January Global Outlook 

Global Outlook

Global Outlook

TAA Model Allocation - As at 13 December 2018



Craig Hoyda, Senior Quantitative Analyst, Multi-Asset Investing

Hindsight is a wonderful thing. As recently as the late 1990s, a number of European insurers offered a ‘known price’ life insurance product. This was a contract allowing investors to switch between weekly-priced funds during the week and before the new prices were published, regardless of market movements in the meantime. Given the volatility in the political, policy and market environment over the past 12 months, many investors must wish that they had taken out such a policy. Instead, investors must use other tools - forecasts, scenario analysis, diversification, and sophisticated portfolio construction, to protect their portfolios against risks.

In this edition of Global Outlook, Jeremy Lawson, Chief Economist and Head of the Aberdeen Standard Investments Research Institute, examines the economic outlook for 2019 and beyond. With growth and inflation largely performing in line with projections made in the late summer, he sees no material reason to alter our outlook. However, large upside and downside risks remain, and are examined in the article. The diversification of portfolios against an array of risks is examined by Gerry Fowler and Tzoulianna Leventi of the Multi-Asset Investing team. They set out two Absolute Return strategies: buying the Japanese Yen versus the Australian dollar, and the characteristics of playing relative yield curve positions in Sweden and Canada.

While old issues such as ‘known price’ life insurance contracts only affect a small number of European insurers, new issues are appearing. In particular, technology affects the whole global insurance industry, both as a large risk and as an attractive opportunity for many companies. Our recent survey of the North American insurance industry details the disruption caused by different forms of technology. Mike Cronin and Tom Dorner of the US and European equities teams, assess how specific insurance companies are adapting.

The survey also highlighted the sector’s concern that future investment returns would continue to fall short of their internal targets. Such risks have resulted in increased allocations to private market strategies, especially those concerned with leverage. Investment Strategist Jennifer Mernagh examines such strategies. She looks at levels of protections afforded to investors under adverse market scenarios including a tightening of liquidity conditions.

Scenario analysis informs our views on currency. Ken Dickson, Investment Director, Foreign Exchange Research, discusses the utilisation of an improved currency valuation framework to determine drivers of currencies both over time, and under pre-defined scenarios. Finally, Brett Diment, Head of Global Emerging Market Debt, discusses the outlook for the asset class in 2019. He examines both the fundamentals supporting emerging market debt, and considers a range of country specific political risks which affect portfolio construction.


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Craig Hoyda,

Senior Quantitative Analyst, Multi-Asset Investing

Chart Editor

Tzoulianna Leventi,

Investment Analyst, Multi-Asset Investing


The return of the policy put

Chapter 1


Jeremy Lawson, Chief Economist and Head of Aberdeen Standard Investments Research Institute

In the face of weaker global growth, inflation and financial markets over recent months, the Federal Reserve has become more data dependent while Chinese authorities have further loosened policy. This return of the policy put is a key reason why we do not expect a recession within the next two years, though we do expect the global economy to slow further.

Weak near-term
growth momentum

According to our proprietary indicators, global economic momentum has moderated further over recent months. Only the US was able to sustain above-trend underlying growth in the second half of the year (see Table 1). Our nowcasting models imply the slowdown has been most pronounced in the Eurozone and the UK, while our China Activity Indicator has shown few signs of responding to recent policy stimulus. Emerging market (EM) growth momentum (ex-China) has improved modestly but is also subdued. The deceleration has been concentrated in the global industrial sector. Industrial production growth has declined to under 2%, on a six-month annualised basis, led by developed markets (DM).

Our nowcasting models imply the slowdown has been most pronounced in the Eurozone and the UK.

Table 1: Micro to Macro Indicator

Micro to Macro Indicator *proxied with Germany in recession modelling.
Notes: macro momentum measured as diffusion index between 0 and 100; Nowcasts measure is deviation of current nowcast value from potential growth and if the pace of growth is increasing, decreasing or being maintained in the current quarter.

Source: Haver, Bloomberg, Eikon, Aberdeen Standard Investments (as at 31 December 2018)

Capital spending growth, including residential investment, has weakened across most economies. Non-residential investment growth has also started to moderate, with weakness most pronounced in the UK and Italy, where ongoing political uncertainty is weighing on business sentiment. There is little evidence that US tax cuts have altered the trajectory of domestic capital spending. By contrast, consumption has been a more consistent driver of growth in most DM economies. This mostly reflects the strength of the labour market, although in the US, housing activity slowed in response to the earlier rise in mortgage rates. Consumption will be further supported by the recent plunge in oil prices.

