Trade Insight April 2015

Currency volatility on the rise | EUR-USD heads for parity while equities climb

 

Executive Summary

 

Delta Economics’ Trade Corridor Index Assets (TCI-A) analysis for April suggests the following:

  • There will be continued optimism about European recovery in particular as the Purchasing Managers’ Indices rise.
  • The optimism in European growth will not boost the value of the euro. Quantitative Easing (QE) is already putting downward pressure on the euro which, combined with the political and financial consequences of Greece’s debt repayments, is pushing the value of the euro down further versus the US dollar.
  • As a result, the TCI-A is suggesting short positions on EURUSD. We expect the bearish trend to continue through the month and although there could be some resistance around €1.05:$1 in the middle of the month, the model suggests it could go as low as $1.01 by the end of the month with parity likely during May.
  • Meanwhile, we are bullish on the Dax and Eurostox 50, which are attracting capital inflows as a result of QE.
  • In the run-up to the general election in the UK we are expecting the value of sterling to fall against the US dollar. If Industrial Production results in the UK are weak, then we expect this to increase volatility in the value of sterling. This volatility is likely to continue as the general election nears as investors weigh up the business consequences of a Labour government versus the uncertainties of a referendum on European membership with a Conservative government.
  • The long positions we are taking on Asian equities reflect the fact that QE in Europe has increased capital availability and weakened the value of the euro.

 


Outlook for PMIs April 2015

 

The Trade Corridor Indices (TCIs) measure the trade flows of any one country and forecasts these forward using its proprietorial forecasting methodology. Each index is specific to the country it relates to in that the trade corridors and flows will differ for each country. The rate of change in the index is correlated with the Purchasing Managers’ Index (PMI) for that country.

The TCIs are based on actual data and although they are highly correlated are in no sense an alternative to the PMIs since the methodologies differ. PMIs, being survey-based, are sentiment indicators while the TCIs give an actual and a forecast indication of how underlying trade conditions, including trade finance, are moving. In other words, the TCIs provide a predictable and quantifiable view of how changes in the global economy are affecting trade at an individual country level. They are constructed as follows:

  • The correlation of a country’s top 500 trade corridors with that country’s Manufacturing PMI to create a trade corridor index associated with the PMIs/sentiment (TCI-S).
  • Correlation of the rate of change in that index (six-month moving average) with the Manufacturing PMI.
  • The monthly change in the six-month moving average (positive change suggests PMIs will improve while negative suggests they will deteriorate).

The full PMIs are expected to move generally in line with the Flash PMIs and consensus in April 2015. Overall, only very small movements in the PMIs are predicted, either by us or by the market. The PMI data has ceased to move markets substantially and the very similar results each month suggest that there will be little market volatility around these indicators this month.

 

Key points:

  • We are generally optimistic and in line with consensus about Europe’s PMIs. We are substantially more positive about French services than consensus, but the correlation is low so there is a high downside risk on this.
  • We are expecting a mild increase in the US Manufacturing PMI while consensus is predicting a mild downturn. However, the spread is very small between the two and, as this is an estimation of a survey, this could be within an error margin.Trade Corridor Index Asset Price Calls

2015-04-14_tradeInsight_fig01_v01

 

Figure 1 | PMI Outlook, April 2015
Source | Delta Economics analysis

 


Trade Corridor Index Asset Price Calls

 

Methodology

The Delta Economics TCI-based asset management strategy takes the top 500 trade corridors (trade between two countries by sector) against an asset price. It creates an optimum corridor index of those trade corridors each month and has been tracking its performance over the past 21 months. This is a systematic model and assets are included in the portfolio if one of the following conditions is met:

  • The signal strength (which measures the percentage of trade corridors that are pointing to a long or short call) must be higher than 95%.
  • The signal strength is greater than 85% and the Information Ratio (which measures the performance of that optimum corridor relative to benchmark returns) is greater than 0.5, indicating good or very good back-tested performance.
  • Where there is a signal strength of 100 and only one corridor in the index, the Information Ratio must be above 0.5.

