GLOBAL MACRO RESEARCH COVID-19: THE TRIGGER THAT ENDS THE US DOLLAR BULL MARKET? JUNE 2020

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FOR PROFESSIONAL CLIENTS AND QUALIFIED INVESTORS ONLY. NOT TO BE REPRODUCED WITHOUT PRIOR WRITTEN APPROVAL.PLEASE REFER TO THE IMPORTANT INFORMATION AT THE BACK OF THIS DOCUMENT.

EXECUTIVE SUMMARY

ECONOMY

• The speed and aggression of policy responses suggests that global economic activity will recover, although the timing and the speed are uncertain

• While economies traditionally geared into the global economy are likely to bounce as global growth recovers, the structural position is weaker and different to the post-GFC era due to:

1. The current fiscal easing is larger than in 2009, but very different in nature: Sectors and countries linked to the ‘old infrastructure’ spending, are unlikely to experience the same bounce

2. The broad level of leverage is higher: Emerging market debt has witnessed a 60% increase in leverage, a sharp contrast to early 2000 when emerging market leverage was on a declining trend.

3. China and globalization will play a more muted role in supporting the rebound: We don’t have the same tailwinds in global trade as caused by China’s inclusion in the World Trade Organization in 2001

4. Trend growth is lower, particularly in emerging markets: The decline has been most aggressive in emerging markets where total factor productivity is estimated to have fallen by 65%

IMPACT ON CURRENCY MARKETS

• While the USD will suffer as global growth rebounds, the reverse will be muted and not as extended relative to the previous cycle due to:

1. The benefit to emerging markets from a global upturn is likely to be weaker than in previous cycles

2. Emerging market central banks have been prioritising domestic growth and bond market stability over currency stability

3. Narrowing interest rate differentials make unhedged emerging market currency positions less attractive

• In a world with limited carry and vulnerable to market dislocations due to shakier foundations, higher volatility and greater differentiation of returns could become the new normal for currency markets

• We believe that the major influences on the strength of a country’s currency include:

1. Being a net creditor to the world

2. Maintaining institutional credibility

3. An independent central bank able and willing to sustain the local bond market

4. The extent of foreign currency liabilities

3

The economic impact of efforts to control the spread of COVID-19

is becoming more apparent, and it is staggering. Record lows

are being registered in business indicators and the stress on

households is visible in the astonishing rise of jobless claims that

are being recorded in the US – a trend that is likely to be repeated

across other countries as data gets released. The IMF has recently

released its World Economic Outlook and expects GDP in advanced

economies to contract by 6.1% in 2020 and for world GDP to fall by

3% (IMF WEO, April 2020). By the IMF’s own acknowledgement, the

risks to these forecasts are skewed to the downside.

Equally remarkable has been governments’ response to the

ongoing crisis. While March 2020 will be remembered by many as

the month the COVID-19 crisis slammed the brakes on the global

economy, it will also most likely go down in history as the month

with the most aggressive expansion in global fiscal spending ever

undertaken. Tallying up the flurry of announcements by fiscal

authorities across the globe suggests that the cumulative fiscal

spend – excluding government guarantees and fiscal slippage

due to fall in revenues – could be double what we saw during the

global financial crisis, reaching 4.9% of global GDP and bringing

overall fiscal deficits to peacetime record levels.

It is the combination of the speed and the aggression with

which governments have moved to fill in the gap left by the sharp

slowdown in activity that suggests that economic activity will

recover – although it may take some time and the speed will

depend on the extent and speed with which ‘social distancing’

measures will be eased. As this recovery takes place, we expect

that flows into safe haven currencies such as the US dollar will

reverse, and this will consequently lead to a rally in the currencies

of those countries more geared to the global growth cycle. While

this reversal could be sharp and powerful, it is worth keeping in

mind that the structural position of many currencies has changed

in the last 10 years and that the extent of the post GFC rally in

cyclical currencies vs safe haven ones might not be as extended.

At an aggregate level a combination of low real yields, a heathy

banking sector, and reduced external imbalances should help

asset prices recuperate some of the losses experienced, but our

sense is we should temper our expectations as any asset price

bounce is going to be on much shakier fundamentals, and could

lead to much greater cross-country differentiation.

