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The stale nature of Brexit developments over the course of Q4 means it has been some time since our last GDP outlook.
In the latter stage of 2020, despite Covid-19 developments, the pound continued to trade based off no-deal Brexit risk as the clock wound down and negotiations stalled.
The dynamic only changed once a deal was finally struck between the EU and UK on December 24th, however, sterling didn’t exhibit a substantive relief rally once a deal was announced despite what many had expected. At the time, we argued the reasoning behind the muted response in sterling was due to the narrow nature of the trade deal, expectations of a trade deal being struck prior to Christmas resulting in markets pre-emptively pricing the reduction of no-deal risk, and the fragile nature of the UK economy at that time. While sterling actually sold off in the aftermath of the deal being announced, in a classic “buy the rumour sell the fact” way, GBPUSD still traded above the $1.35 handle.
Since then, the pound’s focus has returned to the UK’s macroeconomic outlook in light of new national lockdown measures…
Taking stock of the narrow trade deal between the EU and UK, the trajectory for the UK’s vaccine distribution, and our outlook for the UK and global economic recovery, we maintain our mildly bullish call for GBPUSD over the course of 2021 with the pair rising to 1.40 by year-end. The picture for the pound is much clearer amidst the backdrop of broad USD weakness, however, it is less clear-cut against the euro. With both the UK and eurozone economies subject to tight lockdown conditions at present, more aggressive vaccine distribution in the UK has resulted in GBPEUR rising above the 1.13 handle. However, our base case for EUR appreciation in 2021 sees the single currency outperform sterling against the dollar over the course of the year, leading us to believe the cross will trade back down to 1.10 by year-end. We have adjusted our front-end GBPUSD forecasts to reflect the recent pound rally, but maintain our structural view over the 12-month horizon, as outlined in our January forecasts.
GBP forecasts as per our February Reuters submission
The risks to this outlook for the pound are largely centered on the path of Covid-19 developments and thus the UK’s macroeconomic recovery. While we are inclined to agree with the government’s current reopening plans, which consist of schools returning on February 22nd and potentially looser lockdown conditions in March, this is highly dependent on vaccine distribution and the decline in new case counts continuing at current rates. With new strains of Covid-19 from Brazil and South Africa brings new questions for policymakers, especially given their increased transmissibility. The most notable being; are the current vaccines as effective against the new strain? This is arguably the biggest downside risk to the UK economic outlook in the short-run, and thus our GBP forecasts, as any reduction in the vaccine efficacy would only prolong economically damaging lockdown measures. Additional downside risks include the level of economic scarring as a result of lockdown measures and the tail risk of trade relations between the UK and EU deteriorating. While negative rates from the Bank of England may also be regarded as a downside risk, we view them as a stimulative aid to the economic recovery during the upswing. In an environment of low DM yields, we don’t necessarily view negative rates as a headwind for the pound, that is if the Bank will embark on them at all. Upside risks to the outlook include a faster reopening of the UK economy and an expansion of the current UK-EU trade deal to cover the access of the service sector. Meanwhile, the change in consumption patterns due to the pandemic pose an ambiguous risk at present. It is yet visible what consumers will do with regards to their level of savings built up over the lockdown period, but an aggressive release of pent up demand upon reopening would provide a substantial tailwind to the UK economy in the early stages of the recovery.
NARROW TRADE DEAL REMOVES NO-DEAL BREXIT RISK FROM GBP, BUT DOESN’T PROVIDE MUCH OF A TAILWIND FOR THE UK ECONOMY AND GBP BULLS
The announcement of the Trade and Cooperation Agreement (TCA) on December 24th ensured “zero tariffs and quotas on all goods that comply with the appropriate rules of origin” and removed the risk of a disruptive no-deal Brexit on January 1st. However, despite the TCA being a free trade agreement, trade is in fact less “free” than under the previous Single Market and Customs Union framework. Firstly, the limited nature of the trade deal automatically rules out access for services trade beyond the facilitation of short-term business trips and temporary secondments of highly skilled employees, stopping short of any mutual recognition of regulations or professional qualifications and passporting rights for financial services. With regards to the free trade in goods, even the European Commission highlights that “with the new agreement in place, businesses will face new trade barriers, leading to increased costs and requiring adjustments to integrated EU-UK supply chains”. These increased costs are due to the rules of origin clause, which states that roughly 55% of a good must be produced in the home country in order to qualify for preferential terms under the agreement (i.e. no tariffs), while all imports into the EU must now meet all EU standards and will be subject to regulatory checks. A one-year transitionary period will reduce some of the shock to integrated supply chain networks for businesses, but the new agreement places upwards pressure on UK businesses’ bottom line at a time when their balance sheets are already vulnerable due to the impact of Covid-19.