The returns across the portfolio reflect the accuracy of the calls only. They are not optimised in any way, do not include transaction costs and are based on an equally-weighted portfolio across the asset calls that conform to the conditions above. There is no leveraging.

Key point | In March 2015 these paper returns were 1.9% suggesting that over the past 21 months, we have called the assets in a way that potentially produces an above-market performance of 1.4% per month.

 

2015-04-14_tradeInsight_fig02_v01

 

Figure 2 | Monthly Returns of TCI-A strategy (%) June 2013 – April 2015
Source | Delta Economics analysis


Commodities

We are calling metals long this month but our signal strengths and Information Ratios have deteriorated since February. This reflects continuing volatility in commodity prices; the price of oil, for example, is being influenced by uncertainties in the Middle East which, if they continue, could put strong upward pressure on prices.

 

2015-04-14_tradeInsight_fig03_v01

 

Figure 3 | Delta Economics TCI-A Based Strategy, Commodity Calls for April 2015
Source | Delta Economics analysis

 


Equities

QE in Europe and Japan alongside continuing uncertainty around any rate rise means that equity markets are likely to continue their bull run. Information Ratios continue to be weak suggesting that there is real volatility in the market, while the signal strengths on global (European and US) equities are much stronger than they are on EM equities. This is a product of capital movements into Europe post QE and continuing concerns about the depth of any Chinese slowdown. Of the Asia-Pacific markets the ASX 200 and BSE look to be the strongest performers in April.

 

2015-04-14_tradeInsight_fig04_v01

 

Figure 4 | Delta Economics TCI-A Based Strategy, Equity Calls for April 2015
Source | Delta Economics

 


Currencies

We return to a bearish stance on the euro versus USD for April and overall our calls suggest that the strength of the US dollar versus most currencies is likely to continue. The only exception is our bullish stance on the AUD which is based on a reasonable signal strength and strong Information Ratio.

 

2015-04-14_tradeInsight_fig05_v01

 

Figure 5 | Delta Economics TCI-A Based Strategy, Currency Calls for April 2015
Source | Delta Economics

 

Delta Economics Trade Insight April 2015  |  Author  |  Rebecca Harding  |  CEO Delta Economics


 tradeInsight_TCI-BasedStrategy

Trade Insight February 2015

Currency wars and volatility

 

Executive summary

  • January 2015 was a volatile month with markets unsettled by the uncertainty generated at the beginning of the month over European Central Bank Quantitative Easing (QE). This uncertainty was compounded by the removal of the Swiss franc’s currency peg to the euro by the Swiss National Bank.
  • Both events have put significant pressure on the euro during the first month of 2015 which Delta Economics expects to continue throughout the year. We are forecasting that the euro and US dollar may well reach parity by the end of the year, if not earlier if current trends continue.
  • Delta Economics is expecting the PMIs published at the beginning of February to be broadly in line with consensus expectations. We expect China’s PMI to fall back while we are expecting PMIs in Europe to improve slightly. It is too soon to herald a recovery but this is a positive start to 2015.
  • The Delta Economics Asset Trade Corridor Index (TCI-A) reflects the underlying volatility in markets with Information Ratios largely negative for equities and currencies. The TCI-A has produced an average monthly paper return of 1.3% over the past 19 months. The average return on an equally weighted portfolio in January 2015 was 2.2%.
  • We expect oil prices and the value of the euro to fall during February. We expect other commodity prices to rise (against consensus), equities to rise and the US dollar to strengthen against most major Emerging Market currencies. However, the tightest strategy that we use suggests a strong downside risk to all these calls because of the underlying volatility reflected in the information ratios.

 


Greeks bearing gifts? The consequence of January for the euro in 2015

 

Delta Economics is of the view that the euro will reach parity with the US dollar by 2015 and has the potential to fall lower if current volatility and pressures on the currency continues. This is for several reasons:

First, Delta Economics considers the euro to have been over-valued for some time, largely as a result of the German trade surplus. Although Europe needs German trade to be strong because of the supply chains that originate in Germany and spread out across Europe, the high value of the euro has made it harder for the internal imbalances of the eurozone to be corrected by export-led growth outside of Germany.

