As the current bull run continues to crush longevity records, investors can’t help but brace themselves for an imminent market correction as everyone knows that good things don’t last forever. However, the timeline of the next downturn has been shifted forward by market experts again and again, but there’s no consensus of what might trigger it. In hindsight, predicting the next inflection point seems like an easy task, but we all know that’s not the case. Hence, the purpose of this piece is to explore the top three most likely scenarios and offer our best guess on how it will affect the FX market.
- Trade wars
Arguably the highest recession risk is poised by the trade wars that the US is engaging in, especially with China. The negative effects on both economies are already starting to show in the data, as real income, financial conditions, and trade-policy uncertainty have taken their toll. Some might argue that this is just the beginning, and there’s a real risk for the conflict to escalate to cold war era levels. Given the interconnectivity of financial markets, a prolonged conflict between the two superpowers could trigger a global recession. In the short to medium term post the presumed correction, the US dollar is most likely to rise across the board, especially against EM currencies. The main arguments in the greenback’s favour are the safe haven status it benefits from, its world reserve currency status, as well as greater economic growth and higher bond yields than other major developed economies. Unless the downturn impacts the US in a disproportionate level, we expect international money to flow into the dollar even if the trade spat involves them directly.
- Corporate debt meltdown
One of the consequences of the unprecedented levels of quantitative easing is the rise in corpo-rate debt levels to historical highs across most developed economies. Based on graph 1 below, you can see that peaking corporate debt levels have been good indicators of previous reces-sions. Recently, the IMF issued a warning that action was “urgently” needed to avoid financial meltdown in the corporate sector, which could potentially spread into the banking and shadow banking sector. Among the three largest econo-mies, the IMF study argues that the eurozone poses the least risk of a collapse, given that it has addressed some of the issues after the euro crisis in 2012. In China, on the other hand, the impact would be more severe, although the Chinese government is starting to act. Lastly, in the US the situation is probably the bleakest as corpo-rate debt continues to rise rapidly (after already having reached historical highs) and could be stimulated further by the recent Fed cut. More so, the biggest chunk of the increase in debt vol-ume has come in the lowest-quality investment-grade credits and in below-investment-grade. So
far, the increase in borrowing has been support-ed by solid profit margins, but as those margins are starting to come off, the risk of a meltdown increases significantly. In this scenario, where the recession would be US centric, we expect a major dollar correction in the short term.
- Slow growth becomes the norm
In this scenario, we envision a mild recession fol-lowed by a very slow recovery and low levels of inflation across most developed economies. The decade long dollar bull run has driven the curren-cy to be overvalued by double digits percentages compared to most G10 currencies from a PPP perspective and other trade weighted metrics. Eurozone rates have most likely bottomed (or close to have bottomed) while QE looks to have levelled off (yellow), while in the UK (red) rates have little room to fall. We don’t expect much change in policy in the event of a downturn, with structural and fiscal measures most likely to be employed in that eventuality. In the US, howev-er, the Fed has more room for manoeuvre (green) and rates could fall further before other structural or fiscal measures are imposed to stim-ulate the economy. In turn, this will significantly dim appetite for the dollar as it would not benefit from the wide rate differentials from the past years. On the other hand, the current higher rates offer the US more ammunition to tackle a slowing economy, which could potentially help the country to recover faster.
Regardless of the outcome, the record low vola-tility environment looks to be under threat, mak-ing the case for securing long-term protection at relatively low costs.