March 2016 G10 Fundamental Commentary.

EURO ZONE — The euro zone recovery is expected to gain modest momentum, with real GDP growth rising to 1.7% in 2016 and 1.8% in 2017, up from 1.5% last year. Nevertheless, the region is not immune to the challenging global environment. After being one of last year’s global economic bright spots, the recent softening in key leading indicators, such as PMIs, consumer confidence and business sentiment surveys, suggests that the euro zone economy is succumbing to the slowdown in emerging markets and elevated financial market volatility. Indeed, euro zone growth has shown signs of moderation as households have pulled back on spending and weaker foreign demand has weighed on exports and industrial production. Meanwhile, domestic headwinds from the influx of refugees, heightened security amid terrorism concerns, new bank regulations, and the UK’s EU referendum present further downside risks to the regional outlook. The euro bloc has also slid back into deflation, with the headline HICP print declining to -0.2% y/y in February, from 0.3% in the prior month, largely due to lower oil prices. What is particularly alarming, however, is that core inflation has fallen to its lowest level in 10 months, at 0.7% y/y in February. Against this backdrop, the European Central Bank (ECB) is widely expected to unveil another round of monetary stimulus following the governing council’s next meeting on March 9th and 10th. The ECB will likely announce another cut to its deposit rate, currently at -0.3%, and step up its asset purchase program, which is presently set to run at €60bn per month until March 2017.
EUR has entered March with a considerable amount of bearish momentum, its late February decline providing for the formation of a bearish monthly shooting star doji candle. Fundamentals and interest rate differentials appear to have returned as the primary drivers for EUR, overpowering the supportive impact of risk aversion and position squaring that had dominated movement in EUR on a YTD basis. We look to further EUR weakness and hold a Q2 2016 forecast of 1.00.
UNITED KINGDOM — The UK economy is expected to maintain decent growth of around 2% this year, down from 2¼% in 2015. Growth in consumer spending is forecast to remain supportive, but will likely ease over the course of the year as real income gains slow on the back of gradually rising inflation. Some offset, however, could come from a pick-up in UK exports alongside an improving euro zone recovery and prospects of a weaker GBP boosting export competitiveness. Monetary policy will also remain highly supportive of growth as expectations for Bank of England (BoE) policy tightening continued to be pushed back. Given below target inflation and subdued wage gains, we believe that the timing of the first BoE rate hike is unlikely until at least May or August of 2017. The UK’s EU referendum will also likely generate increased uncertainty ahead of the June 23rd vote. UK Prime Minister David Cameron was able to secure a deal on the UK’s relationship with the EU at the February EU leaders’ summit. However, critics have argued that it falls short of what Cameron originally promised as concessions were made on migrant and welfare benefits. While opinion polls suggest that support for the “leave the EU” and “remain in the EU” camp have converged sharply in recent months, we maintain the view that the UK will ultimately vote to stay in the EU. Still the debate leading up to the referendum is expected to be quite negative, and uncertainty surrounding the outcome poses significant downside risks to the outlook. The biggest risk facing the UK economy is that a loss of consumer and business confidence could weigh on household spending as well as hiring and investment intentions.
GBP ended February at fresh multi-year lows, trading around crisis levels last observed in early 2009. GBP has been under a tremendous amount of pressure, its decline driven sentiment and uncertainty surrounding the June 23 referendum on EU membership. We look to further weakness and hold a Q2 2016 forecast of 1.3500.
JAPAN — Economic weakness remains firmly in place in Japan. The country’s real GDP growth returned to negative territory in the final quarter of 2015, as output declined by 0.4% q/q (+0.7% y/y) following a 0.3% (1.6% y/y) expansion in the prior three month period. The main factor behind the weak outcome was a struggling Japanese consumer. In 2015 as a whole, the economy grew by 0.5%. We have revised our real GDP growth forecasts for Japan downward and now expect the economy to expand by 0.7% in 2016 and 0.6% in 2017 (compared with the prior forecasts of 1.1% and 0.8%, respectively). The Bank of Japan will maintain an accommodative monetary policy in place for the foreseeable future and will likely consider additional stimulus measures to complement the existing policy program — Quantitative and Qualitative Monetary Easing with a Negative Interest Rate — which applies an interest rate of -0.1% to financial institutions’ deposits at the central bank. Persistent economic fragility will also put the implementation of the consumption tax rate hike (scheduled for April 2017) at risk. Headline inflation was 0% y/y in January, while core prices — excluding food and energy — increased by 0.7% y/y. We expect the headline rate to accelerate only slightly to 0.5% y/y by the end of this year.
JPY has consolidated its early February gains and has entered March at the upper end of its one year range. Its divergence to EUR has been notable, with a failure to weaken in response to the moderation in risk aversion through the latter half of February. Measures of sentiment are bullish with a four year high in the $5.9bn net long CFTC position as of February 23 and longer-term risk reversals suggesting steady demand for protection against JPY strength. We anticipate a fade in sentiment and refocus toward fundamentals. We hold a Q2 USDJPY forecast of 129.
SWEDEN — Sweden continues to be one of Europe’s top economic performers. Swedish real GDP growth beat expectations by advancing 4.5% y/y during the fourth quarter of 2015, which brings the country’s full-year growth rate to 3.8%. Output was driven by strong domestic demand, but also got a boost from the external sector. Private consumption has been buoyed by rising employment, highly accommodative monetary policy, muted inflation and a buoyant housing market. Meanwhile, low borrowing rates and rising business confidence has supported investment at a time when government spending has edged up and growth in exports has outpaced imports. CPI inflation also rose sharply in January to 0.8% y/y, up from 0.1% in the prior month. The stronger-than-expected growth and inflation data follow the Riksbank’s bolder-than-expected 15 basis point cut to benchmark interest rates on February 11th, bringing its key repurchase rate to -0.5%. While two out of the bank’s six executive board members objected to this decision, further monetary policy loosening remains a possibility this year. Indeed, the rise in inflation could prove short lived as it was partly due to temporary factors, while import prices could be weakened by the renewed appreciation of the krona. Looking ahead, Swedish real GDP growth is forecast to moderate to around 3% in 2016 as tax increases and tighter lending conditions weigh on household spending. Demand for exports will also likely ease on the back of less favourable conditions in key external markets, such as Germany and the UK. Inflation is expected to trend modestly higher to an average annual rate of ¾% in 2016 — still well below the Riksbank’s 2% target.
SEK has entered March at the mid-point of its YTD range vs. EUR, with a 2% gain from the short-lived panic lows seen in early February. We look to weakness in EURSEK on the back of relative central bank policy, however we acknowledge the upside risk inherent to short-lived periods of risk aversion that have been observed over the past few months. We hold a Q2 EURSEK forecast of 9.15.
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