2021 Global Macro Outlook Part Two: Where we might go

Several things go together for those who view he world as an uncertain place: healthy respect for risk; awareness that we don’t know what the future holds; an understanding that the best we can do is view the future as a probability distribution.

– ‘The Most Important Thing: Uncommon Sense for the Thoughtful Investor’, Howard Marks, 2011

We have two classes of forecasters: those who don’t know – and those who don’t know that they don’t know.

– John Kenneth Galbraith, Canadian Economist, 1908 – 2006

Last week, we assessed the lay of the land from a macro perspective, looking at the impact of the COVID pandemic on everything from monetary policy to FX valuation and positioning.  This week, we will examine how this might shape the outlook for financial markets in 2021, with a particular focus on FX and interest rates.

As discussed last week, current market consensus is about as one-sided as I can ever remember seeing it. Almost everyone expects a weaker US dollar in 2021.  A recent analysis by Bloomberg showed that virtually every major investment bank and asset manager surveyed was predicting a bear market for the dollar – the only exception was DWS, a large German asset manager with a 1.15 target for EURUSD. 

Interestingly, our own (unscientific!) LinkedIn poll showed quite different results.  Of the 170 respondents, exactly 50% were bearish on the dollar (the rest were either neutral (18%) or bullish (32%).  This was mirrored by a recent internal survey of our 60+ employees, where just over half (55%) were USD bears.

When it comes to forecasting, I would put myself in John Kenneth Galbraith’s first category of forecasters.  I don’t know what will happen to the dollar in 2021, and I am all too aware of my lack of clairvoyant abilities.  History has been a good, if at times brutal, teacher.  As such, what follows is not a forecast as such. 

Instead, I will lay out what we here at Validus HQ see as the three most likely macro scenarios in 2021, and the likely implications of such outcomes for the FX markets.

Scenario I – ‘Benign Reflation’
Validus Estimated Probability  = 40%


This ‘goldilocks’ outcome reflects the broad consensus view for 2021.  While we are less confident than consensus on this outcome (as reflected in our estimated probability of ‘only’ 40%), it is certainly one of the most likely macroeconomic scenarios to expect in 2021.   

The Benign Reflation scenario is based on the expectation that 2021 will see a strong rebound in economic activity, as a successful vaccine rollout provides a demand-side boost, given further positive supply-side reinforcement from extensive fiscal and monetary stimulus.  This scenario is predicated on two critical assumptions:

1) Inflation remains ‘under control’ (i.e. somewhere around 2%)

2) Interest rates remain at/ near zero at the short end, and under 2% at the long end.


Currency Implications

As per market consensus, we would expect the US dollar to face headwinds in this scenario.  With real yields below zero, international investors will see little reason to buy the dollar, even the rest of the G10 will face a similar negative real return environment.  Furthermore, there will be no ‘risk off’ dollar buying, as the economy (and equity markets) trend higher. 

Whilst we do see this a generally negative environment, the scope for much further downside seems limited, for three key reasons:

1) Valuation – the dollar’s 2020 sell-off has meant that its over-valuation against most G10 currencies has almost completely disappeared. 

2) Positioning – As noted above, the market (as assessed by either forecasting bias or positioning) is heavily skewed against the dollar already.  Further downside moves will be increasingly hard to come by.

3) EUR Vulnerability – The US dollar’s biggest rival, the euro, is suffering from chronic deflation, which is a (the?) major concern for ECB policy-makers trying to navigate a way out of the pandemic and unsustainable debt-loads, particularly in southern Europe.    A strong euro creates a major headache by pushing import prices down, thereby creating deflation, which in turn pushes the real value of debt higher.  The ECB will fight hard against euro appreciation.


This set-up favours GBP (boosted by a faster vaccine-led COVID recovery) and CAD (and other commodity currencies) correlated with global trade growth. 

EURUSD:  1.25 – 1.30

GBPUSD:  1.45 – 1.50

GBPEUR: 1.15 – 1.20 USDCAD: 1.20 – 1.25

Scenario II – ‘Market Meltdown’
Validus Estimated Probability = 20%


This scenario involves the economic train coming off the tracks in 2021, the most likely catalyst being COVID-related (e.g. impact of new strain, problems with the vaccine / vaccine rollout etc.).  Another potential catalyst could be heightened geopolitical tension, either international (e.g. China vs. the West) or domestic (the US, the EU, and possibly the UK, all face significant political tests in 2021).

Currency Implications

This outcome would see equity markets fall (>20%) and market volatility spike appreciably.  Once again, central banks would step in to ‘save the day’ but it is far from certain whether they will be as successful this time.  In this event, we would expect a sharp appreciation of the US dollar, as its ‘risk-off’ appeal collides with the extremely skewed short-dollar market positioning.

In the inverse of the ‘Benign Reflation’ scenario, high beta currencies such as GBP and CAD would be especially vulnerable. 

EURUSD: 1.05 – 1.10

GBPUSD: 1.15 – 1.20

GBPEUR: 1.00 – 1.05

USDCAD: 1.35 – 1.40

Scenario III – ‘Market Melt-up’
Validus Estimated Probability = 40%

Our third macro scenario would likely start along the same lines as the first scenario.  However, in this scenario, central banks begin to lose control of inflation, which breaks higher, quickly approaching, then breaching, the 2% level by the middle of the year (at least in the US, the numbers would likely remain lower in Europe).  This would push nominal rates up across the middle to long-end of the curve. 

This scenario would likely mean volatility across financial markets, including equities, commodities and fixed income, as market speculation around a likely Fed response would grow, probably focused around the potential for Yield Curve Control (YCC).  Eventually we would expect to see YCC implemented in this situation.  Our expectation would be once we see real rates turn positive across the curve the Fed would be forced to act. 

Currency Implications

This outcome is perhaps the trickiest to evaluate in terms of currency impact, as it really depends on the timing of the Fed’s actions with respect to YCC.  As US real yields begin to rise, we would expect the dollar to strengthen initially, helped by increased market volatility.  However, it would likely be a choppy rise, with several, potentially significant pull-backs.  Once the Fed announces and implements some form of YCC, then we would expect the dollar to weaken, especially versus the euro which would outperform in this environment.

Pre-YCC

EURUSD: 1.15-1.20

GBPUSD: 1.30 – 1.35

GBPEUR: 1.15 – 1.20

USDCAD:  1.30 – 1.35

Post-YCC

EURUSD: 1.30 -1.35

GBPUSD: 1.40 – 1.45

GBPEUR: 1.05 – 1.10

USDCAD: 1.20 – 1.25

Summary

‘Unprecedented’ was perhaps the most over-used word in 2020.  However, as we assess the potential financial market outcomes for 2021 there is no doubt that there are many extraordinary factors to consider:

• Pandemic recovery

• Monetary policy

• Fiscal policy

• Market positioning and consensus

• Debt levels (public and private sector)

• Geopolitical stress

Any one of these factors has the potential to move currency markets dramatically. With all of these factors in ‘unprecedented’ territory, a ‘healthy respect for risk’, as Howard Marks says, is essential. 

In this short outlook, we have described what we consider to be the most likely scenarios for financial markets in 2021.  There are also many other idiosyncratic factors and ‘unknown unknowns’ which could also have a big impact on markets over the next year.  If 2020 taught us anything, it was to expect the unexpected!

A robust and adaptive risk management programme will ensure that such risks can be managed, and that underlying investment objectives are realized despite a particularly uncertain macro environment in 2021.

Kevin Lester
CEO