DURING THE GLOBAL FINANCIAL CRISIS, THE US DOLLAR SURGED AS INVESTORS FLED TO THE DEEPEST

AND MOST LIQUID MARKET. BUT, AS EQUITIES BOTTOMED IN MARCH 2009, THE US DOLLAR (USD)

PEAKED AND EMBARKED ON A MULTI-YEAR DOWNTREND.

AS THE GLOBAL ECONOMY FACES ANOTHER SEVERE DOWNTURN, SO THE US DOLLAR HAS MOVED

TO HISTORIC HIGHS. WE EXAMINE THE SIMILARITIES BETWEEN THE COVID-19 CRISIS AND THE GLOBAL

FINANCIAL CRISIS (GFC) AND CONCLUDE THAT WHILE THE USD IS LIKELY TO SUFFER AS GROWTH

REBOUNDS, THE UNDERLYING STRUCTURAL SUPPORT OF MANY CURRENCIES IS MUCH WEAKER THAN

10 YEARS AGO. WE EXPECT A MORE MUTED REBOUND AND GREATER DIFFERENTIATION AMONGST

CURRENCIES WITH A HIGH BETA TO THE ECONOMIC CYCLE.

AN UNPRECEDENTED DOWNTURN HAS LED TO AN UNPRECEDENTED POLICY RESPONSE

Cumulative fiscal spend – excluding government guarantees and fiscal slippage

due to fall in revenues – could be double what we saw during the global financial crisis

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FOUR REASONS WE BELIEVE THE BACKDROP FOR CURRENCY MARKETS IN 2020 IS DIFFERENT TO 2009

1: THE CURRENT FISCAL EASING IS LARGER THAN IN 2009, BUT VERY DIFFERENT IN NATURE

Although the size of the fiscal stimulus is likely to be more than double the stimulus implemented in 2009, its

composition is going to be very different. As can be seen from Figure 1, in 2009 public investment made up 31% of fiscal

spending vs 7% now. If we exclude China, the allocation to public investment in emerging markets and developed

markets falls to 1% and 0%, respectively. Even in China, the definition of ‘public investment’ has changed from projects

such as transport, urban pubic facilities, water and environmental projects to ‘new infrastructure’ projects including 5G,

industrial internet and data centres. Instead, the key area of focus in 2020 is supporting household revenue and

businesses. This suggests that sectors and countries linked to the ‘old infrastructure’ spending, such as commodity

exporters, are unlikely to experience the same bounce in 2020 or beyond that they did in the years that followed 2009.

1 Source: UBS Research, published in April 2020. 2 Source: BIS. Data as at 1 July 2019. 3 Source: Insight and Bloomberg. Data as at 30 April 2020.

Figure 1: Fiscal stimulus 2009 and 20201

2: THE BROAD LEVEL OF LEVERAGE IS HIGHER

Another key difference between 2009 and today is that the non-financial world has seen a notable increase in public and

private debt. According to the Bank of International Settlements (BIS), in the last three years, the average leverage in the

world has increased to 234% of GDP vs a figure of 205% in the three years running up to the GFC. As can be seen in

Figure 2, emerging market debt has witnessed the sharpest rise from 116% to 186%, i.e. a 60% increase in leverage. This

increase in leverage is in sharp contrast to early 2000 when emerging market leverage was on a declining trend. This

point is highlighted in Figure 3 by the change in the rating cycle for emerging markets: the GFC coincided with an abrupt

end to the lengthy period of sovereign credit rating upgrades. It is very likely that over the next few years we will

witness a resumption of steady net downgrades as rating agencies absorb the notable further deterioration in debt

Figure 2: Non-financial leverage % GDP2 Figure 3: Emerging markets, 12-month cumulative

sovereign rating changes3

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2002 2004 2006 2008 2010 2012 2014 2016 2018 2020

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3: CHINA AND GLOBALISATION WILL PLAY A MORE MUTED ROLE IN SUPPORTING THE REBOUND

Beyond the level of leverage, there has been another slow but steady change in structure of the global economy that is likely

to make the comparisons with 2009 more difficult. In 2001, the inclusion of China in the World Trade Organization (WTO) gave

momentum to a further shift towards globalisation, causing a boom in global trade (see Figure 4).

