Investment Research FX Strategy - Danske Bank Research · comparable to UK, but the GDP trajectory...

Important disclosures and certifications are contained from page 4 of this report. https://research.danskebank.com

Investment Research

While a ‘no-deal’ Brexit scenario is not our main case, it most certainly could

happen – and it would have significant economic and financial implications. In

this piece, we share some broad reflections related to which path EUR/GBP could

follow and the duration of it, should the UK leave the EU without a deal.

In the event of no deal, the exact outcome of tariffs, economic performance,

political uncertainty and policy response (fiscal and monetary) will be the key to

the exact pricing of EUR/GBP. In this scenario, we target EUR/GBP close to but

below 1.0 (GBP/DKK above 7.50), staying there for 6-12M, followed by a slow

shift towards 0.85 (GBP/DKK around 8.76) in the following 1-2 years.

To assess the FX implications there are four key factors to forecast (our

expectation in parenthesis): A) the depth of an ensuing UK recession (shallow) B)

the size of spillovers to the euro area (low) C) the inflation shock (mild), and D)

quantifying the effect of tariffs and uncertainty into ‘overshooting’ versus our

macro-fundamental model (we use 5%).

In this paper, we discuss the consequences of a no-deal Brexit under a scenario where the

UK immediately crashes out of the EU with no transition period. Such a scenario is not our

main expectation but it is nonetheless possible. We seek to shed some light on a no-deal

event from the point of view of EUR/GBP as input for risk management discussions.

The paper is structured around the four key factors which enter our model to forecast

EUR/GBP. We start with a discussion on tariffs, and then move to forecasting EU and UK

GDP and inflation forecasts and the cross-country correlation and lastly we put these things

together to create a coherent path forecast for EUR/GBP.

Tariffs: take EUR/GBP 5-10% higher, but it is temporary

In our view, the imposition of tariff and non-tariff barriers between the UK and its largest

trading partner is truly of minor importance for GDP and CPI but the effect on EUR/GBP

is very much measurable.

The point of departure is the institutional (IMF, BoE) ‘disruptive’ no-deal scenarios. These

include an immediate reversion to WTO Most Favoured Nation (MFN – yes, the naming

seems ironical) trading rules vis-à-vis the EU, entailing a 4% increase in tariffs and a

gradual 14% increase in UK non-tariff trade barriers (in tariff equivalent terms) over

a three-year period, according to the IMF.

Based on our experience (chart 1) with US-China tariffs and USD/CNH, we anticipate an effect

on FX markets (beta) to the tune of 0.5-1.0. Taking into account the uncertainty of quantifying

non-tariff barriers and the beta itself, we would suggest that a 5% rise in EUR/GBP can be

justified on the basis of tariffs and tariff-equivalent barriers alone, with risk skewed toward

the upside – but the impact on broad consumer prices is much more uncertain from the current

historical perspective. The UK will also face a new tariff situation and need to respond against

non-EU countries, but the effects of this on EUR/GBP are likely to be much smaller.

17 September 2019

FX Strategy

What if: no-deal Brexit scenario for EUR/GBP

EUR/GBP, if no-deal

EUR/GBP:

Moves towards but below 1.0 and

stays there for 6-12 months.

Moves towards 0.85 in the

following 1-2 years

GBP/DKK:

Target close to but above 7.50.

Moves towards 8.76 in the

following years.

Chart 1. We know the effect from

tariffs to FX is nearly one-to-one

Note: Past performance is not a reliable indicator

of current or future results

Source: Macrobond Financial, Bloomberg

Senior Analyst, FX Strategy Lars Sparresø Merklin +45 45 13 85 18 [email protected]

Analyst Adam Lee Martin Schoolcraft +358 10 546 75 22 [email protected]

Senior Economist/Trading Desk Strategist Vladimir Miklashevsky +358 10 546 75 22 [email protected]

mailto:[email protected]

mailto:[email protected]

2 | 17 September 2019 https://research.danskebank.com

FX Strategy

Over time, the tariffs and non-tariff barriers are broadly expected to fade as deals get done

and the effect on the level of EUR/GBP should hence be temporary. This should provide a

positive driver for GBP strength, in the years after the deals are enacted.

Spillover and macro scenarios: IMF’s, BoE’s and our view

The big macro effects are in our view directly linked to the possible disruption of cross-

border flows of goods, services, capital and people in the immediate Brexit aftermath. The

IMF’s and BoE’s worst-case scenarios suggest that the UK economy will enter recession

immediately and that inflation will spike significantly.

The Bank of England expects (in the worst case) a peak-to-trough decline in GDP of 5.5

percentage points in absolute terms. The IMF projects a 3.5% reduction in GDP compared

to a baseline ‘orderly Brexit’ by 2021. Estimates by the BoE suggest inflation may peak as

high as 5.25% in 2020. By extension, the BoE easily makes the case that EUR/GBP will

go above 1.0. In our view, a very deep recession is not aligned with a surge in inflation

(conversely, a more shallow recession is consistent with a higher level of inflation, as is

our base case). In 2008, there was a huge contraction in GDP but a minor effect of falling

sterling on CPI. In 2016, after the Brexit vote and at a point where the economy worked

fairly well – GDP did fine but consumer price inflation went through the roof on the back

of falling sterling. In our view, the inflation impact appears business-cycle dependent.