With the main drivers of our view that global growth will slow further over the coming quarters – tighter global financial conditions, elevated trade and other geopolitical tensions, and fading US fiscal stimulus – still largely intact, we have made few changes to our forecasts this time around. That said, there is scope for an inventory-led rebound in industrial growth around the middle of the year, as some temporary factors weighing on activity fade and production catches up with stronger consumer demand. However, any pick-up in industrial growth is likely to be far more modest than in the previous upswing.

Oil swings and roundabouts

We expect to see lower rates of headline inflation into 2019, mainly reflecting the sizeable 30% fall in oil prices since the beginning of October. This will drag headline inflation down in the advanced economies over the coming months, but to a lesser extent in those emerging markets where prices are more regulated (see Chart 1). By contrast, wage cost growth in the advanced economies has been surprising to the upside lately, implying a modest upwards trend in underlying inflation pressures.

Chart 1: Oil feed through

Source: Bloomberg, OECD, Aberdeen Standard Investments (as of 31 December 2018)

Nevertheless, the translation of stronger wage growth into higher core inflation is by no means straightforward. The theoretical relationship involves higher wages pushing up unit labour costs, which feed into core inflation. However, any increase in productivity growth would moderate the boost. Indeed, unit labour cost growth in the US actually moderated through 2018. Moreover, corporate margins may absorb some of the pressure of higher unit labour costs, implying less read across to core inflation. This appears to be happening in the Eurozone where unit labour cost increases have accelerated but core inflation has been fairly stable. The upshot is that we expect core inflation to rise in most of the advanced economies, but still only slowly.

In emerging markets, there is still some lagged effect of earlier currency depreciation passing through to consumer prices. The most obvious examples are in Turkey and Argentina, where their earlier currency crises have driven headline inflation as high as 25-45%. More modest currency depreciations in China, India, Russia and Brazil are also pushing up imported goods prices and therefore headline inflation in the near-term. Nevertheless, the recent drop in oil prices will push inflation down over the coming months just as currency effects fade. The sequential trend in EM inflation is therefore likely to be down as 2019 progresses.

Geopolitics: a thaw but for
how long?

The truce in the trade war between the US and China announced at November’s G-20 meeting, followed by China announcing a cut in tariffs on auto imports from the US, produced a short-term circuit breaker in a conflict that was at risk of spiralling out of control. The ceasefire, which was reinforced by further progress in mid-level trade talks in early January, may be a sign that both sides have become more concerned about the economic and market fallout from the dispute and are looking for ways to de-escalate tensions. However, we are sceptical about its durability. The list of contentious issues remains very long, with China needing to reform its economic and policy model to satisfy US demands. Moreover, because the dispute has become much broader than trade, compromise will be even more difficult.

In Europe, the smell of compromise is also in the air as the Italian government scaled back on its fiscal giveaways to satisfy the EU’s budget rules. Resolving the impasse involved the careful consideration of the political cost of walking back on tax and spending promises. Further bouts of Italian financial stress remain a risk as the government’s fiscal projections appear too optimistic. In addition, the European Commission has warned it will closely monitor Italy’s spending to ensure the budget agreement is honoured.

The outlook for Brexit also remains highly uncertain, as British politics has descended into chaos. Prime Minister Theresa May did not give parliament the opportunity to vote on the Withdrawal Agreement in December, and then faced down a no confidence motion from her own party. Though May survived, she is weakened, and at the time of writing has not elicited the concessions on the Withdrawal Agreement from the EU to secure its safe passage before March. This opens up a wide range of possibilities, ranging from a no-deal Brexit all the way to a second referendum with the option of staying in the EU. An extension to the Article 50 timetable has become much more likely, and a disorderly exit somewhat less likely.

On all three fronts – US-China relations, Eurozone fiscal tensions and Brexit – the message is that uncertainty will either be sustained, or could quickly resurface. This should continue to weigh on investment spending in particular.

A challenging environment for central banks

Amidst this more challenging environment, financial conditions have tightened. Global equities shed almost 15% from last September to year end, though there has been a modest bounce in the first weeks of January. Meanwhile, equity volatility has picked up, corporate and EM credit spreads have widened, and our US Financial Stress Index has increased. Equities initially fell as US bond yields rose, but yields have rallied since early November; the US 10-year yield fell by more than 0.5% between November and January while German yields are at their lowest since the end of 2016.