At the outset, markets viewed the eurozone with a degree of scepticism. By June 2001 one euro bought 0.85 US dollars. As time has gone by, eurozone performance has, inevitably perhaps, become more dominated by Germany pushing the value of the euro up and kicking the issues of intrinsic imbalances between Member States down the road. However, instead of resolving imbalances by everyone “becoming more like Germany”, a weaker currency simply reflects the fact that everyone isn’t like Germany.

Second, the fact that QE was necessary in the first place made it abundantly clear that the eurozone is far from a marriage of equals. The euro came under pressure ahead of the announcement and fell to new lows subsequently. But it is here where the facts start to conflict with policy expectations. Theoretically, a lower euro should boost the real economy through trade because exports should become cheaper. However, what we’ve actually seen over the years since the introduction of the euro is a high correlation between the euro’s value and the value of trade: in other words, when the euro goes up, so does trade (Figure 1).

We believe there are two explanations for this: in the first instance, European trade, dominated as it is by Germany France, Italy, the Netherlands and Belgium, is largely at the high end of supply and value chains and therefore does not respond particularly to changes in the value of the currency. Even for weaker nations more dependent on commodities, the importance of Europe-wide supply chains means that the relationship still holds. For example, the correlation of the value of the euro with Greek trade is 0.89.

Furthermore, the value of the euro is actually a signal by the markets about the strength of the European economy: when the economy and institutions seem strong, the value is high and vice versa. In other words, as discussed previously, trade is an important driver of the value of the euro because of its importance as a driver of economic performance in the eurozone generally. While trade is falling, and we are forecasting it will fall by 3.7% within the eurozone in 2015, so too can we expect the value of the euro to fall. The result is that policy can have very little effect on the real economy through currency manipulation.

 

2015-02-03_backToReality_fig01_v01

 

Figure 1  |  Monthly value of eurozone exports, USDbn versus USD per euro spot, Last Price Monthly, June 2001-Dec 2015
Source  |  DeltaMetrics 2015, Bloomberg

 

The third reason why the value of the euro is likely to come under increased pressure is the outcome of the Greek election in January. Syriza is looking to renegotiate its debt and start the process of loosening the tight controls it has had over spending. It will not be helped by a lower-valued euro (Figure 2) because of its inter-dependency with trade in the eurozone as a whole through its role as a trade hub.

 

2015-02-03_backToReality_fig02_v01

 

Figure 2  |  Monthly value of Greek total trade (USDm) versus USD per euro spot price, Last Price Monthly, June 2001-Dec 2015
Source  |  DeltaMetrics 2015, Bloomberg

 

Greece’s trade to GDP ratio is 0.4: in other words, there is a fairly strong pull of trade on Greece’s GDP. Oil is a critical part of this; the correlation between Greece’s trade and the oil price is 0.80 – largely because of the importance of oil in Greece’s total trade structure. Greece’s exports of refined oil, for example, are twice as high as the second-largest export sector – medicines.

 

  2015-02-04_tradeInsight_fig03_v01

 

Figure 3  |  Greece’s debt and the challenge of trade
Source  |  DeltaMetrics 2015

 

Greece’s trade is just 0.4% of Europe’s total trade; however, their trade is nevertheless important both because of the impact that it has on the prospective growth of the Greek economy and as a portent for the negotiations about debt restructuring, austerity and structural reform ahead. Put simply, if a low-valued euro is unlikely to help boost Greek (or eurozone for that matter) trade more generally, then there is little that monetary policy at a European level can do to help long-term growth in the peripheral nations. Greece’s debt is, according to Syriza, not repayable and imposes too many restrictions on the Greek economy. One option is to set debt repayments against growth targets but, given falling oil prices and falling intra-European trade, this looks ambitious.

