"If you do not change direction, you may end up where you are heading"
- Lao Tzu
As we enter the last month of a historic year, it is perhaps appropriate to look forward to 2021. Commentators and analysts have pushed the uncertainty that dominated most of 2020 aside in favour of near unanimous positivity for 2021. There is a clear consensus for a strong economic recovery, higher equity prices, higher US bond yields and thus, by extrapolation, a lower USD. As we have discussed recently, we have little issue with the Glass Half Full outlook for 2021 - there is a clear rationale that the ‘potential energy’ of a global economic recovery, supported by extremely accommodative monetary policy (and global central banks intent to err on the side of accommodation in ‘removing the punch bowl’), significant pent-up demand and the springboard of three very effective vaccines suggest strong economic growth ahead.
Indeed, this backdrop lends itself to the kind of early cycle dynamics that should drive strong earnings growth and thus equity price dynamics - led, in our view, by US (and China) dominated tech. Further, the combination of huge global fiscal and monetary stimulus should provide a backdrop for which credit and inflation dynamics foster higher yields and steeper curves - albeit to a historically modest degree. Strong economic performance. Tick. Strong equity performance. Tick (with differentials). Higher US yields. Likely also a tick.
However, it is at this point that we tend to disagree. The consensus view is that the global risk-on, reflation trade, is a uniform obvious negative for the USD. In the EM world, where valuations, potential extended periods of above-trend growth and still significant, if diminished, carry exist, we are inclined to agree - most clearly in the case of CNY (where the growth dynamic remains both chronologically and nominally ahead of the US, and subsequently the rest of the world.). However, in the words of George Orwell, “not all animals are equal”. Despite the excitement of many analysts over the prospects of a structural decline in the USD and rally in the EUR, and even the EUR outperformance over recent sessions - we remain sceptical. Here’s why.
From a valuation perspective, while the USD is arguably overvalued, most of this overvaluation on aggregate comes from declines in the EM space, with EUR trading above its historic averages. Indeed, there may be a case for stepping aside from this argument for the remainder of 2020, as liquidity begins to decline, and the global market adjusts to the current flow dynamic. In our view, the concern should be the significantly lower ‘potential’ or ‘baseline’ growth rate in the eurozone, negative yielding risk-free assets, a weaker long-term equity market potential (significantly lower growth stock percentages), not to mention higher credit constraints.
The ECB meeting next week is an interesting case in point. The focus of analysts is predominantly on what the ECB can do that would weaken the EUR as a rationale to buy the EUR. However, the reality must surely be the other way around. Central expectations are that the ECB will expand the PEPP envelope by around EUR 500B, extend the duration of the programme by up to 12 months and improve the terms of the TLTROs (perhaps by extending the duration of the benefit from 3 years to 5 years). The rationale is to maintain the transmission mechanism for monetary accommodation through the flexibility of PEPP - however, with intra-eurozone spreads and multiyear narrows, it is not clear that transmission is a problem. Further, the improvements to the terms of the TLTROs is to encourage bank lending to stimulate the recovery, but with Covid-19 restrictions being extended across Europe and the job retention programmes nearing their natural end (along with rising NPL potential), it is not clear that banks will be keen to increase lending books in the way the ECB may desire. A rate cut, on the other hand, would give the opposite impetus for EUR - as might convincing verbal intervention - but both remain a relatively low probability event in our view.
In the current momentum environment, the fact that the ECB didn’t do anything to reverse the rally in the EUR may well be taken by the market as a green light to buy. However, from my perspective, that is a weak rationale in all but the very near term. Under our preferred macro scenario for 2021, the widening growth and ultimately yield differential in favour of the US and China should resume as the dominant force. Furthermore, it is also very possible that 2021 becomes a period of disunity in the eurozone. The standoff between Hungary/Poland and the rest of the EU is likely fudgeable, but also likely a precursor to more tensions over the ratification of Recovery Fund spending plans by peers (and competitor markets), and that is not to mention the fighting over the spoils of Brexit (financial services offerings in Milan, Frankfurt, Paris), or the sensitive subject of tax harmonisation (or the removal of tax haven loopholes within the eurozone).
Lastly, what happens if the ECB actually achieves its mandate… not a reduction in global warming or improved social equality targets… but inflation. Normalisation of monetary policy removes the backstop for spread narrowing, the fuel for the domestic bank carry trade through ‘preferential terms’ under the TLTROs and likely lays bare the disparate credit dynamics within the eurozone. Markets are buying into a story where if the central banks get it right, the implications could be a lot worse than if they continue to get it wrong!
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