Critically, although the Federal Reserve (Fed) lifted rates again in December, it has reacted to the weaker global economic and financial landscape by dropping one of the projected increases this year. Rhetoric has also become more dovish, implying greater caution and data dependence than was the case earlier in the year. This explains part of the bond rally, as does the fall in oil prices. Bond markets are also reacting to fears that the global growth slowdown has further to run.

We expect the Fed to deliver two more rate hikes over the next year, beginning in June, followed by a further one in 2020 (see Chart 2). However, that view is conditional on there being no further correction in risk assets or sharp drop-off in domestic growth. As such, the risk of the Fed overtightening and accidentally causing a recession has receded. The Fed put is still alive and well.

There will be little tightening elsewhere in 2019. The ECB has ended its asset purchase programme but the dramatic deterioration in growth, combined with stagnant, below-target inflation, means that further policy adjustment is a distant prospect. Japan’s yield control targets are unlikely to change, and Chinese monetary policy will continue to loosen to support growth. The direction of policy in other EM economies is highly dependent on whether currencies resume their downward trend.

Chart 2: Rates to increase in most regions

Source: National Sources, Haver, Aberdeen Standard Investment (as of December 2018)

Risks to the outlook more finely balanced

We still think it is premature to call the end to the current economic expansion. Our recession probability models have not yet crossed the necessary thresholds to call a near-term recession. More fundamentally, US and global imbalances are not severe enough to prevent most economies responding to policy loosening, as long as the current US tightening cycle does not go too far.

Although we are not forecasting a recession within the next two years, our US recession probability models imply that the likelihood of a more serious slump in 2020 has increased to around a third. Recession probabilities at these levels for the US naturally tilt the risks to our baseline projections to the downside. Those risks relate to the dangers of policy being tightened too much amidst limited spare capacity and increasingly fragile financial markets.

While it is rare for either economic or earnings growth to accelerate persistently and meaningfully at this point of the cycle, when unemployment rates are very low and wage growth is picking up, there are upside risks to our projections, especially in the near-term and relative to what is priced into markets. As pointed out earlier, industrial growth has slowed more quickly than consumer demand, raising the possibility of an upswing by mid-2019, as production and inventories catch up with solid consumption growth driven by improving real income dynamics and more fiscal stimulus outside the US.

The Fed is another wildcard; further increases in financial stress could keep policy on hold throughout the year in a re-run of 2016. This would support stronger growth and financial markets through 2019. Similarly, our current expectation is that Chinese policy easing cushions growth rather than leading to a meaningful acceleration in growth. However, past experience has been that the authorities have overstimulated, creating upside risks to the Chinese growth outlook.

Meanwhile, our political risk analysis has led us to maintain our cautious outlook for US-China trade protectionism, as well as European political tensions. But if either or both dissipate more quickly, the boost to consumer and business confidence would be very positive.

Our nowcasting models imply the slowdown has been most pronounced in the Eurozone and the UK.

The continued search for diversifiers

Chapter 2


Gerry Fowler, Investment Director, Multi-Asset Investing

Tzoulianna Leventi, Investment Analyst, Multi-Asset Investing

With a wide range of possible outcomes from events such as Brexit and the US-China trade tensions, we analyse ways in which investors can diversify in an Absolute Return context. Specifically, we examine the characteristics of the Japanese yen versus the Australian dollar, and the relative yield curves in Sweden and Canada.

2018 was a volatile year for markets: in the region of 60% and 90% of all global asset classes delivered negative returns when measured in local currency and US dollar terms respectively. Uncertainties persist into 2019 and include the outcomes for Brexit, US-China trade tensions, Eurozone fiscal tensions and the expected global economic slowdown. We examine portfolio diversifiers expected to protect against such adverse outcomes.

When risk aversion rises, Japanese investors repatriating money drives JPY strength.

Out of Down-under

An example of a strong diversifier is buying Japanese yen (JPY) against selling the Australian dollar (AUD). This currency pair has a negative correlation with global equities, making it very attractive to hold during periods characterised by uncertainty when risk assets sell off. Below, we set out the key drivers of each currency that combine to produce this diversification characteristic.