The eurozone needs more than QE and a low value of the currency for growth. The eurozone’s peripheral nations’ struggle for growth is accentuated by the fact that they must trade in euros internally and externally. Given “austerity” constraints attached to their sovereign debt, this makes it very difficult to grow. There will continue to be sustained political dissent between Member States on the best way to resolve the issue of Greece, and there is a danger that the debate will spill over to other nations, like Spain, Ireland and Portugal.

The likely outcome of all of this is continued market pressure on the euro (Figure 4).

 

2015-02-03_backToReality_fig04_v01

 

Figure 4  |  Monthly value of Eurozone exports versus USD per Euro spot price and linear forecast, Jan 2014-May 2016
Source  |  DeltaMetrics 2015, Bloomberg, Delta Economics analysis

 

The pressure on the euro over the last year has mostly been downwards. The Delta Economics asset price forecasting model, which is itself based on country-sector-partner trade flows, is indicating short positions on the euro for most of 2015. Even if the trend continues in a linear way as it has done over the past 12 months, this suggests parity by the end of the year.

 


 

Outlook for PMIs February 2015

 

The Trade Corridor Indices (TCIs) measure the trade flows of any one country and forecasts these forward using its proprietorial forecasting methodology. Each index is specific to the country it relates to in that the trade corridors and flows will differ for each country. The rate of change in the index is correlated with the Purchasing Managers’ Index (PMI) for that country.

The TCIs are based on actual data and although they are highly correlated are in no sense an alternative to the PMIs since the methodologies differ. PMIs, being survey-based, are sentiment indicators while the TCIs give an actual and a forecast indication of how underlying trade conditions, including trade finance, are moving. In other words, the TCIs provide a predictable and quantifiable view of how changes in the global economy are affecting trade at an individual country level.

Generally we are expecting manufacturing PMIs to move in line with consensus this month with very little movement on their December values. The only exception is French services where we are expecting a bigger increase in the service sector PMI compared to consensus. However, although the accuracy of the predictions has been reasonable over the past 12 months, the correlation is substantially lower.

The predictions are based on:

  • The correlation of a country’s top 500 trade corridors with that country’s Manufacturing PMI to create a trade corridor index associated with the PMIs/sentiment (TCI-S)
  • Correlation of the rate of change in that index (6 month moving average) with the Manufacturing PMI
  • The monthly change in the six-month moving average (positive change suggests PMIs will improve while negative suggests they will deteriorate).

Outlook for PMIs February 2015  |  Outlook risk

  • The above information is based on the PMI tickers as listed.
  • The predictive capacity of the model is strong, but not perfect as they are based on correlations rather than causal relationships
  • Note – the correlations and values given are against the Tickers listed and not with the Flash PMIs although the Flash PMIs follow similar patterns
  • Note – forecast values are indicative of scale of change only and should not be seen as absolute values

 2015-02-04_tradeInsight_fig05_v01

 

Figure 5  |  PMI outlook, February 2015
Source  |  Delta Economics

 


 

Trade Corridor Index Asset Price Calls

 

Overview

The Delta Economics TCI-based asset management strategy takes the top 500 trade corridors (trade between two countries by sector) against and asset price. It creates an optimum corridor index of those trade corridors each month and has been tracking its performance over the past 19 months. This is a systematic model and assets are included in the portfolio if one of the following conditions is met:

  • The signal strength, which measures the percentage of trade corridors that are pointing to a long or short call: this must be higher than 95%
  • The signal strength is greater than 85% and the Information Ratio (which measures the performance of that optimum corridor relative to benchmark returns) is greater than 0.5 (indicating good or very good back-tested performance)
  • Where there is a signal strength of 100 and only one corridor in the index, the Information Ratio must be above 0.5.

The returns, which are not optimised and based purely on an equally weighted portfolio strategy, were 2.2% in December 2014. This means that over the past 19 months, returns have averaged 1.3% per month with above average returns in 11 months.