Figure 4: Global exports as % of GDP4

4,5 Source: Insight and Bloomberg. Data as at 30 April 2020.

Over this period, China’s share in global export markets rose from 2.5% in 2000 to roughly 11% in 2015, supporting a significant

expansion in China’s production capacity and fuelling strong growth in commodities prices. This trend, coupled with a significant

allocation to ‘old infrastructure’ spending as part of the fiscal package in 2009, supported growth in many commodity exporting

countries as well as in countries that are part of the Chinese production chain, many of which are in the emerging market space.

In 2020, it is unlikely that the same dynamic will play out again. While growth will rebound, there are reasons to think the

pattern of the winners and losers seen in 2009 will be different:

I. the current composition of the fiscal expenditure that has been announced is much less infrastructure heavy and should

therefore be less supportive to countries linked to the global infrastructure cycle, such as commodity producers;

II. the structure of the Chinese economy itself has changed radically and the importance of the service sectors has increased

meaningfully, suggesting that any pickup in Chinese activity will be much more supportive for services, domestic and

international; and

III. one of the buzz words likely to emerge from the COVID-19 crisis is ‘resilience’. In the context of the global economy, this is

likely to mean greater ‘re-shoring’ and more automation to reduce countries' dependence on faraway production chains.

Although one should be careful in calling for changes to longer-term trends based on single events, our sense is that a

combination of ‘re-shoring’ concerns and the escalation in trade tensions that pre-dates the COVID crisis suggest that we

have seen the peak in globalisation;

4: TREND GROWTH IS LOWER, PARTICULARLY IN EMERGING MARKETS

Possibly the most important difference between 2009 and 2020 is that trend growth at the global level – which we define as

the five-year moving average of total factor productivity (TFP) and population growth – is much lower than it was prior to the

GFC (see Figure 5). At a global level, trend growth has fallen from 2.1% to 1%, due to meaningful drops in both population and

TFP growth. The decline has been most aggressive in emerging markets where TFP is estimated to have fallen by 65% versus

only 35% in developed markets. Although measures of TFP need to be taken with some caution, some of the declines are

remarkable. TFP in Latin America appears to be negative at -1.4%. With population growth moderating from 1.2% in 2009 to

0.9% in 2019 it suggests that trend growth in Latin America is actually negative. Our sense is that in the absence of structural

reform, these trends are unlikely to reverse, as they are likely linked to the changing role of China in the global economy and

peak globalisation. Quite the contrary, the notable increase in government debt we are likely to experience in the next few

years as a result of the coronavirus crisis is likely to put further downward pressure on trend growth.

Figure 5: Trend growth (population and TFP growth)5

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A MORE MUTED DOLLAR CYCLE

Currencies tend to be driven by both cyclical and structural

factors. While structural factors refer to the underlying economic

factors that can be expected to lead to better growth prospects

in the future, such as sound macroeconomic policies, level of

government debt etc, cyclical factors tend to be linked to interest

rate differentials and global growth. With interest rate differentials

compressed to zero in developed markets and close to all-time

lows in many emerging markets, global growth is likely to play

a more dominant role. As such, an improvement in growth

prospects is likely to put pressure on the US dollar. That said,

our sense is that this decline is going to be more muted and with

greater dispersion amongst currencies as the structural factors

have notably deteriorated for a number of different currencies.

There are a number of reasons to believe this.

The benefit to emerging markets from a global upturn is likely to be weaker than in previous cycles

The combination of deteriorating fiscal balances, lower trend

growth, lower cyclical support from public investment,

globalisation, and China’s expansion of productive capacity

following WTO membership means the current downturn is likely

to be felt particularly strongly by emerging market currencies.

In order to analyse this we have taken a number of key structural

factors – current fiscal balance, level of government debt, extent of

foreign ownership, net international investment position, current

account, trend growth, and health of the economy entering the

coronavirus crisis highlighted by the unemployment rate – then

ranked individual countries via Z-scores before aggregating

them into regional scores for easier comparison (see Figure 6).