The AUD is expected to remain weak over the medium term: China’s economy is slowing and its rebalance away from investment to consumption-led growth will remain a headwind for AUD. This is because Chinese investment has made it a globally significant buyer of commodities. Reduced investment means less commodity demand and therefore weaker export markets for Australia. One risk to this thesis that we are watching closely is that of structural growth in gas exports (Chart 1). Australia’s trade balance may have reached a sustainable surplus again as a result of large gas fields moving in to production after a decade of investment. This supports Australia’s external position somewhat at a convenient time given the weakening outlook domestically.

Chart 1: Step on the gas

Source: Australian Bureau of Statistics, Refinitiv Datastream (as of October 2018)

Given high debt levels, Australian banks require some foreign funding that is becoming more expensive as global yields rise. Domestically, this is exacerbating a regulatory-driven credit contraction and house prices are falling. Political uncertainty is also on the horizon as parliamentary elections must be held by May. Should the current opposition win power, as opinion polls currently indicate, they may remove tax incentives on property investment that could lead to further weakness in housing and construction activity.

The yen, on the other hand, is considered a safe-haven currency because of its very large net international investment position. When risk aversion rises, Japanese investors repatriating money drives JPY strength. Macroeconomic models suggest the yen is significantly undervalued. We are mindful however, that the JPY is more often driven by interest rate differentials that do not favour JPY strength currently. Valuations are not against our JPY vs AUD strategy, but they are not a key driver for our view.

Curving in Canada and Sweden

Another diversified strategy is a yield-curve relative value investment that we maintain. The Swedish 2 year to 10 year curve is the steepest amongst G10 countries while the Canadian curve is the 2nd flattest – just steeper than the US curve, but flatter than in Japan. Our expectation is for the Swedish curve to flatten and the Canadian curve to steepen. This combination offers a positive carry (the return from holding an asset) with no significant correlation to rates or equities.

The key factor driving this strategy is central bank policy differences driven by divergent growth and inflation expectations. The characteristic that both Sweden and Canada shared until recently was robust gross domestic product (GDP) growth – but this may change. We expect the Bank of Canada to lower rate-hiking expectations in the coming years as growth expectations are missed. The recent weakness in the oil price is one potentially contributory factor; others include the escalating tariff disputes and the softening in US auto and housing activity that all affect Canada.

In contrast, as Swedish inflation expectations rise, the Riksbank is finally raising rates. Canadian growth decelerated more than expected, by 1% to 2.5%. At the same time, the economy has a more volatile inflation path. Swedish GDP growth stabilised at 2.4%, but inflation is rising. Given the current point in the economic cycle and considering employment conditions, we believe the Swedish curve is too steep while the Canadian curve is too flat.

Political uncertainty in Sweden has risen after elections last September. A fruitless effort to create a government is prolonging a political limbo. We are of the view that this uncertainty in the political environment will not affect our strategy significantly. The political parties are not so far apart on policy and this should not influence growth and inflation substantially.

While the global economy is expected to slow in 2019, corporate profits growth is anticipated to be positive and valuation positions have improved in many markets. While fundamentals support moderate risk positions in selected equity markets and emerging market debt, we are conscious that the risk of a larger-than-expected economic slowdown is not one to be ignored. We therefore continue to ensure portfolios are adequately diversified.

When risk aversion rises, Japanese investors repatriating money drives JPY strength.

Technology – a double edged sword for the insurance sector

Chapter 3


Mike Cronin, Investment Manager, North American Equities

Tom Dorner, Investment Director, European Equities

Rapid technological developments combine with falling investment returns in a world of low rates, demographic and regulatory changes – all add up to pressures on the insurance sector.

Facing new challenges

Big data, machine learning and artificial intelligence are examples of a new wave of technologies which are beginning to present considerable risks and opportunities for many companies. The insurance sector is an example of an industry adapting its business strategies to meet this challenge. Against the backdrop of other major, often adverse, trends, success has so far been mixed.

Technological solutions could help improve the profitability of the sector. However the adoption of technology is still in its infancy.

Surveying the situation

We recently carried out a major survey of the insurance industry in North America, which provides a good example of the disruption taking place, and the resulting risks and opportunities, not just in that region but globally. The survey was comprehensive, involving firms representing about $3.6 trillion of assets under management, which represents around 30% of total insurance assets within the region. Specific themes were identified as shaping the future path of the industry. The first was a tipping point in technological developments. Major changes were expected in the operational facets and distribution routes of the sector (Chart 1), especially the rise of digital offerings, often from new private equity backed insurers. Other technological advances, including telematics and big data analytics, were expected to improve underwriting practices and pricing with implications for future growth. Meanwhile, the growth of autonomous vehicles will materially affect some insurance subsectors.