 

2015-02-04_homepageGraph_v01

 

Figure 6  |  TCI-A returns, June 2013-January 2015
Source  |  Delta Economics

 

The calls for February 2015 reflect underlying volatility in markets with Information Ratios largely negative or mildly positive. Although the TCI-As across a portfolio of assets produced a return of 0.7% in October, this was against a similar backdrop of low or negative Information Ratios, which arguably underpinned the correction in the middle of the month. Because of these low, even negative, IRs our portfolio suggestions potentially have substantial downside risk attached to them.

 


 

Commodities

 

The short call on oil reflects continuing downward pressure on oil prices despite the mild rally at the end of January 2015. While the signal strength is low, the information ratio is high suggesting that this is a strong call. Similarly, the long call on Gold has weak information ratio but strong signal strength suggesting that Gold may continue its upward path as a hedge against deflation. Because of underlying uncertainties in the global economy and the fragility of commodity markets, the long calls on copper and steel appear contrary to market sentiment currently. However, our trade outlook for the world in 2015 is mildly more positive than it was during 2014 and Asia in particular is forecast to grow strongly. A long call on copper and steel suggests prices may start to increase during February as a lead indicator of manufacturing activity increases towards the end of Q1 2015.

 

2015-02-04_tradeInsight_fig07_v01

 

Figure 7  |  Delta Economics TCI-A based strategy, commodity calls for February 2015
Source  |  Delta Economics analysis

 


 

Equities

 

We are expecting all equity markets to increase this month, but the signal strengths are weak and the Information Ratios largely negative. A long position arguably reflects the sustained flight to equities following European QE, but the negative information ratios reflect volatility and substantial downside risk.

 

2015-02-04_tradeInsight_fig08_v01

 

Figure 8  |  Delta Economics TCI-A based strategy, equity calls for February 2015
Source  |  Delta Economics analysis

 


 

 

Currencies

 

The calls generally suggest that the euro will continue its weaker path against the US dollar this month. The information ratio on this call is strong, but the signal strength relatively weak. Other emerging market currencies similarly paint a picture of a strengthening dollar as expectations of an increase in US interest rates later this year versus perceived weakness in Europe and Japan continue to stoke up its value.

 

2015-02-04_tradeInsight_fig09_v01

 

Figure 9  |  Delta Economics TCI-A based strategy, equity calls for February 2015
Source  |  Delta Economics analysis

 

 

Delta Economics Trade Insight February 2015  |  Author  |  Rebecca Harding  |  CEO Delta Economics


tradeInsight_TCI-BasedStrategy

What goes up…

Why markets should recover but uncertainty will remain |  For almost all of this year, Delta Economics has been arguing that global equities are long overdue a correction. The reason for this is simple: there is a high correlation between trade values and the global markets (68% for the FTSE and S&P 500 and 85% for the Dax). There is an even higher correlation between trade and emerging market equities at over 90% for the Kospi. If the Delta Economics forecast for trade growth is flat, then it should stand to reason that markets will also underperform.

But, as Figure 1 shows, what goes up appears to be going up forever. Since the bull-run began, trade has been relatively flat while markets have reached unprecedented heights. Even the putative crisis in emerging markets at the beginning of 2014 failed to have a lasting impact on equities generally despite ever-more negative news about trade.

 

 

2014-10-20_whatsGoesUp_fig01

Figure 1  |  Value of World Trade (USDbn) vs S&P 500, Last Price Monthly, June 2001-Dec 2014
Source  |  DeltaMetrics, 2014, Bloomberg

 

As markets do not consider trade data as market-leading, this should not be a surprise. What appeared to happen during the second week of October was that market analysts reacted to suspicions that interest rates might rise and that Quantitative Easing might stop in October. Simultaneously they realised that the Ebola crisis in Africa could have an economic impact while tumbling oil prices raised a spectre of disinflation and poor German data put the Eurozone crisis back in the spotlight.