Figure 6: Z-score of structural factors6

A number of interesting points stand out from this simple analysis.

• Although emerging market currencies score better than

developed market currencies, their relative appeal has fallen.

Indeed, the difference between the emerging market and

developed market score has fallen by half from 1.76 to 0.78

• Whilst both Latin America and Asia have seen their scores drop

over time, predominantly due to a rise in debt and a fall in trend

growth, the Latin American currencies, on average, face the

biggest structural headwinds, while their Asian counterparts are

better positioned to face the upcoming economic challenges

• The aggregate for CEEMEA (Central Eastern Europe, Middle

East and Africa) has the strongest score and has witnessed

the only improvement relative to 2009, both supported by

relatively low levels of debt and healthy current accounts; and

• The US dollar’s score was and remains one of the lowest,

reflecting the country's weak fiscal situation and still sizable

current account deficit. On the surface, this seems at odds with

the 40% rally the Fed’s broad USD index has experienced since

2011, but it just underscores that the US dollar has the key

advantage of being a reserve currency and that the US is home

to the deepest and most liquid financial markets, as well as

having a credible and independent central bank. The decline

in the US dollar’s dominance is a serious structural risk, but as

long as the domestic institutions remain solid and until there

is a clear alternative that can absorb the demand for risk free

assets that US markets can accommodate, the US dollar is likely

to continue to punch above it’s ‘structural’ weight

Emerging market central banks have been prioritising domestic growth and bond market stability over currency stability

The ability and willingness to pursue countercyclical monetary

policy has been evolving for some time, but the degree of

aggressive monetary easing including quantitative easing is new

and is likely to reflect increased institutional credibility and a much

more subdued currency pass through to domestic inflation. This

can be clearly seen in the case of a high interest rate region like

Latin America: during the GFC, 2-year real rates – defined as

2-year nominal less a 5-year moving average of CPI – increased

aggressively and supported the currency, but in 2020 they have

collapsed into negative territory and are currently hovering

6 Source: Insight and Bloomberg. Data as at 31 December 2019.

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Structural Position 2009Structural Position 2019

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around the levels of US 2-year real rates (see Figure 7). In this

new regime, the currency is likely to act as a safety valve,

especially if rate volatility cannot appropriately reflect changes

in underlying fundamentals.

Figure 7: Counter-cyclical policies in context7

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Narrowing interest rate differentials make unhedged emerging market currency positions less attractive

It is important to consider both expected returns from the nominal

spot rate and the interest rate differential (carry). In reality these

two factors cannot be disentangled, but the breakdown matters

for the currency outlook. One way to think about it is that changes

in spot rates should be a pure reflection of changes in the

fundamentals while the carry is the compensation for the risks

around the fundamentals. As such, it is usually the case that lower

yielding currencies tend to have a better distribution of risks

around the fundamentals – this is most obvious in currencies

deemed to be ‘safe haven’ like the Swiss franc.

Our sense is that in the last few years, the skew of risks around

currency fundamentals has deteriorated consistently with the

decline in emerging market productivity and driven by the

perceived change in the central banks’ sensitivity to exchange rate

vs domestic growth stability. At the same time, the cost of carry

has also fallen, making unhedged emerging market currency

exposure a less attractive proposition. This is unlikely to be

improved by the impact of the coronavirus crisis. Overall, our

analysis suggests that we are unlikely to see a sustained upswing

in growth currencies such as emerging markets in this cycle, so

this is unlikely to be a driver of a US dollar downtrend.

7 Source: Insight and Bloomberg. Data as at 30 April 2020.

WE MAY SEE GREATER DIFFERENTIATION BETWEEN CURRENCIES

Although financial repression might help some countries better manage the downturn, our sense is that it is also

likely to lead to more differentiation in terms of performance across different currencies. More specifically, our

sense is that there are a number of characteristics that will support countries’ endeavours to keep interest rates

low and help to differentiate them from others that are likely to be less successful, which could also translate into

currency weakness.

