In Brief

• Despite the challenges posed by the northern hemisphere winter amid rising Covid- 19 cases, we believe the rollout of a vaccine is likely to have the greatest influence on financial markets in the first quarter of 2021 as the growth outlook for the year is set to recover sharply.
  
  
• Periods of growth recovery are historically associated with a weaker US dollar, particularly vs. cyclical and emerging market currencies (EMFX). With favourable valuations, flows into EMFX could be significant.
  
  
• Deteriorating structural support for the US dollar reinforces our view that the historical pattern of dollar weakness will be repeated in 2021, though not sufficient in itself to justify significant dollar underperformance.
  
  
• The greatest risks to our outlook are medical in nature. Any adverse vaccine developments or viral mutation that prevents a successful widespread vaccination programme would be significantly negative for financial markets due to the more limited space for additional monetary and fiscal support.
  
  

Vaccines spark hopes for sharp growth rebound

Economic growth has been exceptionally depressed in 2020 as a result of the COVID-19 pandemic and the resulting lockdowns. Several metrics, such as virus case counts and mobility tracking data, have taken over from typical economic data releases and continue to be highly correlated to growth outcomes around the world. The signal from these measures is rather concerning at present as economies in the northern hemisphere look set for a challenging winter. However, we view the recent announcements of successful vaccine trials as a game changer for the outlook for 2021.

Fiscal and monetary policy are highly supportive of growth and are set to be maintained even when growth recovers due to the size of output gaps. We see scope for a significant rebound in growth in 2021, with pent up demand for services such as leisure and tourism and a less confrontational geopolitical backdrop under a Biden administration that should pose less of a drag on global trade.

Periods of strong and improving global growth are historically associated with a weaker US dollar, along with weaker trade-weighted exchange rates for other reserve currencies, such as the Japanese yen and the euro. Currencies of commodity exporting countries, small open economies and emerging market countries tend to outperform.

Exhibit 1: The growth outlook for 2021 should be an important driver of currency performance

Source: J.P. Morgan Asset Management, Bloomberg. Data as at November 2020
* Regression period 2000-2020, REER vs PMI. EUR negative correlation likely to negative as a result of peripheral European crisis impact on growth, CNH likely too negative given historical peg to the USD

Starting valuations in EMFX appear particularly favourable, with Latin American currencies, the Turkish lira, the South African rand and the Russian rouble close to decade lows in real effective exchange rate terms. Strong commodity prices are typically one of the key factors supporting higher beta currencies. Global demand for housing and autos have recovered very sharply and, along with high levels of infrastructure investment in China, look set to provide ongoing support for currencies of commodity exporting countries. Given investor allocations to emerging market local currency assets have been fairly limited in recent years, we see scope for financial flows to align with trade flows in support of emerging market currencies.

The greatest area of pent-up demand that could be released with a successful vaccine rollout is international tourism, where activity remains close to zero. Beyond the potential to directly support currencies of countries such as Thailand, Turkey and New Zealand, we see indirect support for energy producer currencies, such as the Russian rouble. Rebounding demand for travel could reverse one of the largest hits to fuel demand in 2020, and while OPEC production quota changes may reduce gains in energy prices, rising volumes of exports would still provide additional revenues to producer countries.

Exhibit 2: Extent of undervaluation of “cheapest” currencies looks quite extreme relative to the recent USD trend

Source: J.P. Morgan Asset Management, Bloomberg; data as of November 2020. REER = real effective exchange rate.

A deteriorating fundamental backdrop for the US dollar creates an environment that should be supportive for the outperformance of cyclical currencies. Non-US dollar reserve currencies, such as the euro, also typically appreciate against the US dollar in environments of strengthening global growth. However, we anticipate a more nuanced outlook for these currencies. There are certainly signs that the US current account is starting to worsen more broadly, following years of stability in the face of more significant overvaluation as the secular rise in the US energy sector offsets rising consumer imports.

The worsening US fiscal position is likely to compound this decline in the current account as broad measures of net savings in the US move into deficit, placing more structural downward pressure on the US dollar. However, the cyclical recovery in the US has been more dynamic than its developed market peers and this had lent support to the US dollar via relative equity market flows. However, there are now some signs of a rotation in sector and factor performance. Should we see an increase in flows to value sectors and markets, such as Europe, then the dollar could fall more sharply, but so far our tracking of cross-border equity flows shows little movement.

Exhibit 3: The US current account balance deteriorated sharply in Q220 and the US trade deficit widened further in Q320

Source: J.P. Morgan Asset Management, Bloomberg; data as of November 2020.

Low yields have weighed on the dollar and supported risk asset pricing throughout the second half of 2020. We expect this dynamic to persist even as the outlook brightens in 2021 due to the new average inflation targeting regime adopted by the Federal Reserve, given large output gaps should remain a disinflationary force. There is some risk that higher year-over- year headline inflation towards the end of the first quarter, as a result of comparisons to the height of the lockdown period, could sow some doubt in the market, but we believe central banks are likely to assuage market fears while unemployment levels remain well above pre-Covid norms.

The greatest risks to our outlook are medical in nature. Any adverse vaccine developments or viral mutation that prevents a successful widespread vaccination programme would be significantly negative for financial markets due to the more limited space for additional monetary and fiscal support.

We are also aware that many of the key parts of our outlook are widely shared by other market participants. This may result in increased volatility around the recovery trend, but ultimately we expect the strength of the recovery in 2021 to be the predominant driver of currency markets.

The manager seeks to achieve its objectives, there is no guarantee they will be met. Risk management does not imply elimination of risks.

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