So is this the moment where Delta Economics steps back and says, “We told you so”? The short answer is no, not yet. We are expecting markets to continue to recover their lost ground in October, but for volatility to remain high. We are forecasting a seasonal pick-up in trade, which means that Purchasing Managers’ Indices may well show some sign of recovery at the end of the month. This could spur equities if not to new heights, then at least to reverse the correction earlier this month (Figure 2).

 

2014-10-20_whatsGoesUp_fig02

Figure 2  |  Eurozone PMI (normalised value) versus Eurozone Delta Trade Corridor Index (Sentiment) change (June 2001-Dec 2014)
Source  |  Delta Economics analysis

 

The Delta Trade Corridor Index-Sentiment (TCI-S) measures the change in a country’s or region’s trade against its PMI. For the Eurozone, the correlation is 86% thus the slight pick-up we expect to see in trade this month is likely to be accompanied by a similar increase in the value of the Eurozone’s PMI. Similarly, we expect the PMI to improve for China and the US as well.

This is nothing more than a seasonal fluctuation and it is always a mistake to react to one month of data. Instead, it is more useful to look at the macroeconomic momentum. This is precisely what the TCI-S measures: the way in which trade is changing over time. What is clear from Figure 2 is that the Eurozone trend is downwards; the same is the case for the Global Manufacturing PMI, as measured in Figure 3.

 

2014-10-20_whatsGoesUp_fig03

Figure 3  |  Global manufacturing PMI normalised values vs Global Delta TCI-S change
Source  |  Delta Economics analysis

 

Figure 3 presents a more worrying picture of momentum: that well into Q2 next year will be the earliest we see any pick-up in our TCI-S or trade more generally. After an increase this month, the next five are likely to be weaker with the TCI-S turning negative.

The reason for this has as much to do the uncertainty caused by geopolitical risks as it does with macroeconomics; these risks will affect emerging markets in particular. While conditions remain uncertain, investment will be held back and it is likely that Africa will suffer first. Since March 2014 we have seen a year-on-year decline of 8% in West Africa’s trade. Further, we are expecting Chinese imports from West Africa to halve (from over 16% to 8% growth) in 2014. With falling oil and commodity prices generally, this represents a perfect storm for investment in Africa.

 

2014-10-20_whatsGoesUp_infographic_v01c

 

Second, Turkey is likely to suffer substantial economic fallout from the Iraq crisis. Turkey’s trade with Iraq alone is worth some USD11.6bn. Much of this trade is in oil and, although Iraq’s oil reserves are largely in the South rather than the ISIS-controlled North, we are still forecasting a 21% reduction in its imports from Iraq to January 2015. We also expect a 23% reduction in its trade with Syria over the same period.

Finally, oil prices have not risen as a result of the crises in the Middle East or in Ukraine although this may have been expected. Instead, prices have fallen as Saudi Arabia has increased its oil supply and as the USA, now the world’s largest oil producer has loosened its restrictions on exports. Trade values and oil prices are 94% correlated and our forecast of 0.56% trade growth in 2014 suggests that oil prices are set to fall further (Figure 4).

 

2014-10-20_whatsGoesUp_fig04

Figure 4  |  Value of world trade (USDbn) vs NYSE ARCA oil spot, Last Price Monthly, June 2001-Dec 2014
Source  |  DeltaMetrics, 2014, Bloomberg

 

The falling price of oil is a double-edged sword: while it lowers costs, it also raises the spectre of deflation, which is increasingly causing concern amongst analysts. If prices turn negative then it threatens global economic growth – as witnessed in the latest downgrading of IMF economic and trade forecasts.

Delta Economics is of the view that the IMF and WTO forecasts for trade growth, at over 3.1%, have still not sufficiently factored in the effects of falling oil prices. Based on data produced by the CPB Netherlands Bureau’s World Trade Monitor, the Delta Economics forecast still appears to be closer to actual trade than that of either the IMF or the WTO (Figure 5).

