By Jamie Jemmeson ACSI, MSTA at Infinity International

Background

The UK officially entered a recession following the Q2 GDP release in early August – a recession is defined by two consecutive quarters of negative growth. Whilst a recession was not unexpected, the position of the nation’s economy in comparison to its peers is somewhat of a concern. The official reading saw UK Q2 GDP contract by 20.4%, a record low. Compounding the concern for the UK economy is that this is the largest contraction for Q2 GDP amongst its peers in the G7.

State of play

The UK has not only suffered the highest number of COVID deaths in Europe, with 41,499[1] deaths at the time of writing but is also suffering from the deepest recession in the G7. This is not coincidental; the figures are intrinsically linked. The surge in deaths due to late lockdown dented economic confidence resulting in the dire GDP figures reported.

Please don’t emigrate to Japan just yet – it’s not all doom and gloom. The monthly UK GDP figure, as opposed to quarterly detailed above, is likely a more appropriate reading of recent economic activity.  Given the fluid changes in guidance, travel corridors and easing of restrictions we have seen over the last few months, the figures are certainly more upbeat. The monthly figure for June reported an increase of 8.7% – a record single-month increase and slightly stronger than forecasts suggested, with May’s GDP figure also revised higher. This trend has not gone unnoticed as Bank of England chief economist Andy Haldane recently commented in The Daily Mail newspaper[2]:

“Economic activity in the UK is not falling like a stone. In fact, it has now been rising for more than three months, sooner than anyone expected. It has also recovered far faster than anyone expected.

Over the past three months, I estimate the economy has been rising, on average, by around 1 per cent per week. While that leaves activity well below pre-COVID levels, the UK has already recovered perhaps half of its losses.”

In short, the headline quarterly figures look grim, but the more recent monthly figures have turned positive.

Will the UK emerge from recession?

May and June’s figures posted positive readings, the big questions for growth are:

  • Can the UK maintain this momentum in growth?
  • Will restrictions be reinstated?
  • Will terms surrounding the furlough scheme be changing?
  • How will sentiment be affected?

With the catastrophic Q2 GDP during the lockdown, it is probable that Q3 GDP will show the economy return to growth, however, the market will likely be focused on what type of bounce back it will be.

For an answer to this, we looked to The Organisation for Economic Co-operation and Development (OECD) who deciphers economic data from global economies to construct its Composite Leading Indicator. This provides indications of major turning points in an economic cycle and allows us to see how economies are performing relative to each other.

This graph shows the Composite Leading Indicators for the UK, US, Japan and Eurozone; demonstrating the UK outperforming the other three blocks:

Source – OECD – Composite leading indicator (CLI)

Can the momentum be maintained?

In order to navigate the markets, we have forecast a worst, best and likely scenario for UK economic activity in the second half of 2020:

Best case scenario – V-shaped recovery – Q3 and Q4 GDP growth

  • COVID second wave is avoided resulting in increased economic activity
    • COVID restrictions remain more relaxed than Q1&2 with further opening of the economy
  • Furlough scheme extended resulting in lower job losses
  • EU/UK trade talks result in a smooth transition

Worst case scenario – W shaped recovery (Double Dip) – Q3 GDP Growth, Q4 GDP Contraction

  • COVID second wave results in another lockdown halting economic activity
  • Furlough scheme not renewed resulting in an additional 2 million unemployed[3]
  • EU/UK trade talks break down resulting in a no-deal

Likely scenario – U shaped recovery – Q3 GDP Growth, Q4 GDP small contraction/growth

  • COVID new case increase resulting in partial or localised lockdown and travel restrictions
  • Furlough scheme extended or replaced to focus on worst-hit sectors
  • EU/UK trade talks result in compromise leading to a partial deal or further extension

What does this mean for Sterling?

Sterling didn’t plummet when the record low GDP for Q2 was announced in July. This is because the terrible figure was expected, largely given the severity of lockdown and the fact that the UK is a service-driven economy. In recent times, Sterling has not only been driven by local economic factors, but also global factors such as equity market sentiment. However, whilst we are an island nation, we can assume that if a second wave of COVID hits our shores, it is possible that we will be seeing a second wave throughout the developed world, denting global sentiment.

The clearest way to articulate what this means for Sterling is to look at what large financial institutions are forecasting for the currency. Whilst we cannot specify that their views will be identical to the above best case, worst case and likely scenario as they will have their own economist and independent views; they will certainly be factoring in COVID, GDP, EU/UK trade talks and other economic factors such as unemployment.

The below forecasts show the consensus of over 40 financial institutions:

It is likely that the low forecast would represent a potential W shaped recovery (double-dip recession conditions) and the high forecast represents a V shape recovery. The differential on the GBPUSD interbank rate is 24 cents and on GBPEUR is 17 cents for 6 months. Emotional responses to COVID and UK/EU trade talks may drive sentiment and subsequently, the economic data associated. One problem with emotional responses in the short term is they can often be irrational, which could result in volatile reactions in the FX markets, as is highlighted in the differential between the high and low.

Managing FX Volatility

The economic landscape is likely to remain fluid as government guidance changes surrounding COVID and Brexit UK/EU trade talks continue. These outcomes are one of the factors to drive the level of volatility that will follow.

If your business has currency exposure now or in the future, you may or may not have a hedging strategy and access to a range of products which you utilise to manage this. We understand that the world has become a little more uncertain and as we adapt, it will be necessary to review all areas of our businesses for efficiencies in cost and strategy.

We have highlighted the effect that Sterling may encounter on a double-dip recession or V shape recovery.

One of those factors that could drive this is the outcome of the Brexit UK/EU trade talks, in our next article, we will unpick these trade talks and detail how they could affect Sterling price action.

[1] https://www.ecdc.europa.eu/en/cases-2019-ncov-eueea

[2] https://www.dailymail.co.uk/debate/article-8629279/A-healthy-dose-optimism-save-jobs-writes-Bank-England-chief-economist-ANDY-HALDANE.html

[3] https://www.theguardian.com/uk-news/2020/aug/16/end-of-uk-furlough-scheme-means-needless-loss-of-2-million-jobs

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This blog post is intended to provide you with information on the services Infinity International Limited (IIFX) offer and should not be interpreted as advice or as a solicitation to offer to buy or sell any currency or as a recommendation to trade. Foreign exchange rates provided therein are for indicative purposes only and are not intended to give an accurate reflection of current currency exchange rates or to predict future movements in currency exchange rates. IIFX is a company registered in England with registered number 06333730 and registered address at Third Floor, 24 Chiswell Street, London, United Kingdom, EC1Y 4YX. IIFX is authorised by the Financial Conduct Authority under the Payment Service Regulations 2017 (FRN: 567835) for the provision of payment services. IIFX is authorised and regulated by the Financial Conduct Authority in the conduct of designated investment business (FRN: 671108).