With this in mind, the limited reaction in the pound in response to the TCA announcement is understandable, especially after its rally in the week prior as it was well signalled to markets that a deal of this nature was expected ahead of Christmas. With the UK running a trade deficit with the EU on goods, but a surplus in services, the deal isn’t necessarily providing a tailwind to the UK economic recovery. Instead, it is merely reducing the potential disruption that would have ensued in the event of a no-deal exit. This was eloquently summarised by former Prime Minister Theresa May when she said “we have a deal in trade that benefits the EU, but not a deal in services that would have benefited the UK”. While both sides are aiming to agree a “memorandum of understanding” by March on regulatory cooperation, this doesn’t necessarily imply Brussels will grant equivalence rulings on regulations in order to allow the passporting of financial services. For now, until services access has been granted, sterling’s focus on Brexit has passed, with the deal in itself providing little upside to the UK economic outlook apart from a minor boost as businesses gain eventual clarity.
However, while we expect Brexit to slip into the rear-view mirror for GBP, risks of a unilateral departure from the terms of the TCA could bring the prospect of tariffs being levied and thus the start of increased trade tensions between the EU and UK.
Inside the TCA is a clause that allows the UK to deviate from the terms of the level playing field (EU rules on environment, labour, taxation, and subsidies), but it is notable that this would come at the cost of losing some TCA benefits. Additionally, there is a 4 year review period of this section of the TCA, which could result in the free trade agreement being ripped up should tensions deteriorate substantially. However, we view the above as a theoretical risk but not one that will provide any economic benefits in practice and is therefore unlikely to materialise.
AGGRESSIVE VACCINE DISTRIBUTION SHOULD SEE THE UK ECONOMY REOPEN SOMEWHAT IN MARCH
With Brexit now wrapped up until March when the services memorandum comes into scope, sterling’s focus remains fixed to the UK economic outlook, which in itself is at the mercy of Covid-19 and the effectiveness of the government’s vaccine distribution plan. Despite the government’s attempts to control the outbreak of a new more transmissible strain via tiered measures as recently as December, the rise in case count placed intense pressure on the nation’s healthcare system. This resulted in the government announcing a national lockdown in England, with devolved nations following suit. The national lockdown measures include the closure of restaurants, shops and schools, with no household mixing allowed. While many of the measures were in place for a large part of Q4, the closure of schools was a new measure implemented in the latest restrictions. The government prepares to review the current guidelines in March, and plans to have the top four priority groups, which equates to around 15 million people, vaccinated by February. This would allow for the reopening of schools on February 22nd, which is the current priority, while the reopening of non-essential retail and hospitality will likely follow in the months thereafter. We expect a return to tier 3 restrictions in mid-March, when the most vulnerable part of the population has been vaccinated, while we expect the broader reopening of the hospitality and service sector to follow in April.
Lockdowns have proven effective in lowering hospitalisation rates, meaning an easing of pressure on the NHS before schools are scheduled to open in late February is likely
Earlier, full lockdowns in Q2 and November 2020 were followed by a reduction in new daily cases. Growth in new cases has been an indicator of the change hospitalisation rates in previous lockdowns, with the levels of hospital cases falling just weeks after the daily infections decreased as well. January saw a fresh peak in new cases recorded when the new strain was discovered, after which the government reimposed stringent lockdown measures. These measures have proven effective in lowering new cases by over 2,500 a day thus far. Given the dramatic reduction in new cases, the pressure on the UK health sector should ease in the coming weeks. Coupled with increased vaccinations, the current trajectory of the third wave means the government’s aim to reopen schools on February 22nd is plausible, with further loosening likely to follow in March.
Current vaccinations rate means government is on track to reopen schools in late February
Upside risks to the outlook remain as the vaccination process may be more aggressive than the government’s initial plans, while there are clear downside risks to the outlook as well. Even though cases may be falling dramatically, hospitalisations may fail to follow the trend in parallel manner, largely due to the higher transmission rate of new variants, while issues with vaccine supply may also occur. Pfizer confirmed in mid-January that estimated volumes of vaccine deliveries “may need to be adjusted” as part of efforts to deliver more doses meant extra regulatory approvals were required. For now, this means there would be a temporary impact to shipments in late January and early February, but Pfizer stated there would be a significant increase in doses available for patients in late February and March. Therefore, the medium- and-longer-term outlook should remain unchanged. The UK relies less on the Pfizer vaccines than other European countries, as the UK also purchased 105m of Oxford AstraZeneca and Moderna vaccines, while the EU focused its main purchases around Pfizer.
This could cause divergences in the vaccine distribution between the EU and UK, meaning the UK may reopen on a stronger footing and earlier than EU nations.
Similar supply disruptions from other suppliers could still weigh on the UK’s recovery throughout the vaccination plan. The largest downside risk, however, is reduced vaccine efficacy against new Covid-19 strains, causing lockdown measures to remain in play for longer. Given the reduction in cases and the trajectory in vaccinations, a gradual reopening from February/March seems like a feasible target at present.