Chart 1: Tech worries

Source: Aberdeen Standard Investments (as at 31 December 2018)

Another theme from the survey was falling investment returns, an issue we have considered in our long-term returns analysis. Based on their current asset allocations, a large majority of insurers expect to see future investment returns fall short of their internal targets. A prolonged low interest rate environment was cited as a key risk to investment portfolios. Some insurers are responding by actively seeking to rotate out of traditional fixed income into alternative assets such as corporate and real estate loans or infrastructure debt, or to develop new tactical and strategic asset allocation skills, but there are practical difficulties in moving in this direction. These include a limited supply of long-duration investment-grade private credit meeting the needs of insurers, and the time required to build up the necessary skills internally, or otherwise develop relationships with external managers, to oversee the additional complexities and risks.

Our strategy in this environment

Our funds have been underweight US insurance over the past year. In principle, technological solutions could help improve the profitability of the sector. However, the adoption of technology is still in its infancy and many questions remain unanswered about future developments. For example, in auto space how quickly will customers be willing to adopt telematics? How will the data collected impact underwriting and pricing? Will the benefits from new technologies just be competed away? How could ride sharing and/or autonomous driving change the basics of insurance policies in the future?

One example where use of big data is in its infancy concerns AIG. It created a technology-enabled platform to apply data science, automation, and digital technology to improve underwriting and lower costs in small and middle market commercial insurance. This market is extremely fragmented, with a number of regional and mutual fund players who lack the resources available to AIG to make these technology investments. However, this investment will take some time to translate meaningfully into results, and unfortunately in the near-term AIG continues to be affected by earnings volatility.

For European insurers, so far the main impact of technological change has been on how insurers distribute products. However, big data and AI are increasingly having an impact on underwriting (using innovative data sources in pricing decisions) and claims handling (automatic assessment and payment of claims). Smaller companies have made some headway. Admiral and Direct Line in the UK are at the forefront of innovations like telematics and were well placed to benefit when motor insurance distribution shifted from brokers towards online price comparison.

Nordic insurers such as Tryg or Gjensidige are moving an increasing share of their claims handling towards automatic processing, which should ultimately lower costs for customers and the insurer. In contrast, some of the bigger European players have found it more challenging to turn technological change into a real competitive advantage. Operating in multiple jurisdictions and having legacy IT infrastructure that is often built through mergers does not easily lend itself to change. The danger for some of these companies is that despite large IT budgets and affiliations with technology companies, these are more about public relations and testing ideas rather than having a real impact on the customer or the insurer’s profitability.

In European funds we are overweight the insurance sector because we think that a solid outlook for earnings and strong balance sheets support attractive dividends and capital returns to shareholders.

In conclusion, the insurance sector faces some structural pressures requiring investment in new skills and new technology. New IT approaches do present some material opportunities to use data and software to improve pricing and the cost of claims handling, but we expect smaller players to benefit more than the large insurers. Over time, however, technology will increasingly have an impact, for example ride sharing or autonomous cars could challenge about one-third of the sector’s general insurance premiums.

Technological solutions could help improve the profitability of the sector. However the adoption of technology is still in its infancy.

Leverage in Private Markets

Chapter 4


Jennifer Mernagh, Investment Strategist, Global Strategy

With allocations to leverage-based strategies increasing, investors must monitor security quality and the protections afforded to them should market conditions turn. Using scenario analysis, we examine the effects of tightening liquidity conditions and the degree to which markets have priced in risk.

Private markets and corporate lending

Depressed interest rates, slower global economic growth and rich equity market valuations have led investors to further examine non-traditional investment opportunities. The alternative asset management universe has grown significantly over the past few years, managing $8.8 trillion (tn) as at the end of 2017; in context, total world equity market capitalisation stood at $81tn on the same date. By March 2018, those managers held $2tn of this total in cash awaiting investment – a large absolute amount, but a slightly lower-than-average proportion of assets under management (Chart 1).

Current weakening of covenants and documentation could mean that history fails to provide a good representation of future expectations.

