Stormy Waters Ahead
Covid-19 jumped back to the forefront of investors’ mind this week as financial markets woke up to the possibility that current growth forecasts may be too optimistic given the spread of the more contagious delta variant, something we had flagged in these pages three weeks ago. Sentiment deteriorated at the beginning of the week, with the S&P 500 registering its largest fall in four months on Monday. On currency markets, the dollar benefitted from associated safe haven flows, while sterling came under pressure as markets questioned the wisdom of proceeding with ‘Freedom Day’ when new UK infections are running at 6-month highs. As a result, cable (GBP/USD) dipped to around $1.357, its lowest level since February, from $1.377 at the close on July 16.
Sentiment did recover over the course of the week, with cable pushing back up toward the $1.375 mark, but investor confidence remains fragile. Ultimately, the elevated growth forecasts that are underpinning current lofty asset valuations, particularly in the US, leave limited room for error and were largely based on the assumption that Covid would disappear over H221. They certainly do not account for the surge in cases we are now seeing across developed economies, which has not prompted a return to lockdown but remains a major headwind to activity nonetheless.
This was highlighted by data released last Friday in the UK, as the flash composite PMI, a closely watched measure of aggregate economic activity, dropped back to a four-month low of 57.7 from 61.7 and pointed to a sharp deceleration in growth. This backed up anecdotal reports from retailers, who warned of a major supply chain shock as the ‘pingdemic’ resulted in roughly 600k persons (or 1% of the UK population) being ordered to self-isolate in the week leading up to July 14. With the UK government so far refusing to move the date forward when those doubled jabbed no longer have to isolate if they are exposed to a positive case from its current August 16, indications are that these problems will not be resolved in the near-term.
The positive is that real-world data from the UK continue to suggest that vaccines work and that the link between infections and hospitalisations has been severely weakened. The week-on-week growth rate of new cases also turned negative on July 22 for the first time since mid-May, suggesting that the peak of the exit wave is in sight. Assuming the data continue to trend in the right direction and we don’t see the emergence of a vaccine resistant virus strain, a return to lockdown does not appear to be on the cards. Importantly consumer confidence data have also continued to improve, with the UK’s GfK sentiment index rising back to pre-pandemic levels in July. This suggests that when self-isolation requirements are eventually rolled back and the fourth wave subsides, there is potential for growth to accelerate again as households get to work running down their excess savings that are worth some 10% of GDP. As a result, we maintain our view that what we are seeing now is a delayed rather than a derailed recovery.
In terms of what this all implies for financial markets, we see scope for a modest dip in risk appetite in the coming months as the Covid-19 backdrop remains relatively downbeat, with infections in the eurozone and the US also now beginning to surge. This could see the dollar benefit from safe haven flows at times, while sterling may be at risk of further dips if the trend lower in new infections in the UK temporarily reverses as the impact from ‘Freedom Day’ comes through. Looking ahead, however, we expect that as it becomes clear that the current rise in cases represents an exit wave, in developing countries at least, sentiment will begin to rebound. We expect that this will see sterling return to its upward trend, with cable pushing back toward $1.42 and GBP/EUR to €1.20 over Q421.
The focus this week will be on the outcome of the Fed’s FOMC meeting on Wednesday evening, though we see scope for the meeting to be something of a non-event for the dollar. No changes to policy are expected, with Fed Chair Powell having guided in mid-July that the economic conditions do not yet justify the central bank tapering its asset purchase programme, despite confirming that June was the “talking about talking about tapering” meeting. Powell’s view appears to be shared by a majority of FOMC officials, though concerns over the outlook for price pressures are growing after inflation unexpectedly picked up to 5.4% y-o-y in June (f’cast 4.9%). In-line with consensus, we anticipate that the Fed will begin the tapering process in Q122, but we too are growing slightly uneasy about inflationary developments as housing and labour costs continue to push higher.
Away from monetary policy, the highlight of the US data calendar is the advance estimate of Q2 GDP. Output is projected to have picked up to 8.4% in annualised terms from 6.4% in Q1, as a relatively efficient vaccine rollout saw the US economy re-open over the course of the quarter. While we expect growth to come in strong, there is potential for a modest downside surprise given the fading boost from fiscal stimulus which was largely concentrated in Q1. A raft of other economic indicators, including the ISMs, the PMIs and retail sales, also suggested that growth began to lose some momentum in the second half of the quarter. Overall, the data may pose some downside to the dollar as a result, though GDP figures are typically not a significant mover for currency markets. Later in the week, the July print of core PCE (Fed’s preferred measure of inflation) is due, but as we already have CPI inflation data for the same month, dollar impact may be limited.
There is a very quiet schedule in the UK this week, with a speech by BoE speaker Gertjan Vlieghe the highlight. However, as he is leaving the central bank at the end of the summer, his comments should attract limited attention from a currency market perspective. Overall then, risk sentiment looks set to remain the primary driver of sterling, with UK Covid figures remaining in focus.
GDP figures for Q2 are also due in the eurozone this week, with a robust 1.5% q-o-q increase in output expected after the bloc entered a technical recession in Q420/Q121. Output will be boosted by re-opening effects as progress in vaccination campaigns allowed for the easing of Covid restrictions from mid-quarter after a period of rolling lockdowns from October 2020. Nationally, growth is expected to be strongest in Germany (+2.0%) and Spain (+2.2%), with both benefiting from base effects after contractions in Q1. Euro impact to the release is likely to be muted, given a strong rebound is priced in by this point, with markets instead focused on what the spread of the delta variant implies for the future trajectory of growth. The July reading of the German Ifo, a closely watched business confidence index, due Monday morning will offer a timelier update in this regard, with a strong print possibly offering modest support to the euro.
The other main highlight in the eurozone this week will be the release of flash HICP figures for July, which are expected to show that inflation picked up slightly to the ECB’s target of 2.0% y-o-y in the month from 1.9% in June. The driving force behind this increase will be a surge in the German national figure to 3.0% (June 2.1%) as a result of base effects associated with a reversal of a temporary VAT cut, in other words the rise will not reflect an increase in underlying price pressures. Indeed, consensus expects that the core inflation rate (ex-food & energy) will ease to just 0.7% y-o-y from 0.9%, though we see some scope for an upside surprise given the German tax change and on the back of supply chain disruptions that are pushing up costs for businesses. However, given the clear messaging from the ECB that it is not contemplating tightening policy in the near-term as labour market conditions remain inconsistent with a sustained rise in price pressures, an upside surprise may not lead to the emergence of significant euro strength.