BUSINESSES COPING MUCH BETTER WITH LOCKDOWN MEASURES BUT DOUBLE DIP RECESSION STILL AN INEVITABILITY
“Probably the impact of lockdowns in economic terms is diminishing somewhat” said Bank of England Governor Andrew Bailey on a webinar on January 20th. These comments won’t have come as a surprise to anyone who read the November GDP report, which highlighted the improved adaptation of UK businesses to lockdown conditions relative to spring 2020. During the last one-month national lockdown in November, the UK economy shrank some 2.6% MoM. While this sounds dramatic, it is a stark improvement from the economic hit the initial lockdown in Q2 2020 presented and surprised expectations to the upside by a whole two percentage points. In contrast to spring 2020, the November lockdown saw manufacturing and construction firms remain open, while retailers also showed greater adaptation to the new business conditions with increased deliveries and click-and-collect services. This ensured that output in the distribution sector was only 5% below its pre-Covid peak. Meanwhile, takeaway services limited the output shortfall in the accommodation and food service sector to 63% from its pre-Covid peak, a vast improvement from April’s 90% decline.
While this shows positive signs as the economy is adapting to tougher lockdown restrictions, the 2021 Q1 GDP print is still expected to make for ugly reading. Firstly, the shutting of schools in this latest national lockdown will weigh even more on GDP relative to November, while mobility and transport usage data points to more people staying at home this time around. With no-deal Brexit concerns likely resulting in production orders being moved forward to December 2020, we expect a soft January GDP reading and Q1 growth to confirm that the UK experienced a double dip recession. This is evident in the latest Bloomberg survey of economists, where most forecasters downgraded their 2021 growth projections to reflect the deterioration in the near-term outlook.
Bloomberg UK GDP surveys show economists downgrading 2021 growth expectations in response to January lockdown, offset by an equal increase in 2022
While current economic conditions remain fragile, it isn’t all doom and gloom. Upon reopening, the health of household finances could create a consumption windfall for the UK economic recovery. Along with a quicker distribution of vaccines, this dynamic poses upside risks to the above economic forecasts, especially considering the vast majority of savings have been placed in liquid deposit accounts – around £91bn of excess deposits is estimated to be in the UK financial system at present. While in other economies, central bankers have been reluctant to factor in the release of pent up demand into their forecasts, the UK consumer has always astonished in their ability to spend regardless of economic conditions. This means the upward surprise to the UK economic recovery is a meaningful risk, one that could extend sterling’s rally above the $1.40 level should data prove more positive than current expectations suggest.
BANK OF ENGLAND TO STICK WITH QE DURING THE RECESSION, WITH NEGATIVE RATES RESERVED FOR RECOVERY PHASE IF AT ALL
With the current lockdown measures and the risk to the economic recovery in mind, speculation that the Bank of England will embark on negative rates has risen. While we previously took the view that the Bank would only embark on negative interest rates in the event of a no-deal Brexit, the impact the latest national lockdown has had on the UK economy means that negative rates remain a viable option at present. However, we don’t see the Bank implementing such a policy in the near-term. What has been consistent from Bank of England communications is that negative interest rates have the most effective transmission to the real economy during economic upswings. This is due to banks’ balance sheets being more secure, meaning they won’t be constrained by capital ratios when passing on the effects of negative interest rates to the economy in the form of lower lending rates. Additionally, during the economic upswing, the positive impact of improved domestic growth conditions offsets some of the impact negative interest rates has on bank profitability – banks issue more loans in times of strong economic growth while delinquencies fall, improving revenue streams at a time when costs rise due to negative rates.
Thus far, the Bank of England hasn’t provided markets with any explicit forward guidance on the viability of negative rates as it continues to hold consultations with financial institutions. The results of the consultations are expected to be released at February’s MPC meeting, where markets may be given a bit more clarity on the operational feasibility of such a policy.
Despite Governor Bailey’s comments about negative rates having “lots of issues” in early January, markets are still adamant that they are a realistic tool in the BoE’s toolkit.
We are inclined to agree, however, they are a tool that will only be implemented should the economic recovery prove sluggish and the level of economic scarring from the pandemic be substantial. In the interim, the Bank of England is likely to focus on the early arrival of vaccines as a reason to maintain its current policy stance despite the near-term economic headwinds. However, any additional economic shock in the coming twelve months or a more protracted economic recovery than initially expected is likely to lead the BoE to implement negative rates to provide a steroid injection to a weak economy.
Overnight Index Swaps (OIS) imply an increasing probability of negative rates by the Bank of England due to the implementation of national lockdown measures in January
It isn’t just economic conditions that we believe is holding back the Bank of England from implementing negative rates in the short-term. Even if uncertainty around the economic outlook clears and the recovery is deemed to be more sluggish than expected, the Bank of England will have to give financial institutions time to implement systems capable of processing negative rates. This should delay their implementation by at least a quarter, pushing the timeline back even further.
We therefore agree with current market pricing; negative interest rates from the Bank of England are unlikely before Q4.
However, we argue that the threshold for them being implemented in the first place is quite high. Even then, the implementation of negative interest rates is unlikely to be a substantive headwind for the pound, especially if it is coupled with commitments that it will be a short-term policy. In this scenario, given the environment of depressed DM yields, FX markets are likely to focus on the stimulative impact of negative rates on growth as opposed to the reduce carry appeal.
Authors:
Simon Harvey, Senior FX Market Analyst
Olivia Alvarez Mendez, FX Market Analyst
Ima Sammani, FX Market Analyst