Chart 1: Dry powder at the ready

Source: Prequin (as of March 2018)

One underlying common feature of alternative investment strategies is leverage. Investors have been increasingly investing in alternative credit funds, or originating private lending deals themselves. Corporate lending, particularly leveraged loan lending, has led current and former policymakers to draw attention to unhealthy lending practices that have become more common.

At a time when the market expects monetary policy and financial conditions to tighten, investor demand for floating rate, senior secured loans has driven issuance higher. Concurrently, credit quality has been eroded as borrowers take advantage of indiscriminate lending. Debt levels have been steadily rising, and where leverage limits have been in place, lenders have increasingly accepted future potential earnings to be taken into account when calculating leverage levels. Lending protections have also been diluted, as most loans now have few covenants, if any. In addition, there is anecdotal evidence of other protections weakening. This includes the opportunity to move collateral around, meaning that loans may not always be backed by specific assets.

Recovery rates in corporate loans can vary significantly over time: currently in excess of 80%, but less than 50% in times of market stress. The current weakening of covenants and documentation could mean that history fails to provide a good representation of future expectations, and that in a period of adverse market conditions, recovery rates could be low. Moody’s forecasts that the average US first-lien senior secured term loan recovery rate will decline from the long-term average of 77% to 61% during the next recession. Industry exposure has also changed over time, from being a utility-led, asset-heavy market to one that is technology driven and asset light. The recovery rates on these companies are likely to be different. The default rate has been 3.1% on average, and is currently around 1.5%; this may also change going forward.

Changes to earnings growth and interest rates will impact the interest coverage of these loans. Applying economic scenario analysis, such as our assumptions about a quantitative tightening driven market tantrum or a rebound in trade growth, we can estimate how the average loan is impacted by changing economic fundamentals over time. It is clear that tightening financial conditions will play a major role in the performance of loans and that for lower credit quality loans there may be significant stress, even under the less extreme scenarios.

It is a reasonable assertion that quantitative tightening would impact these markets. Liquidity has been plentiful and its removal is likely to impact leveraged loans directly and indirectly. It is possible that margin calls elsewhere will impact markets and lead investors to require liquidity in other parts of their portfolios.

Risks being recognised

Markets are now recognising the risks of this type of lending – credit spreads for new issuance have widened, and the secondary market has sold off. Despite recent spread widening, many loans were issued at very tight spreads over a prolonged period. Furthermore, a large proportion of those loans have been packaged into collateralised loan obligations, which have been divided into tranches with credit ratings from AAA through to equity. They are held by institutions such as banks, as well as open and closed-ended funds, and insurance and pension funds.

From a financial stability perspective there are issues to consider. The Financial Stability Board’s (FSB) Global Shadow Banking Monitoring Report highlighted situations where banks have had to withdraw from some types of lending due to regulation and other providers have been able to step in. Investors are providing shadow banking services in growing numbers and size. While these investors are providing capital to the economy, there may be a liquidity mismatch for others, which could cause systemic issues. In addition, the extent of investor reliance on bank funding is unclear.

There is more work to be done to fully understand the risks, as noted by the FSB in its report. The fact that global debt is at record highs underlines the importance of knowing the details of what this debt looks like, who owns it, and where the risks are. Following the Global Financial Crisis, the FSB and the IMF jointly entered into the Data Gaps Initiative and, going into 2021, they plan to gather more data on the shadow banking sector.

In loans specifically, it seems sensible to monitor appetite for and acceptance of aggressively leveraged deals, as well as an increasing ratio of downgrades to upgrades and a cash interest coverage ratio tending towards 1.5x. From a macroeconomic perspective, we are continuing to monitor GDP growth, interest rate and inflation forecasts and, perhaps most importantly, financial conditions.

Current weakening of covenants and documentation could mean that history fails to provide a good representation of future expectations.

Driver and scenario analysis support currency views

Chapter 5


Ken Dickson, Investment Director, FX Research

The value of models extends well beyond point estimates of equilibrium exchange rates. We see value in driver and scenario analysis when preparing our currency views.

Monthly is the new quarterly

We have long thought that valuation models are a valuable input into decisions about currency trades and the broader return environment. If models are correctly calibrated, they are useful for identifying the key macroeconomic drivers of exchange rates over relevant investment horizons. We also use this analysis to assess the changing importance of these drivers over time.

USD tailwinds have been significant since March 2018 but are fading now.

