Macro Analysis: UK, US & China

By Grisham Bhatia, Abisha Bastian, Dias Kazymov and Adam Hearnden from the LSESU Trading Society

UK economy:

The UK economy has experienced significant shock since the beginning of the Covid-19

pandemic. After falling by 20.4% during Quarter 2, 2020, the economy is in a technical recession. In order to combat the economic damage caused by Covid-19, Bank of England has strongly relied upon quantitative easing to stimulate the UK economy. Last week, the BoE announced an extra £100bn of purchases on top of the £300bn announced a few months ago. However, there now exist concerns about the ability of the BoE to purchase more bonds in the future. Following the latest round of purchases last week, the BoE now owns 44% of the outstanding government bonds. This is approximately double the proportion of the Federal Reserve’s ownership of US Treasuries. As a result of running out of room with quantitative easing, the BoE is being forced to explore other strategies such as the implementation of negative interest rates to incentivise spending and consumption. Interest rates have already been reduced to 0.1% this year and markets are currently pricing in a decline in interest rate to 0.05% - or potentially a negative interest rate - by the middle of 2021. In addition to tackling the Covid-19 pandemic, the UK government is also fixated upon securing a Brexit deal with the EU before 31st December 2020. However, there exist growing concerns in Brussels at the lack of progress being made. The major outstanding issues remain the mechanism in the final treaty for resolving future disputes, the level of access to UK waters provided to EU fishing fleets, and fair competition rules for business - including rules for domestic subsidies. With only a month left for the transition period to end, Boris Johnson and the rest of the government is now well prepared for the final-stage talks to fail and leave the EU without a deal.

With the Covid pandemic and Brexit talks occurring at the same time, the UK economy is currently in a vulnerable position. More specifically, it is crucial to focus upon the GBP in relation to these ongoing events. Though quantitative easing helps stimulate the economy, it does so at the expense of increasing money supply and thereby reducing the value of the currency. Shortly after the fresh round of quantitative easing was announced last week, the pound edged around 0.1% lower against the US dollar. The occurrence of a similar pattern is also visible after the BoE announced its first round of quantitative easing on March 15th, 2020, to negate the economic impacts of Covid-19. Soon after this decision was implemented, the GBP slid in value against the USD from 1.31 to 1.15. Since quantitative easing still remains as a viable strategy for the BoE in 2021, the pound can be expected to depreciate further. Along with quantitative easing, a further cut in interest rates - and potentially negative interest rates - is yet another option being currently explored by the BoE. A reduction in interest rates can reduce the demand for GBP amongst foreign investors and thereby reduce its value relative to other currencies too. Finally, the risk of Brexit occurring without an official deal might create an atmosphere of financial and business uncertainty. The lack of clarity regarding a series of decisions might make retail and institutional averse to investing in the UK until all the impacts of Brexit are understood. Such an adverse attitude may further depreciate the value of pound due to lack of demand for it.

Consequences of the US election:

With the declaration from major news sources that a Biden victory is imminent, this has the potential to have several key consequences for the markets. From a policy perspective, Biden has proposed a $2 billion investment into both infrastructure and ‘green energy’, with a key element of his economic policy is transitioning away from a previous reliance on oil and natural gas. Biden proposes, on day 1, to enact ‘aggressive methane pollution limits’ and to develop a rigorous new fuel economy standards which aim for all new sales of zero-emissions for heavy-duty vehicles. Although his rhetoric of placing the US on an ‘irreversible path to achieve economy-wide net-zero emissions by 2050’ may be an exaggeration of the feasibility of his policies, it signals his intent to boost the clean energy sector and correspondingly harm the oil industry. In the short-term, many economists such as James Williams, chief of WTRG economics, have noted that Biden is more likely to impose more business shutdowns. With US coronavirus cases constantly rising and have reached over 100,000 for a number of days now, the possibility of a temporary lockdown is becoming more apparent. This will lower fuel consumption and hence lead to downward prices as there is less demand present. Hence, we would recommend to short oil futures in the short-term. The industry is facing an increasingly uncertain couple of months with both an unclear strategy for the pandemic and worries surrounding Biden’s potential plans which do not look promising. Furthermore, Biden may in fact re-enact the Iran nuclear deal which would place increasing pressure on oil prices as Iranian oil would now be back on the market.

It is also important to note the implications of a Republican senate which will limit the extent of change that Biden can implement. Credit Suisse noted that this will only lead to a stimulus of $500 billion which is far below what Democrats were hoping to spend. However, the key factor determining the long-term strategy for the USA markets is the country’s robust economic recovery. In October, the US unemployment rate fell to 6.9% (from 7.9% in September and as much as 10.2% in the middle of summer), showing quite a confident recovery in the American Labour market. US GDP grew by 33% in the 3rd quarter while forecasts for the 2021 economic growth are somewhere around 5-6%, as of now. Although a larger fiscal stimulus would have facilitated the pace of economic recovery, these macroeconomic indicators show a relatively good and stable performance of the US economy. Lower economic volatility and positive signs of robust economic recovery, in turn, encourage investors to engage in more stable long-term strategies, which generate returns over a longer period of time. As Ashok Varadhan (Global Co-Head of Goldman Sachs’ Global Markets Division) put it, ‘investors now want to engage in strategies where, if the world, 6 months from now, looks not too different from the forecasts, they will generate returns.’ Ashok Varadhan also outlined traders going back into the bond asset class because the government’s funding sources of the economic growth are less likely to come from bonds, thus incentivising traders to invest in bonds. Hence, we propose that investors should consider US treasury 10-year bonds. With a lower stimulus, the US is likely to keep lower interest rates to facilitate increased investment into the economy. This means that investors are likely to seek US treasury bonds in the short-term as a way of maximising their return (in comparison to traditional saving accounts, for example) which will drive the price of bonds up.

Chinese market:

China is the only large economy expected to show a positive advance in GDP this year, with the IMF projecting growth of 1.9% for 2020. Yet with continuing trade frictions between the USA and China, the USA is not expected to benefit from China’s expansion. China is also forecast to grow 8.2% next year so It would be advisable to take a long position on Chinese ETFs. One which may be of interest is the Singapore-listed pure Chinese government bond ETF, by CSOP Asset Management, that has attracted over US$1bn in assets and has seen continuous capital inflow since last March.

The renminbi (CNY) has been one of the most sensitive to the US election results, which in recent weeks has been boosted by hopes of a Biden victory and a potential easing of tensions between Beijing and Washington. However President Trump will remain in office for 70 more days, so over this time he may be motivated to make final changes to his trade policy with China, so the exchange is likely to be very volatile over this period. To hedge against this volatility in a long position on CNY/USD, a long position could also be taken on CNY/JPY as Japan is China’s second-largest trading partner by value, a fall in trade with the US as a result of currency appreciation could lead to more exports to Japan, which would likely lead to an appreciation in the renminbi against the Japanese Yen.

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