With the vast majority of the world’s nations fully emerged from recession by late 2009, you could have been forgiven for hoping that 2010 would solidify the global economic recovery. With little doubt conditions have improved, but when referencing the recovery on a global scale we are still in the nascent stages.
Whereas southeast Asian and southern Pacific countries have benefitted from the far reaching strength of the Chinese economy, Europe and the US remain vulnerable to the pillars of recovery crumbling. Already the Federal Reserve (the Fed) has taken steps to boost the economy through a second round of quantitative easing (QEII), and the debt crises in the eurozone have sparked the creation of a stability fund geared at bailing out heavily indebted countries.
The upshot of the current situation is a decidedly mixed market outlook where even scenarios broadly considered to be left of field would scarcely raise eyebrows. As has been the case in the latter part of 2010, we expect to see the situation in the eurozone hold focus going forward. Despite what EU officials may say, Europe’s debt crisis is getting worse, not better. The European Central Bank’s (ECB) bond-buying efforts have failed to prevent borrowing costs from soaring to levels that mean each new sale of securities drags euro region governments closer to bankruptcy.
December witnessed a slew of credit rating warnings and downgrades, with Ireland notably suffering a five-notch cut and even France finding itself on the agencies’ radar. These warnings raise government borrowing costs further, necessitating tough austerity measures that in turn threaten to strangle the economic recovery. Under these conditions it’s not hard to see why the euro was the worst performing currency against the US dollar in 2010. And indeed we see the euro coming under increasing pressure during the first two quarters of this year.
What is not quite so clear is why the UK pound has failed to take advantage of the euro’s weakness. With investors shedding their euro holdings, one might imagine that the UK would be an obvious destination for these funds. However, the Swiss franc and the Scandinavian currencies have been the real winners with investors understandably cautious about the UK economy.
While the crisis has been deepening in Europe, there has been an increasing awareness of the UK’s exposure. British banks are major holders of European debt, notably Ireland’s, and a default from one or other eurozone country could result in massive (perhaps even unsustainable) losses in the City of London. The acute awareness of this situation has in the past limited sterling’s upward momentum and will almost certainly continue to do so.
The other factor depressing the UK currency is the well-publicised government austerity measures. For months now the spending cuts and public sector employment cull have held a priority position in the headlines. To an extent the market has been able to price in their potential impact, but a great deal of unknowns remain. Encouragingly, UK economic growth in the latter half of 2010 did surprise to the upside, but the risks going forward remain prevalent. For one, there is a broad-based fear that the private sector will be unable to soak up the excess unemployment derived from the public sector. The evident constraint on consumer demand that the increase in value-added tax (VAT) will have is also unnerving investors.
The nuance that is working in sterling’s favour is inflation. Running stubbornly above target for over a year now, inflation is serving to keep the dovish members of the Bank of England (BoE) at bay. Given the upcoming test of the recovery, one policy member, Adam Posen, has been repeatedly calling for an extension to the QE budget. However, at present he remains the sole defendant of this policy on the Monetary Policy Committee (MPC) owing to the threat of rising prices. Adding an additional £50bn to the economy would run the risk of fuelling inflation into unsustainable realms, while also undermining the BoE’s credibility (the BoE has said for a long time been that inflation will fall back below the 2% target over the next 18 months).
The upshot of this is that the risk of additional QE is minimal, and not a scenario we envisage playing out. Rather as long as inflation continues to run above target (currently at 3.3%), the argument to raise interest rates, a policy currently being backed by another of the MPC, Andrew Sentance, will build in credibility. We expect that by the end of the 2Q11 the BoE will be viably entertaining this option with the first move coming in August. With little doubt such a move will come ahead of comparative action from either the ECB or the Fed, raising the prospects for the pound. Any move towards normalising monetary policy in the eurozone will be stymied by peripheral economic weakness as a result of fiscal austerity.
With conditions in both the UK and the eurozone looking precarious at best, the early months of 2011 are likely to be dominated by US dollar strength. This is due less to the so-called ‘risk on/risk-off’ status, which has in fact loosened its grip on the dollar in recent months, but rather to an improving picture of recovery in the US. Amid rallying equity and commodity prices and continued economic strength in China, risk appetite is actually set to improve but we expect the dollar to remain strong as figures paint a picture of continued economic recovery. The event risk in the US is that unemployment runs riot above 10.0%, and the Fed have been quick to point out that ‘QEIII’ is not unfeasible.
Again, this is not a scenario we envisage – the Fed is more likely to opt for an earlier withdrawal of QEII (currently planned for June) as business activity picks up and the housing market stabilises.
We see the euro slipping back below the key US$1.30 level in the early part of the year, dropping down to US$1.20 by the summer. The close correlation between the euro/dollar pairing and that of sterling/dollar in recent months suggests that we do not have to look too far past the former to conclude the outlook of the latter. Euro weakness looks set to drag sterling down with it, taking the price below US$1.50 in the short term and dropping to the low US$1.40s over the medium term.
Sterling’s fortunes against the single currency look somewhat brighter although, as mentioned above, upward momentum will be steady. As we head through the year developments in the eurozone will hold focus and increasingly the possibility of a finite, conclusive resolution to the crisis seems to be slipping. Policymakers and politicians have the task of restoring confidence to the 16-nation region, but amid fractious opinions that is proving tricky. Without political cohesion the market will continue to bid bond yields higher, making it harder for the periphery to rein in costs. On top of this the ECB is struggling with a dual recovery, where the central countries will be looking for an interest rate rise and the peripheral are still dependent on a drip feed of financial aid.
Our view is that the euro will survive 2011 intact, but only at the expense of significant moves towards a deeper fiscal union. This will imply a progressively larger financial input from Germany and other northern European eurozone members. Although at present Germany looks to be vehemently against this scenario they will undoubtedly conclude that this represents the viable option against the backdrop of a eurozone break up.
As the situation develops the market will continue to speculate and we find the idea of a sudden shift in sentiment unlikely. We see the pound winding its way back toward the €1.20 level in the short term but could struggle to sustain a push far beyond that point. The market is acutely aware that circumstances could all too easily prompt a fresh round of QE from the BoE, particularly if UK banks suffer losses following a peripheral default. In addition, an improving eurozone situation later in the year could also curb sterling’s progression even with a UK interest rate rise. The potential forced acceptance of the so-called “E-bond” (a unifying eurozone-wide bond issuance) would go a long way towards stabilising eurozone credit ratings, which may prove to be a significant positive event for the euro in 2011.
In a final note, having talked about the prospects for the UK, the eurozone and the US, it’s worth taking the briefest of looks outside of this western core. In 2010, the commodity-linked currencies were among the biggest winners, with the Australian dollar moving into the front and we see little risk of these currencies coming to any harm in 2011. Improving risk appetite, high-yields, and rallying commodity prices look set to keep the likes of the Australian, New Zealand, and Canadian dollars on top through much of the year. The outstanding risk would be if China failed to quell inflationary pressure. Or, indeed, if they over-cook policy tightening measures, leading to a hard landing for the economy as growth gets reigned in. However, considering China’s very steady approach to adjusting policy (however frustrating the international critics may find this), we see little risk of such an eventuality.
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