Over the past year, we developed models using the same macroeconomic framework as before but with monthly rather than quarterly datasets. Although the traditional quarterly models have provided a useful input into our valuation assessment and decision-making, they do have limitations. Some of the data is only available with a long lag, some is only available over shorter time series for a number of countries and is subject to considerable revision. All of these issues undermine the reliability of the estimates.

Working with our new Macro Monthly valuation model, we have sought to determine the importance of each input to the valuation of each of our selected currencies versus the US dollar (USD). Table 1 shows the output from various regressions of currency changes against shifts in fundamental data. We combine coefficients, significance and a stability measure over various time-periods to create a single score showing what drivers help to explain medium-term developments in each currency.

Table 1: Input Importance

Source: Aberdeen Standard Investments (as of December 2018)

The analysis shows us that the interest rate differential is an important driver for all of the models and these relationships appear very stable over time. Yield-curve steepness is also an important variable but its significance varies across currencies and over time. It is clear that interest rates are particularly important for the Japanese yen (JPY) exchange rate.

The commodity index is particularly relevant to the Australian dollar (AUD), Canadian dollar (CAD) and Norwegian krone (NOK) currencies. Although this is an expected result we also conclude, perhaps surprisingly, that commodities are a strong driver for all the G10 currencies with the exception of the JPY – probably reflecting that commodity prices will often be driven themselves by the global industrial cycle. We have also established that many of the variables in the AUD model are stable across the full data period. Specifically, the trade balance is one of the AUD’s most significant drivers. We have calculated the combined driver metric in a way that makes it difficult for shorter-term influences to override longer-lasting relationships. Therefore, we are confident that this is not simply a recent phenomenon.

Supporting our scenario analysis

A further value of the model framework is its ability to produce forward-looking foreign exchange scenarios based on alternative projections for the key variables.

Our economic analysis suggests a moderate mid-cycle slowdown with still quite strong 2019 global growth of 3.4%, albeit a little lower than 3.7% in 2018. While we see recession risks creeping higher, they are still tolerably low. We still expect the US economy to lead the G10 growth table but there will be some catch-up as the US fiscal boost fades in the second half of the year. Specifically, we still expect the Federal Reserve (Fed) to hike rates three times before ending its tightening cycle by mid-2020.

Our main conclusion is that the USD will remain supported at least through the first half of 2019. Scenario analysis informs us that the USD rarely falls when economic momentum is negative and yield differentials are high. For example, our valuations forecasting tool calculated that the fair value of the USD would rise 5% under the two following conditions: the World PMI (a business sentiment measure) dropping to 50 and commodity prices (measured using the GSCI commodity index) declining 10%. This sort of slowdown would see the euro fair value decline to $1.10 and the AUD fair value decline to $0.68 (Chart 1). Note, we use the simplistic assumption that no other variable changes when we conduct the analysis.

Chart 1: Fair value scenario analysis

Source: Aberdeen Standard Investments (as of December 2018)

Similarly, a scenario where US rates rise further but with the yield curve flattening a little also results in the USD appreciating against most currencies. What is most evident is the JPY exhibiting sensitivity to changes in interest rates but not reacting to changes in the world PMI - indicating strong safe-haven characteristics.

Dollar tailwinds fading but rate differentials powerful

USD tailwinds have been significant since March 2018 but are fading now. Growth and interest rate divergence has driven fair value higher and the market was positioned moderately short USD. Risk aversion and liquidity demand supported appreciation too. However, the dollar starts 2019 modestly overvalued and the market positioned long USD. With year-end USD liquidity demand no longer an issue and our forecast of modest global growth, convergence should slowly curtail USD outperformance. Nonetheless, we expect that the US fiscal policy boost will unwind only slowly so that interest rate differentials, risk aversion and the new risk of higher US tariffs will keep the dollar firm – at least through the first half of the year. We note that the dollar’s value barely changed during November when there was a focus on the Fed’s policy stance and communication. We do not think that the Fed’s tilt to data dependency is a signal to pause, in itself. It is natural to change communication strategy as policy becomes closer to neutral. When data is strong, as we expect, then rates will still rise – supporting the USD.

USD tailwinds have been significant since March 2018 but are fading now.

EMD fundamentally positive

Chapter 6


Brett Diment, Head of Global Emerging Market Debt

Fundamentals are supportive for emerging market debt in 2019. However, elections remain a source of country-specific risk.

