In February’s edition of Currency Outlook – HSBC’s top FX publication – we can find bank’s GBP forecast 2020.
According to HSBC’s views, GBP-USD should rally to 1.45 by year-end. Here’s an extract from the report:
GBP: Theory of relativity
“We expected the political certainty provided by December 2019’s clear election result in the UK to create conditions for a significant rally in GBP. So far, our expectations have been disappointed. But we are not throwing in the towel just yet. We see GBP-USD rallying meaningfully in 2020 to 1.45 with EUR-GBP falling to 0.76.
The FX theory of relativity
Einstein’s general theory of relativity provides a mathematical framework for gravitational interactions across space and time. In simple terms, the theory submits that there is no fixed frame of reference in the universe: everything is moving relative to everything else. In FX we adopt a somewhat simpler approach, applying a perspective of relativity onto how different forces apply to different currencies under varying circumstances. The one overriding similarity is that in FX everything is also relative.
The varying circumstances for FX are which of the broad drivers – cyclical, structural or political – is going to be dominant for a currency’s behaviour. We believe that cyclical forces are going to be dominant for GBP. Once we have determined which driver will likely be dominant, we can then think about how this looks in the relative world of FX. Currencies are generally traded and valued against other currencies, so we therefore have to think in relative terms. When thinking cyclically, we believe there are three key areas of relativity for assessing a currency’s outlook:
1. Relative to other currencies
2. Relative to recent trends
3. Relative to expectations
This framework can help to explain why currency weakness might not occur even if a currency’s fundamentals look terrible on a stand-alone basis. Despite looking soft in absolute terms, if those fundamentals are better than elsewhere, better than what was expected or are improving relative to a prior trend, then a currency can still appreciate. On all three fronts, we believe there is room for GBP to rally, especially given the currency remains some way below estimates of long-term fair value.
GBP to gravitate towards cyclical forces
It is easy to think that politics will remain a crucial component when thinking about GBP in 2020. Chart 1 shows the correlation between UK-US interest rate differentials and GBP-USD. The higher the line, the more dominant the cyclical forces on the currency. Since 2018 the cyclical relationship between rates and FX has been relatively weak, suggesting that politics has been the dominant driver of the currency.
1. Politics has been dominant but is swinging back to cyclical forces
Many might think this will continue. But we are already seeing this change. Post-election the relationship has already spiked, suggesting there are already signs of this cyclical dominance coming back, although this could be a flash in the pan. So why do we believe the market’s focus will shift more permanently?
In some respects we have been here before. In 2017, after a politically dominated 2016, we expected GBP to remain under pressure from those same forces. We were proved wrong, as political factors moved to the sidelines. The Article 50 notification provided a long enough time horizon for markets to park concerns around Brexit, and cyclical factors came to the fore as growth bounced at the start of 2017, and the Bank of England hiked rates later in the year.
We don’t wish to make the same mistake by expecting a different outcome in terms of GBP performance. To paraphrase Einstein’s alleged words, this would be the definition of insanity (“Insanity is doing the same thing over and over again and expecting different results”).
So this time, with the Brexit deal agreed and the UK leaving the EU on 31 January, we believe political factors will again become a less important driver of the currency. Many market participants and media commentators are quick to point to the risks of ‘no deal’ at the end of 2020. But previous fears of a ‘no deal’ proved to be unfounded in both March 2019 and October 2019. The fear of a ‘no deal’ at the end of 2020, or even by June 2020 as some are focused on as the potential deadline this time around, should also subside. Cyclical factors are set to take over in 2020 with the possibility of a rebound in the UK economic data. In this space, relativity favours a stronger GBP.
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It’s all relative for GBP
Once we have determined which driver – cyclical, political or structural – will likely be dominant for a currency, then we can apply our FX theory of relativity. As mentioned earlier, we see three key areas of relativity for assessing a currency’s cyclical outlook. We will now address each one in more detail, but on all three fronts, we believe there is room for GBP to rally.
1) Relative to other currencies
UK economy rebounding
Global growth looks set to slow, while HSBC’s economic team are looking for something of a stabilisation in UK growth. This relative expected improvement in UK growth looks quite stark when compared directly to the likes of the US and the Eurozone. Charts 2 and 3 show the annual growth rates we expect each quarter through 2020. It seems clear that from a relative economic growth perspective, the UK is going to be in a better place than the US and Europe.
2. UK economic growth seen improving relative to the US…
3. …and significantly outperforming the Eurozone in 2020
This relative difference may be all the more important in a low-for-longer world, in our view. We have previously suggested that when interest rates get close to the zero bound, marginal changes in rates can matter more for FX. So a 25bp hike from 0% is more meaningful for a currency than a 25bp hike when base rates are at 5%, for example. The same may be true from a growth perspective. When growth is so low, and with ongoing stagnation expected elsewhere, any sign of a pick-up in UK growth versus other G10 economies could be a very strong positive for UK assets and for GBP, which have been unloved by investors for the last few years.
