As the US now finds itself in the longest expansionary cycle in history, economists continue to ask themselves how much further can this run continue? I’m sure that most of you have seen plenty of articles over the past few years claiming that a recession is just around the corner, with governments and central banks standing powerless in front of this inevitable outcome. Nevertheless, economists, major banks and leading financial figures alike have been compelled into pushing their recession forecasts further into the future as economic growth keeps marching on. However, this time it might be different as indicators are flashing towards a recession harder than ever before.
Just to summarize a few of the developments in recent weeks, we have seen the U.S. 2Y10Y yield curves invert (a phenomenon seen prior to the last seven U.S. recessions – see Chart 1), U.S. 30Y government yield dropped below 2% for the first time ever, the UK and German economies shrank in Q2, the Argentinian peso and stock market crashed, financial markets volatility spiked (the Dow posted its largest single-day decline this year) and purchasing managers indices dropping to multi-year lows. Taking a rather simplistic view of what has transpired in the global economy in the past couple of months, we can’t help but wonder why we haven’t seen a significant correction yet.
Besides the obvious argument of strong employment and reasonable consumer spending, one argument could be the optimism bias that markets tend to show throughout history. As you can see in Chart 2, forecasters tend to underestimate the magnitude of recessions consistently. Most recently, we can see how the impact of the US-China trade conflict and Brexit had been underestimated by the market participants. With regards to the US-China trade dispute, markets have misread the willingness of both parties to strike a deal repeatedly, while the spillover effects on an already slowing economy are still being downplayed. Secondly, there seems to be a false sense of security given by the additional easing measures central banks might impose. With $14tn negative yielding bonds already floating in the market (a quarter of the bonds issued), and with the private sector saturated with debt, it is hard to imagine that additional stimulus would do much to spark up demand.
But what does a world entering a recession mean for currencies?
Looking at the U.S. dollar, we believe that it stands to gain mainly against the euro and most EM currencies. The U.S. has a relatively closed economy which will not be as affected by a global slowdown. Additionally, their economy is in better shape than most other developed nations and is not export-dependent to the extent Germany or some other Asian countries are. Furthermore, a widespread flight to quality would heavily favour U.S. fixed income as it is one of the last places where investors can earn a yield.
In Europe, on the other hand, the picture is slightly bleaker. When Germany, Eurozone’s growth engine for so many years, is forecasted to enter a technical recession next quarter, it is not a great sign. Although things can get even worse before they will get any better. Germany, which is a big exporter stands to be hurt massively by the trade spat between the U.S. and China. Furthermore, a no-deal Brexit and additional tariffs imposed by Trump on the EU could only deepen the downturn. The economic gap between the two economies combined with historically high yield differentials can only mean sell pressure for the euro against the greenback.
Despite some encouraging retail and inflation figures the prior week, the UK economy has contracted in Q2, while the 2Y10Y yield curves have inverted. Sterling is heavily dependent on the outcome of Brexit but attempting a recovery during a period of global downturn will not be easy.
Historically, Emerging-market currencies have been hit the hardest during global recessions. And compared to 2008, EM dollar denominated debt stands at levels double than what they were during the previous crisis (Chart 3). Therefore, it wouldn’t be too surprising if we see multiple sovereign defaults along the way.
This time around, the old saying “When the U.S. sneezes, the world catches a cold” might also apply to China. The Asian superpower accounted for more than 30% of global consumption growth over the past 10 years and disrupting the traditional trading system would inflict deep uncertainty and costs to the economy. But things might not as bad as they seem, or at least that’s what markets seem to think.