With rising US interest rates and the US-China trade war intensifying, 2018 was a volatile year for emerging markets (EM). The US dollar’s strength led to broad-based EM currency depreciation, aggravated by currency crises in Turkey and Argentina. In this article we examine the prospects for EM debt in 2019.

Politics presents risks, although these are likely to be more country-specific.

Letters between Beijing and Washington

Examining fundamentals, there are reasons for optimism. A few countries aside, debt is not at levels that would present systematic risks. Furthermore, the superior growth rates of EM countries provide a tailwind for the asset class; while growth is likely to remain soft at first, the differential over developed markets should increase as the year progresses. As a result, capital flows into EM should improve.

The US growth cycle is also important. We expect US growth to moderate but avoid a recession; this would prompt the Federal Reserve (Fed) to conclude its rate-hiking cycle, relieving the pressure on EM currencies. However, continued economic strength in the US that results in a hawkish Fed would be an adverse scenario for emerging markets, as currencies again would be expected to depreciate against the dollar. The result of the US mid-terms, which should reduce the chance of further fiscal stimulus, offers grounds for optimism here.

Another potential catalyst is China. In addition to US tariffs taking effect, China’s economy is slowing; GDP growth for the third quarter of 2018 was the lowest since 2009. But Beijing has considerable monetary and fiscal firepower at its disposal (Chart 1). Efforts are already being made to improve corporate access to credit, and issuance of municipal bonds to fund infrastructure investments has been rising. Should these measures prove insufficient, we can expect further monetary easing, more local-government bond issuance and, potentially, a cut in corporate taxes. The positive impact on EM debt markets is likely to be smaller than the massive infrastructure-related stimulus measures of 2009 and 2015/16, but it could still be considerable.

Chart 1: Room for easing

Source: China Bureau of Statistics, Haver, Aberdeen Standard Investments (as of November 2018)

Against these positives, there are certainly risks. The most obvious danger is an intensification of the US-China trade war. The temporary ceasefire agreed at the G20 summit in Argentina already looks fragile, and the most likely scenario is that US protectionism will persist, jeopardising global trade. China will remain the focus, although global tariffs on cars represent an additional risk.

But given the unpredictability of the US administration, there is also a possibility that the trade war might end sooner than most expect. Any resolution of the conflict would significantly boost sentiment towards emerging markets – especially as an escalation of hostilities is already priced in.

Elections on the horizon

Politics also presents risks, although these are likely to be more country-specific than the consequences from 2018’s elections in Mexico and Brazil. In Argentina, President Macri is currently level in opinion polls with populist former president Kirchner. Macri’s hope is that the economy will recover in time for October’s election, but this might be overly optimistic. If Kirchner wins, her previous statements make it difficult for the markets to imagine her cooperating with the IMF on the reforms that the country so urgently needs.

In South Africa, the ruling African National Congress is certain to retain its parliamentary majority, but the margin of victory might change the balance of power between President Ramaphosa and his party rivals. The country’s credit rating has been on a downward trajectory over the past few years, and decisive policy action is needed to change that. This can only be achieved under an empowered president. Meanwhile, India’s ruling party has been pressing ahead with much-needed reforms, but further progress depends on it retaining its position in the 2019 general elections. Recent defeats in state elections suggest that this is far from certain.

Ukraine, however, is a special case. Its debt sustainability remains questionable, but the country has been in an IMF programme that has helped it to implement important structural reforms and regain market access. However, March’s presidential election could imperil this. Former Prime Minister Tymoshenko currently has a significant lead in the polls on a populist programme. Given rising tensions with Russia, Ukraine also represents a potential geopolitical flashpoint.

Oil effects

Finally, there’s oil. Despite recent weakness, the oil price is still higher than the assumptions baked into most EM budgets. But a weaker oil price is likely to benefit local-currency debt markets rather than hard-currency ones. That’s because oil importers – including India and many other Asian countries – make up a higher proportion of local-currency benchmarks than oil exporters, who have a greater share of the hard-currency indices. As such, there are opportunities as well as risks here.

Overall, 2019’s risks appear largely country-specific. The potential catalysts for positive performance, however, are broader-based, and the systematic risks – such as a step-up in the US-China trade war – are already priced in. So, we enter 2019 with some confidence, albeit tempered with caution.

Politics presents risks, although these are likely to be more country-specific.