The Japanese economy is underperforming. While the recovery is in place, it remains uneven and weak. The Bank of Japan (BOJ) recently upgraded its assessment to “severe” from “extremely severe” previously, and its latest Tankan survey shows Japanese firms remain pessimistic about the outlook. Deflationary pressures are rising and it’s clear that the BOJ will miss its inflation target for several more years. Its macro projections will be updated in its Outlook Report for the October 29 meeting. Currently, the BOJ sees core inflation (ex-fresh food) staying below its 2% target at least until FY2023, coming in at -0.5% in FY2020, 0.3% in FY2021, and 0.7% in FY2022.
Yet the Bank of Japan is widely expected to remain on hold in Q4. Really, it may have reached the limits of what it can do beyond its current expansive settings. Here too, we think there is little appetite to take rates more negative. Its yield curve control policy is working, with required asset purchases pinning the 10-year JGB yield close to 0%. While the official target is 0% +/- 20 basis points, the 10-year yield has rarely deviated that much, trading largely within a +/- 5 bp range for much of this year. We see no need to deviate from its current policy settings anytime soon.
The strong yen is doing the Japanese economy no favors. After testing the 110 area in June, USD/JPY has since retreated and largely traded in the 104-108 range for most of Q3. As Q4 begins, the pair is trading near the middle of that range but feels heavy. With the weak dollar backdrop in place, we believe USD/JPY will down to trade in a new 102-106 range for the rest of this year. Indeed, we cannot rule out a test of the March low near 101.20.
Our current views on emerging markets (EM) emanate from two major themes: US elections and the risk of policy anchors (fiscal and monetary) weakening in the post-pandemic future. Broadly speaking, we remain negative on EM FX and local rates, positive on external debt, and selective in the equity space. In the medium term, however, we wonder whether EM central banks will start surprising on the hawkish side once weakening currencies and rising inflation risks start becoming a problem.
At the time of writing, a democratic sweep looks like the most probable outcome, which would be a mixed bag for EM, with Russia the clearest causality. Russian CDS perhaps offers the best risk reward for a pre-election strategic trade. At around 125 basis points (bps), the downside is limited but there is a lot of room for an upwards repricing. To be clear, we don’t expect Russia to face troubles replaying its sovereign external debt, but a Democratic controlled US government would warrant a re-thinking of the country’s risk premium. Not only will Democrats be looking for a payback for perceived wrongdoing by Putin, possibly tapping into a similar trend in Europe (especially Germany) following the poisoning of Alexey Navalny and the events in Belarus. On top of this, Democrats would be more forceful in pushing a green agenda thus accelerating the move to renewable resources.
The relationship with China in the post elections is less straightforward. A Biden victory would pivot the tension in the conflict from trade policy to human rights and would reduce the erratic (and often market moving) news flow on the matter. This is positive for markets, at least in the near term. But stand firm on the view that the two nations are in an irremediable process of distancing on all spheres with wide-ranging consequences for markets and the global order. The Pew Research poll on opinions towards China is an easy way to see why the US-China conflict will remain a centerpiece of US foreign policy no matter who wins the Whitehouse — it’s an issue of rare bi-partisan agreement. This means that the process of re-drawing supply chains and technological divide will continue, benefiting outsource alternative countries such as Vietnam and Mexico who are well position to collect the spoils.