 

2014-10-20_whatsGoesUp_fig05

Figure 5  |  World Trade Organisation and Delta Economics World Trade Forecasts versus actual
Source  |  Delta Economics analysis

 

We are expecting a temporary increase in world trade in October that could well boost markets for the remainder of the month. However, we are also expecting trade to drop back considerably into the first quarter of 2015. The immediate reaction to the return of volatility in the early part of August must surely have been, “What goes up must come down” and over the longer term, we expect continued uncertainty to fuel volatility in markets. The potential for a major correction before the year end cannot be discounted. However, in the very short term, the reverse might well be the case: what goes down must surely come up again.

 

 

United Kingdom, but the problems are the same

Why interest rates will stay on hold for at least 9 months |  UK markets started to rise as soon as the opinion poll gap between the “yes” and the “no” votes in the Scottish referendum widened. This was as much out of a sense of relief as anything else. A more considered, if slightly glib, response when the final votes were counted came from a BBC interview with a bond trader, his view was that it would be business as usual: markets would start looking back at “fundamentals” and price in a rise in interest rates early next year.

Delta Economics does not see a rise in interest rates as likely in the next 9 months. This is because the macro-economic fundamentals, specifically trade, are too weak for this to be an option for the foreseeable future. The reassurance that the United Kingdom will remain intact as a currency union may initially play well with market sentiment; however, over a longer time period of time the spectre of falling prices and the performance of real economy in the form of exports cannot be excluded from the Bank of England’s thinking on interest rates. Add to this three things: first, there will be a Westminster election in May 2015; second, between now and then Scotland’s membership of the UK is to be renegotiated; third, if there is a Conservative government after May 2015 then there will be a Referendum on EU membership in 2017. All of this creates enough uncertainty around investment decisions to render an increase in UK interest rates extremely inadvisable.

But leaving the politics on one side, the first reason for suggesting that the UK cannot raise interest rates is that there is evidence of disinflation in recent historical export trade figures. Nominal values of trade have been on a downward trend since October 2011 and the UK’s annual export growth in 2013 was just 0.3%. In current prices, Delta Economics is forecasting negative export growth in 2014 (-0.65%) and 2015 (-0.1%) as illustrated in Figure 1.

 

2014-09-22_UKbutProblemsAreStillTheSame_fig01

Figure 1  |  Value of UK exports, June 2001-August 2015, USDbn versus Euro per GBP, June 2001-August 2014
Source  |  DeltaMetrics 2014, Bloomberg

As Figure 1 also shows, there is a low correlation between trade and the value of sterling against both the dollar and the Euro. This indicates that there are no advantages to be gained from altering interest rates. Higher rates would not be a powerful tool to make imports cheaper and, as there are disinflationary pressures anyway, lower import prices may be something that policy makers should avoid. Similarly, higher interest rates may push up the value of sterling but could damage exports and will exacerbate deflation.

In any case, sterling’s value has risen against the Euro and the dollar over the last 18 months and it would be dangerous to accelerate the process too quickly. Illustrated in Figure 2 are the UK terms of trade (i.e. the value of exports in relation to the value of imports), which have been improving gradually since early 2013 when sterling first started to strengthen. A gradual process allows UK exporters to become more competitive through quality and productivity rather than focusing simply on price. A hike in interest rates would distort this and make exports artificially expensive thereby lessening the impact of any productivity improvements by widening the gap again.

 

2014-09-22_UKbutProblemsAreStillTheSame_fig02

Figure 2  |  UK terms of trade vs Euro per GBP, last price monthly, June 2001-August 2014
Source  |  DeltaMetrics 2014

Second, the sustained uncertainty around the global economy, European and Asian demand is affecting global trade. As Trade Views have noted successively, actual trade in 2014 is substantially below IMF expectations but, with the IMF and the OECD now reducing their forecasts for growth in 2014 and suggesting that Q4 may see a slowdown, it is likely that the manufacturing and export Purchasing Managers Indices (PMI) will suffer over the next 6 months. Our Trade Corridor Index – Sentiment (TCI-S) for the UK certainly suggests that the key PMI sentiment indicator is currently disproportionately high compared to export performance.

