Markets scenarios & risks - March 2020

Monthly update

We keep probabilities unchanged but we “darkened” and detailed the narrative in our different scenarios.

1. Corona Virus Outbreak

Temporary, albeit profound and impactful, shock to the Chinese economy (4.5% 2020 Q1E (was 5.8%) and 5.6% YoY 2020E, was 5.8%), impact on Asian countries primarily regarding exports and tourism. This shock and the bleak tone of hard data (led by Germany) results in slowing global trade dynamics and shift of USD denominated paper. US remains resilient on weaker imports. The shock delays expectations for a global (tactical) momentum.

2. PMIs: manufacturing PMI was potentially recovering, but coronavirus impact not yet embedded

In the US, the divergence between ISM and PMI narrowed: potential surveys do not fully reflect the coronavirus (surveys conducted in early stages of the news). Progressive recovery in the manufacturing PMI in the Eurozone but still below 50. Negative prints in China might reflect early coronavirus spillover to confidence already in December.

3. USD paper attracts investors, but the sharp repricing of fed funds rate expectations and the surge in volatility pushed down carry strategies, thus supporting the EUR

While concerns on global growth still point to a resilient USD, the USD rate advantage is sharply pointing south as the Fed cuts 50bps while ECB is perceived as having less ammunition from a monetary policy perspective. EUR/USD has recovered the loss registered since the end of January, as volatility surged and carry positions have been closed, with funding currencies like the EUR and SEK moving higher vs. the greenback.

4. Global financial conditions corrected lower in response to Covid-19 concerns 

Global financial conditions tightened in February, with all regions in the “tightening” zone at the end of the month. GEM were the area with the strongest shift in financial conditions, which moved even lower to the levels seen during the summer of 2019. All sub-components moved lower, with the biggest negative contributions coming from stock market volatility, the widening in corporate spreads and USD strength vs. high yielders in the EMFX universe.

FX under the microscope - what’s behind the EUR/USD move?

With the USD trading at a premium on fundamentals, growth is what we need to see investors turning structurally bearish on the greenback. We entered 2020 with signs that the rest of the world (RoW) may have grown at a faster pace than the US, but the temporary, Covid-19-related shock to Chinese economic activity – with its negative spillovers to the RoW – is making this less likely. US assets are looking more attractive at this stage, and the USD safe-haven status, together with the highest carry in the G10 FX space, tends to attract foreign flows during periods of low market volatility like the one we are currently experiencing. Moreover, the USD’s positioning is less of a concern than a few months ago, and the possibility of further USD steps higher can therefore not be ruled out. In other words, alternative scenarios need to materialize before we will see investors definitely closing USD longs – the flight to quality will need to dissipate, the policy mix will need to spur growth outside of the US, and the USD carry trade will need to vanish in response to a more aggressive Fed.

While it is true that the sharp repricing of fed funds rate expectations would point to a diminishing USD rate advantage in 2020, and that periods of high market volatility tend to push high yielders lower in response to closing carry positions, with no growth the USD safe-haven status will be predominant in our view, despite high valuations.

In other words, a few conditions will need to materialize before we see investors definitely closing USD longs – the flight to quality will need to dissipate on stabilizing global growth, the policy mix will need to spur growth outside of the US, and the USD carry trade will need to vanish in response to intervention from the FED.