Our expectation in a no-deal macro scenario is a mild recession and rising inflation

but in scenarios which combined are milder than the worst case of BoE and IMF.

Shock duration: expect a 12M slowdown, 1-2y to normalise

In terms of duration, we expect a 12-month slowdown and a normalisation period of

1-2 years after a no-deal as we look at recent stops in capital flow in emerging markets as

a guideline for no-deal Brexit. The inflation dynamics experienced in EM are probably not

comparable to UK, but the GDP trajectory should be rather the same as the shocks for

capital and trade flows are quite the similar.

In 2018, Turkey’s lira went into free fall on the back of a self-feeding inflation feedback

loop, policy failures, and geopolitical standoff versus the US. The economy went from

boom to bust in a matter of months, bottoming out in early 2019 - after one year (chart 2).

The construction sector was badly hit and the supply shock (imported and domestic

inflation) was partially mitigated by significant interest-rate hikes. Today, the economy

appears to have been bottoming out and, in line with fading inflation, the central bank has

been able to ease monetary policy somewhat and help growth. From the beginning of the

slowdown to the bottom of the recession, the duration was one year and it appears it will

take an additional 1-2 years for growth to come closer to the previously normal levels.

In 2014, Russia faced two sudden external shocks: a sharp fall in oil price and geopolitical

deterioration linked to the events in neighbouring Ukraine. A 60% oil price slide within

several months created massive pressure on the Russian economy and a massive fall in the

RUB. On the back of which came a severe spike in consumer prices. Overall, the Russian

economy contracted 2.5% y/y in 2015, before returning to tepid growth in 2016, and

accelerating in 2017-2018 (chart 3). Roughly the same time frame as with Turkey.

In light of the limited historical experiences, we suspect a no-deal implies that the UK

should expect a slowdown which will end in a recession which bottoms out 12 months

after the country’s formal departure from the EU.

Chart 2. Turkey in 2018: 1yr down, 1-

2yr to normalise


Chart 3. Russia in 2014: 1yr down, 1-

2yr to normalise



FX Strategy

Summary of model input: GDP, CPI, tariffs and spillover

To forecast EUR/GBP, our fundamental model takes our view on expected GDP and core

inflation as input and the model output is the exchange rate which historically has been

consistent with getting those macro outcomes. To arrive at our expectation, we add an ad-

hoc adjustment for tariffs as EUR/GBP would likely overshoot our model-implied forecast.

We expect normalisation in GDP growth, CPI and tariff levels after some years which

is also in line with the IMF’s and BoE’s worst-case forecasts. In the event of a ‘no deal’,

the resulting move in EUR/GBP would thus probably be temporary in nature.

There is uncertainty linked to thinking about how deep the ensuing recession would

be relative to Europe. We apply a small spillover coefficient, in line with the institutional

forecasts (see chart 4 and 5). With regards to expected GDP, we work with a baseline of

consensus expectations at -1% growth (i.e. half the downturn that we saw during the 2008

recession). The European GDP thus follows a less extreme UK scenario (chart 4). Turning

to inflation, we apply a correction for being in a state of recession and thus expect a

similar shock as in 2016 but milder than the official worst-case estimates.

What if: Brexit without a deal? EUR/GBP towards 1.00 and back

to 0.85 in 1-3 years

From these projected paths (see chart 6), the supply shock unfolds on a slightly larger scale

than what we saw in 2016. As illustrated in chart 7, our macro expectations are aligned

with EUR/GBP moving towards but staying below 1.0 and hovering there about 6-12

months. Following this and during, we expect EUR/GBP to start drifting down,

targeting 0.85 based on economic differentials over a period of 1-2 additional years.

What will happen in a no-deal scenario is obviously highly uncertain but we nonetheless

think the IMF and BoE have very negative worst-case scenarios and we have adjusted our

‘no deal’-view accordingly. The normalisation process in EUR/GBP may arrive faster if

fiscal policy becomes extremely expansive or if trade and tariff agreements are reached

quickly. Conversely, slower in the opposite situation. Our macro model is consistent with

EUR/GBP at 0.95 but we add a buffer for uncertainty about when/if/what will happen and

thus expect close to but below 1.0 as the initial reaction to no-deal.

Chart 7. EUR/GBP if no-deal: towards 1.00 and back to 0.85 in total of 1-3 years

Note: Past performance is not a reliable indicator of current or future results


Chart 4. Our expectation for consensus

GDP one year ahead, in case of no-deal –

mild UK recession and limited contagion


Chart 5. Our input to CPI in case of no-

deal: (minor) UK inflation shock


Chart 6. Relative paths of GDP and

inflation in case of no-deal: supply shock

Source: Macrobond Financial , Bloomberg


FX Strategy

Disclosures This research report has been prepared by Danske Bank A/S (‘Danske Bank’). The authors of this research report

are Lars Sparresø Merklin, Senior Analyst, Adam Lee Martin Schoolcraft, Analyst, and Vladimir Miklashevsky,

Senior Analyst.