The correlation between changes in the Delta TCI-S and the PMI is over 70% and the flat outlook for UK trade is reflected in the TCI forecast; it is likely that the PMI will drop over the next few months reflecting the inherent weakness in underlying trade conditions and reducing the likelihood of a rate rise.

 

2014-09-22_UKbutProblemsAreStillTheSame_fig03

 

Figure 3  |  Delta TCI-S changes against changes in the PMI, June 2001-December 2016 (forecast)
Source  |  Delta Economics analysis

Third, the trade of key innovative exports sectors like cars and pharmaceutical products is highly correlated with the last price monthly value of sterling against the Euro (70% and 79% respectively). Both have been falling over the last few months as sterling has strengthened. Substantial policy effort has been put behind stimulating export growth in both of these sectors and particularly to China. Given that both are forecast to grow substantially over the next two years it is unlikely that the Bank of England will raise interest rates. This is because the effect of a rise in interest rates would be to strengthen sterling too far, too fast. This could potentially jeopardise any embryonic export-led growth outside of Europe.

 

2014-09-22_UKbutProblemsAreStillTheSame_fig04

 Figure 4  |  Value of UK exports of private cars to China (USDbn) vs Euro-GBP Last Price monthly, June 2001-August 2014
Source  |  DeltaMetrics 2014

 

2014-09-22_UKbutProblemsAreStillTheSame_fig05

 

Figure 5  |  Value of UK exports of medicines to China
Source  |  DeltaMetrics 2014

Fourth, trade is currently a drag on GDP. This is illustrated by the UK’s net trade openness: in other words the UK’s net exports as a proportion of GDP. The fact that this is falling means that the increases in GDP are forcing a rise in the deficit. This is creating the biggest drag on GDP since the financial crisis.

 

2014-09-22_UKbutProblemsAreStillTheSame_fig06

Figure 6  |  UK net exports as a proportion of GDP vs Euro per GBP, Last Price Monthly, June 2001-August 2014
Source  |  DeltaMetrics 2014

The disconnect between rising GDP and net exports has, as a consequence, created an asset bubble. The correlation between FTSE 100 and economic fundamentals trade has weakened since October 2011; the FTSE has risen while nominal trade values have been on a downward trend suggesting markets are no longer pricing in macro fundamentals such as trade. Disinflation, as evidenced by nominal export values and falling volumes (the forecast in current prices) means that this over-valuation is unsustainable. However, without a gradual correction, a rise in interest rates would exacerbate this detachment and pose the risk of a greater correction in Q4.

 

2014-09-22_UKbutProblemsAreStillTheSame_fig07

Figure 7  |  Value of UK exports (USDbn) vs FTSE 100 Last Price Monthly, June 2001- August 2015
Source  |  DeltaMetrics 2014

There are manifest reasons why a rise in interest rates is inadvisable in the current situation. In essence they boil down to the fact that national and global geo-political and economic uncertainties are too great to make a rise in interest rates probable in the next 9 months. A cynic might say that, in any case, there is a UK general election in 2015 and interest rates will not rise before then, but the weight of economic evidence suggests that there is no forecast pick up in the real economy or improvement in productivity. The economic problems remain the same and the process of building competitiveness through high value exports would be damaged by any increase in the value of sterling as a result of a rise in rates.

 

Webcast 017 | Is volatility back?

Why markets need to price in geopolitical risk  |  July was again dominated by geopolitical risk and this seems set to continue through the summer months. Delta Economics expects market nervousness to build while global trade, which has already been disappointing in 2014, to remain flat, if not fall back further.  Delta’s Trade Corridor Index for the United States measuring how the trade climate changes month-on-month, is set to increase dramatically in August but fall back again in September and for the rest of the year.  Our TCI-based asset management strategy suggests that August will see an increase in volatility rather than a decrease.

 

Webcast 017 Author  |  Rebecca Harding  |  CEO