‘Oil, the dollar and monetary policy: it’s all (or at least mostly) good’, proclaims the most recent Global Outlook report from Barclays.
That slightly-qualified assertion neatly sums up the drivers that are shaping the global economic environment so far in 2015. Perhaps the two biggest changes that economists didn’t quite see coming – at least not to the extent that has been so evident in recent months – are the plunge in the oil price and the jump in the strength of the US dollar (USD). The Barclays report examines both issues and was presented to the press at a briefing that gtnews attended in London this week.
A Tale of Ups and Downs
The global economy is still adjusting to cheaper oil and a resurgent greenback over the past two to three quarters. “People had been bullish on the dollar for a while, but never bullish enough to catch up with the reality,” said Christian Keller, Barclays’ global head of economics research.
The drop in the oil price combined with the surging dollar is affecting real economies and will continue to for several more quarters. The impact is reflected in a redistribution of growth within the global economy, predominantly from oil producers to oil consumers. The US had the biggest initial gains from the oil price drop – consumer spending was strong and there was high private consumption. However, the report finds that the US is now seeing slightly less investment from oil-related spending and the strong dollar is starting to hurt. But while the US may be coming off the boil to some extent, it is offset by an improved outlook for both the eurozone and Japan.
The picture of emerging markets (EM) that is painted by the report is not as rosy. China’s growth is slowing due to credit issues in its real estate market. Barclays has revised down its China growth forecast for this year to 6.8%, which is below the official target although this was also recently trimmed to 7% from 7.5%. Recession is forecast for both Russia and Brazil, and it was noted that the Pacific countries are generally in better shape than Latin America due to Brazil and Argentina flagging, which in part was put down to policy differences.
“2015 could be one of the narrowest gaps between EM growth and developed market growth that we have seen since the beginning of the millennium,” said Keller.
The relationship between the USD and the euro has shifted recently, as the appreciation of the dollar has made currency parity a very real prospect. Marvin Barth, head of European FX strategy at Barclays, noted that a level of eurodollar downside had been predicted last summer, albeit not to the level that has since been experienced. He reflected on this, and said that he sees little change between the drivers that existed then and conditions today:
“Since last year the two-way risks have probably increased a bit, but the two underlying fundamental drivers of that huge currency movement are still there,” Barth commented. “There is an incredible economic divergence between the two economies. In particular, the euro area has a much larger output gap than any other major economy, and the US output gap is closing much more rapidly.
“So despite the fact that the Fed pushed back to some extent the pace of rate hikes, the US is still where you should look to get higher returns on capital, particularly on a risk adjusted basis. We still see that as helping support dollar strength, even though it is likely to pause in the near term as people reassess what the Fed is telling them.”
In the euro area, the report finds little potential for a significant upturn in real returns to capital – the underlying returns to capital on investment activity. Instead, investment activity continues to be very subdued despite the cyclical upswing in indicators. “This makes perfect sense,” said Barth. “When you have a huge output gap and all sorts of unused capacity, why would you build another factory when there are unused ones out there that are ready to be utilised? That ultimately is one of the drivers of the currency in the long run under this big trending move. That still has not changed from last summer to now.”
The other major factor highlighted in the report is the European Central Bank’s (ECB’s) credible commitment to maintain low rates for an extended period and what that means in terms of its ability to accommodate financing flows out of the euro area. The issue is just as present today as it has ever been, reinforced by the ECB’s commitment to quantitative easing (QE). The euro area rates curve has flattened and is increasingly negative further along the curve – negative rates go out to five years at this point, which is facilitating the euro being used as a funding currency.
“What is really interesting is that if you look at foreign issuance in the euro area debt markets, it has been as high in the past three months as it was in the peak boom months of 2006 and 2007,” said Barth. “However today, unlike then, it is not being accompanied by an investment boom.
“That is the key difference, there is this huge output gap and a lack of investment in the euro area, but lots of money can be raised here. Most of that money is being currency hedged when it is taken out, so the direct effects are pretty low. Nonetheless, it does have powerful indirect effects in that it has further exacerbated the eurodollar basis, making it much cheaper to hedge and encouraging an increasing number of both financial and non-financial entities to do that.”
Non-financial firms – which have been the primary issuers – have been extending out the duration of their hedges, because financing conditions in the euro area are so attractive and that the euro is expected to decline and trend still further. Many of these firms are issuing debt against expected future receivables rather than undertaking ever-longer foreign exchange (FX) forwards. “The use of these funds is being taken out of the euro area, either to pay down debt elsewhere or to undertake investment in economies that are more constrained,” said Barth.
Parity Sooner Rather than Later
Barclays has readjusted its eurodollar forecast, with parity and beyond not only a possibility but also a probability, with the added likelihood that it will happen sooner than expected.
“Previously we were expecting parity by the fourth quarter of the year, but we are now expecting this by the third quarter,” explained Barth. “We have also now added another quarter to our rolling annual projections, and in the first quarter of 2016 we are forecasting it will have gone beyond parity, to around 95 cen
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