Analyst certification

Each research analyst responsible for the content of this research report certifies that the views expressed in the

research report accurately reflect the research analyst’s personal view about the financial instruments and issuers

covered by the research report. Each responsible research analyst further certifies that no part of the compensation

of the research analyst was, is or will be, directly or indirectly, related to the specific recommendations expressed

in the research report.

Regulation

Danske Bank is authorised and subject to regulation by the Danish Financial Supervisory Authority and is subject

to the rules and regulation of the relevant regulators in all other jurisdictions where it conducts business. Danske

Bank is subject to limited regulation by the Financial Conduct Authority and the Prudential Regulation Authority

(UK). Details on the extent of the regulation by the Financial Conduct Authority and the Prudential Regulation

Authority are available from Danske Bank on request.

Danske Bank’s research reports are prepared in accordance with the recommendations of the Danish Securities

Dealers Association.

Conflicts of interest

Danske Bank has established procedures to prevent conflicts of interest and to ensure the provision of high-quality

research based on research objectivity and independence. These procedures are documented in Danske Bank’s

research policies. Employees within Danske Bank’s Research Departments have been instructed that any request

that might impair the objectivity and independence of research shall be referred to Research Management and the

Compliance Department. Danske Bank’s Research Departments are organised independently from, and do not

report to, other business areas within Danske Bank.

Research analysts are remunerated in part based on the overall profitability of Danske Bank, which includes

investment banking revenues, but do not receive bonuses or other remuneration linked to specific corporate finance

or debt capital transactions.

Financial models and/or methodology used in this research report

Calculations and presentations in this research report are based on standard econometric tools and methodology as

well as publicly available statistics for each individual security, issuer and/or country. Documentation can be

obtained from the authors on request.

Risk warning

Major risks connected with recommendations or opinions in this research report, including as sensitivity analysis

of relevant assumptions, are stated throughout the text.

Expected updates

None

Date of first publication

See the front page of this research report for the date of first publication.

General disclaimer This research report has been prepared by Danske Bank A/S. It is provided for informational purposes only and should

not be considered investment advice. It does not constitute or form part of, and shall under no circumstances be

considered as, an offer to sell or a solicitation of an offer to purchase or sell any relevant financial instruments (i.e.

financial instruments mentioned herein or other financial instruments of any issuer mentioned herein and/or options,

warrants, rights or other interests with respect to any such financial instruments) (‘Relevant Financial Instruments’).

The research report has been prepared independently and solely on the basis of publicly available information that

Danske Bank considers to be reliable. While reasonable care has been taken to ensure that its contents are not untrue

or misleading, no representation is made as to its accuracy or completeness and Danske Bank, its affiliates and

subsidiaries accept no liability whatsoever for any direct or consequential loss, including without limitation any

loss of profits, arising from reliance on this research report.

The opinions expressed herein are the opinions of the research analysts responsible for the research report and

reflect their judgement as of the date hereof. These opinions are subject to change and Danske Bank does not

undertake to notify any recipient of this research report of any such change nor of any other changes related to the

information provided herein.

This research report is not intended for, and may not be redistributed to, retail customers in the United Kingdom or

the United States.

This research report is protected by copyright and is intended solely for the designated addressee. It may not be

reproduced or distributed, in whole or in part, by any recipient for any purpose without Danske Bank’s prior written

consent.


FX Strategy

Disclaimer related to distribution in the United States This research report was created by Danske Bank A/S and is distributed in the United States by Danske Markets

Inc., a U.S. registered broker-dealer and subsidiary of Danske Bank A/A, pursuant to SEC Rule 15a-6 and related

interpretations issued by the U.S. Securities and Exchange Commission. The research report is intended for

distribution in the United States solely to ‘U.S. institutional investors’ as defined in SEC Rule 15a-6. Danske

Markets Inc. accepts responsibility for this research report in connection with distribution in the United States solely

to ‘U.S. institutional investors’.

Danske Bank is not subject to U.S. rules with regard to the preparation of research reports and the independence of

research analysts. In addition, the research analysts of Danske Bank who have prepared this research report are not

registered or qualified as research analysts with the NYSE or FINRA but satisfy the applicable requirements of a

non-U.S. jurisdiction.

Any U.S. investor recipient of this research report who wishes to purchase or sell any Relevant Financial Instrument

may do so only by contacting Danske Markets Inc. directly and should be aware that investing in non-U.S. financial

instruments may entail certain risks. Financial instruments of non-U.S. issuers may not be registered with the U.S.

Securities and Exchange Commission and may not be subject to the reporting and auditing standards of the U.S.

Securities and Exchange Commission.

Report completed: 16 September 2019, 17:14 CEST

Report first disseminated: 17 September 2019, 05:45 CEST

Investment Research FX Strategy - Danske Bank Research · comparable to UK, but the GDP trajectory...

Documents

Transcript of Investment Research FX Strategy - Danske Bank Research · comparable to UK, but the GDP trajectory...