• Being a net creditor to the world. One of the reasons Japan has managed to successfully keep interest rates

low in spite of high levels of government debt is that it is a net creditor to the rest of the world – not only does it

run an 3.6% current account surplus, but it is a net creditor to the world to the tune of 68% GDP – thereby limiting

the impact of the international perception of the sustainability of its policies. Countries that rely on external

financing and are net debtors are likely to be more vulnerable to changes in sentiment and perceptions of their

own sustainability.

• Maintaining institutional credibility. Venturing into quantitative easing may not have led to a structural decline

in the quality of policymaking in developed markets, but the risks of a slip into unorthodox policies such as pure

monetary financing and capital controls for countries with less institutional strength are not negligible – see

Argentina’s return to monetary financing of the fiscal deficit. For less developed countries, venturing into the

world of quantitative easing and aggressive liquidity injections, it will be critical for authorities to credibly

commit to an exit plan.

• An independent central bank able and willing to sustain the local bond market. Central bank demand is a

crucial tool in maintaining low interest rates at a time of great fiscal issuance. As mentioned above, the response

by central banks, particularly in developed markets, has been very aggressive. Three potential issues could limit

the use of this tool.

I. Not all countries have independent central banks able to purchase unlimited amounts of domestic

government bonds. The recent question marks around the European Central Bank's ability to purchase

sufficient amounts of eurozone peripheral debt is a very good example of this issue.

II. The ability for central banks to absorb any losses on the assets bought. This limitation is likely to

be a function of both the seigniorage a central bank earns as well as the ability for the sovereign

to recapitalise it.

III. Central banks need to be comfortable that inflation remains consistent with the medium-term

objective. While some degree of inflation overshoot may be desirable from both the debt

sustainability and the monetary policy perspectives, an excessive rise in inflation would be

problematic and limit both the ability and desire to implement financial repression – especially

for central banks with inflation targets.

• The extent of foreign currency liabilities. US dollar-denominated debt of non-banks outside the US has

doubled since 2009 and currently stands at $12 trillion of which $3.8 trillion are owed by emerging markets.

Although the level of external debt for the median emerging market economy is still distinctly lower than in the

late 1990s and stands at just over 200% of FX reserves – roughly half of the peak in the late 1990s – there has

been a deterioration in this trend as the outstanding value is now more than double the level in 2010 and

currently stands at roughly 18% of emerging market GDP. Even in the case of countries that have historically

been able to match USD debt with a stream of USD income, a sharp drop in revenues can leave them

meaningfully exposed.

A combination of factors suggests to us that even in a period of successful financial repression at the global level

there is likely to be notable differentiation from country to country and that these differences are likely to be more

pronounced than in the past as the economic stresses are greater, particularly once the impact of the expected

post-coronavirus growth rebound is priced into currency markets.

8

CONCLUSION

It is clear that policymakers will deal with the exceptional slowdown in growth

and resulting debt build-up by enacting policies that attempt to anchor bond

markets at levels that are highly conducive to growth. Our sense is that this

effort will be largely successful and that a combination of low real rates and

a bounce in economic activity are likely to support cyclical asset prices in the

months to come. But we also believe that the benefit for the currencies of

those countries traditionally geared into the growth cycle will be limited.

We also remain cautious that the structural underpinning of the global economy

has been left notably weaker by two major economic crises within a 13-year

period and will require much greater sensitivity to bottom-up analysis and

greater differentiation between countries and asset classes. One of the places

where the divergence from the GFC is likely to be stark is in the currency space.

For currency investors we see two benefits of financial repression across the world.

• For those looking to purchase foreign assets, limited interest rate differentials

reduce the cost of hedges relative to history.

• In a world where there is greater relative performance between currencies

as markets differentiate more, this could provide opportunities for alpha

strategies. The low volatility of recent years and subdued trading ranges

have made it more difficult to add value. But careful judgement will be

needed, to determine which currencies will benefit and which are vulnerable

in the current environment.

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CONTRIBUTORS

Francesca Fornasari, Head of Currency Solutions, Insight Investment

Simon Down, Senior Content Specialist, Insight Investment

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