The powerful but temporary correction from late Q2 to early Q3 that we warned of in the Q2 editions of Macro Strategy Views appears to be taking place, albeit later than we envisaged. We took this view at the time because of an alarmingly similar fundamental backdrop in early H1-2008 and H1-2011, including soaring food and energy prices, broad US dollar (USD) weakness and a hawkish European Central Bank (ECB). More generally, global asset markets were being inflated by excessive credit and liquidity – in the first case by the credit market, and in the second case by the Federal Reserves QE2 programme, which ended on 30 June 2011. In both cases, once the source of global excess liquidity was removed, the underlying weakness of the global economy was displayed for all to see.
In H2-2008, the massive implosion in the credit markets and the contraction in bank lending across the US and Europe helped to trigger a global recession. For H2-2011, we see good news and bad news; the bad news first. Unlike in H2-2008, G4 – US, euro-area, UK and Japanese – policy makers have few policy levers left to avert renewed recession. In Q4-2008, it has been argued that China saved the world with massive fiscal easing. This time, China could still enact fiscal easing to support growth. However, with CPI inflation at 6.5% y/y, the policy bias is still towards tempering inflation (though we expect this to change sooner rather than later).
More positively, we do not expect the global economy to tip back into recession. To be sure, there are risks aplenty. Moreover, the collapse in equity-market sentiment could yet weigh on real economic activity. However, our base case is a muddle-through economy rather than a recession, for three reasons. First, G4 bank lending, while improving, has remained anaemic compared to pre-global financial crisis levels. As such, there is little room for a sharp contraction in bank lending. Second, the trend in economic data in the US and Japan in particular has been improving. Third, Asia ex-Japan (AXJ) remains a strong source of support for global final demand.
There are similarities between H2-2008 and H2-2011, but there are also major differences. First, as the S&P downgrade of the US reflects, the USD is less of a safe haven than it was in 2008, so one should expect it to be less of a beneficiary of „risk-off moves. Second, EM local bond markets have benefited from a structural reallocation away from G3. The AXJ has seen part of this reallocation, which has in turn changed the flow dynamics for IDR, KRW, SGD and MYR in favour of bonds. Third, FX and equity vols remain well short of 2008 levels.
Given the state of the cycle, with banks continuing to revise down growth estimates, AXJ currencies may remain choppy near-term. In this context, market positioning may play a part, with the likes of the CNY, KRW and IDR underperforming given heavy market positioning. However, the THB and PHP should do better, in our view, due to lighter positioning. Moreover, the SGD is likely to benefit from accelerated reallocation away from the USD in the wake of the US downgrade.
Overall, from late Q3, we expect sovereign debt issues in the US and euro area to lead to accelerated diversification from DM to EM. Within this, AXJ and some Latin American currencies should benefit on stronger fundamentals. Liquidation has been evident in Latam currencies, with the Brazilian real (BRL) and Mexican peso (MXN) down 4.16% and 5.00% in August. Given Mexicos particularly strong ties to the weak US economy, we expect the MXN to underperform. The BRL has also been hit, but Brazil's more closed economy provides more fundamental medium-term support for the currency relative to the MXN.