The International Monetary Fund (IMF) recently released its updated global economic forecasts, contending that ‘the recovery in global growth is on a firmer footing’. Although its forecast for headline global GDP growth in 2017 and 2018 was unchanged, it revised down its growth forecasts for the US and the UK while increasing them for Europe, China and Japan. In 2016, the consensus expectation was of desynchronised global growth, with the US moving ahead and Europe and the rest of the world lagging behind. This view culminated after Donald Trump’s unexpected election win. His pledges on trade, tax reform and fiscal stimulus gave rise to a new market trend – the “reflation trade” underpinned by the prospect of a better environment for risk assets and yields that would rise as inflation picked up.
These expectations remain unrealised. With President Trump so far unsuccessful with any sweeping reforms, the view discounted by the market has reversed and wiped out the “Trump trade”. A few months after the US election, the US dollar index, DXY, started to weaken and is now at a 30-month low (see Exhibit 1). Despite US job market tightness and encouraging growth figures, the Fed has been unable to normalise monetary policy as quickly as anticipated, notably due to softer inflation prints. Some 80% of the trade-weighted DXY index comprises European currencies, with the euro accounting for 60%. For that reason, the euro has strengthened significantly against the dollar so far this year.
Even though financial markets have completely retraced the reflation trade, we still think President Trump will achieve some reforms that would support the US economy. The Republican Party is likely to become more effective at voting in and implementing at least some level of tax reforms as its need for a political win before the mid-term elections next year is becoming ever more urgent. We believe the euro’s valuation against the US dollar is stretched and will progressively reverse as the US dollar rebounds.
In part for this reason, we recently added a long US dollar position versus the euro. In line with our FX approach, this is a long-term, high-conviction trade. The rebound in the US dollar could happen sooner rather than later as market participants are discounting weak data in the US while expressing positive views on the eurozone. A relatively minor change in outlook could thus induce a reassessment of expectations and a repricing. As the eurozone PMI seems to have reached a peak, it could signal an upcoming change in market sentiment.
Exhibit 1: US dollar index
Source: Bloomberg, BNP Paribas Asset Management, as of 31/07/2017