2) Relative to recent trends
The only way is up?
It is easy to see why GBP has been unloved. The data have clearly been deteriorating. Chart 4 shows a diffusion index of a broad range of data, averaged over the last 12 months. When the index is in negative territory, as it has been since late 2017 for the most part, it means more UK data is
weakening than is strengthening. The current narrative, for example the Bank of England’s dovish shift in late 2019 and early 2020, appears to assume an extrapolation of the weak trend.
4. UK activity data in a downtrend
The above (alleged) quote is relevant when thinking about the GBP outlook for 2020 with a cyclical bias. Right now, we know that the recent economic data in the UK was softening and it is easy to think those trends will continue. But we have to use our imagination to some extent to think about how things might look now that we have a completely different political situation versus what has prevailed for the last few years. Two examples of how recent trends could shift very quickly are consumer confidence and business investment.
Consumer confidence has been stagnant for the last few years despite a positive real wage story (Chart 5). Of course it may be a complete coincidence that this breakdown became much more apparent as political instability increased. But it is also plausible – even likely – that
political uncertainty has had some negative impact on confidence. Real wages are likely to remain resilient with low inflation and a tight labour market. So there is every possibility that consumer confidence might rise to close the gap that has opened up now that UK politics looks more stable. Of course, this requires a leap of imagination to think the most recent trends will no longer continue and actually an old relationship might take hold.
5. Consumer confidence could bounce
6. Investment has room to play catch up
Similarly, the trend of investment has been very poor – both in terms of domestic investment and FDI (Chart 6). But that has obviously been against a backdrop of political uncertainty. Investment growth, while already on a softening trend, fell most sharply from mid -2016 onwards. The fall in FDI at around the same time is even more notable. It is possible this had nothing to do with the UK’s EU referendum outcome in June 2016. But this seems unlikely.
Now that there is a more stable backdrop on the political front, it is not hard to imagine that there is at least some pent-up investment demand from UK corporates, which has been sorely lacking in recent years. Similarly, for foreign investors who may have harboured some concerns
either about a ‘no deal’ Brexit, or a left-wing Labour government, at least some of those worries will now be dissipated. While it may be easier to extrapolate the recent trends, we believe the market might be under-pricing the possibility of a rebound through both of these channels.
3) Relative to expectations
Consensus fears the worst
So in trend terms, UK economic data have been deteriorating. But the data have also been weak relative to expectations. Given the narrative is for an extrapolation of the downward trend, we see good reason to believe that economic performance relative to expectations could revert
higher. Chart 7 shows the 3m change in HSBC’s UK economic activity surprise index. The index was falling at a very fast pace in Q4 2019, showing that data has been coming in worse than expected. But it is rare for such weakness relative to expectations to persist. Indeed, a bounce already appears to be occurring.
7. UK economic data has been surprising to the downside
Consensus expectations should be somewhat adaptive, so as data deteriorates, expectations fall as well. The risk now is that the consensus adapts to, or extrapolates, the recent data trend and looks for even worse data in the coming months. In that light, even a stabilisation in economic activity would end up being better than the expectations. The FX market should largely reflect what is expected at any given time and therefore any improvement in data relative to expectations would be GBP supportive.
An example of GBP already outperforming relative to expectations is the recent developments with the Bank of England. After disappointing (albeit pre-election) data, a rate cut by the BoE was c50% priced in for the January meeting. The BoE voted 7-2 to keep rates on hold, a decision which likely factored in the bounce in post-election data, and GBP rallied following the decision.
Conclusion – GBP has relative value
Einstein’s work on relativity built on that of Sir Isaac Newton’s around gravity. Newton said he could “calculate the motion of heavenly bodies, but not the madness of people.” In a sense, forecasting FX, which is often driven by irrational human behaviours rather than cast-iron economic relationships, can often feel even more difficult than predicting complex physical interactions. Where Einstein’s theories of relativity help with the latter, we hope our FX theory of relativity can help with understanding the confusing interactions of currencies.
The outlook for the UK economy may not be for a blast-off. Political uncertainty may not have been completely eclipsed. And the current trend of both data and surprises is clearly negative. But in our view, in the relative world of FX, all that is needed for GBP to rally is some kind of relative improvement, whether that is versus other economies, versus the prior trend or versus expectations. We think there is potential for the UK to outperform on all of these metrics as it moves into a more cyclical orbit. This suggests that there is plenty of room for GBP to rally in the coming months, especially as the currency has been a popular short for the last few years and remains some way below its long-term fair value range. We see GBP-USD moving to 1.45 this year with EUR-GBP dropping to 0.76.”
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