Risk Insight. Is the Single Market overrated? What are the chances... Volume 9, Issue 5 30 th January Inside this issue

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1 Inside this issue Big Picture GBPUSD... 3 GBPEUR... 4 Risk Insight Volume 9, Issue 5 30 th January 2017 EURUSD... 5 USDCAD... 6 Economic Data and Market Indicators... 7 Appendix... 8 Is the Single Market overrated? Over the last two weeks, Sterling has experienced its biggest rally against the dollar since 2008, rising 5.7% over the course of ten days, followed by a 1.3% fall to the current level. This appreciation was driven by the following events: + 3.6% = Positive market reaction following Theresa s May speech on the 17th January; + 1.0% = Trump s inauguration speech; + 1.1% = Supreme Court ruled that the government cannot trigger Article 50 without the Parliament s approval and stronger-than-expected UK Q4 GDP release; - 1.3% = Price correction, given sterling struggled to support the latest rally. GBPUSD last month What are the chances.....that the BoE will keep interest rates unchanged this week? 98.3%..that EURUSD will be below at the end of Q2? 28.9%..that EURUSD will touch 1.28 in the next month? 45.0% Source: Bloomberg Even though May s speech confirmed, as feared by many, that the UK will leave the single market, many welcomed the end to months of uncertainty and confusion. May s conciliatory tone, reassuring that the government will work on a staggered exit to avoid a cliff edge scenario, also helped to calm markets fears. Despite this initial optimism, the outlook for the UK hasn t changed much and we are still heading for a clean Brexit. So, is this a temporary rally for the pound, or will it continue to rise? First, it appears that GDP growth in the UK has not yet been affected by Brexit. With 0.6% growth in We are happy to announce that out of 80 contributors (including all major banks), Validus Risk Management has been the most accurate forecaster for GBPUSD and third-most accurate forecaster for GBPEUR in 2016, according to Bloomberg rankings. Validus Risk Management Ltd (FRN: is authorised and regulated by the FCA) +44 (0) info@validusrm.com

2 Q confirmed last week, the growth rate for the whole year was 2% in the UK, the fastest rate among developed countries. Furthermore, in annualised terms, the growth rate accelerated towards the end of the year (post-referendum). Two weeks ago, Mark Carney conceded that the Bank of England is very likely to improve its economic forecast next month and that Brexit is no longer the biggest risk to Britain s economy. One could argue, however, that the impact of leaving the single market is yet to be seen and there is still significant downside risks to GDP growth. Let s then look at two main aspects of the single market: reduction (or elimination) of tariffs and reduction of non-tariff barriers such as licensing and minimum standards. Tariffs on global trade have fallen over time. According to the World Bank, average weighted tariffs for products in the European Union peaked at 6.27% in 1995 and were down to 1.5% in Clearly, this is only an average and some sectors will be more affected than others, however these tariffs do not seem like a huge threat especially considering the pound has suffered a 16% devaluation since the referendum, more than offsetting potential competitive disadvantage. Non-tariff barriers, therefore appear a more relevant threat. financial services. In summary, we have been bullish on sterling for a while and our quarterly forecast of 1.21 has already been reached, which prompted us to review it to 1.23 for Q Multiple risks are still on the table and we expected nothing short of a very bumpy ride, however the recent events have only reinforced our long-term expectation of a sterling appreciation, finishing this year at 1.44 against the euro and 1.30 against the US dollar. Author: Marilia Shewchenko Source: World Bank Some studies suggest that the benefits of the Single Market have always been overrated, supported by the lack of thorough research around it. In a paper titled Myth and Paradox of the Single Market, Michael Burrage observes that, over 20 years of the Common Market (pre-eu Single Market), UK exports to the EU members grew faster than American exports to the EU, and by 1992 were 50 per cent higher in value. After the Single Market was implemented, the differential between the two countries steadily declined, so that by 2011, for the first time since 1972, the value of US exports of goods to the EU exceeded the value of UK exports. This point suggests that, contrary to what one would ve expected, the volume of UK exports to the EU did not benefit from the implementation of the Single Market. Another important point worth mentioning is the potential impact of the UK losing passporting rights of financial services to the EEA. Despite massive media attention dedicated to show its downsides, there is no consensus on this issue. According to a report published by Moody s, the impact of a formal withdrawal of the UK from the EEA would likely be manageable for most UK-based financial firms. Moody s considers it unlikely that all permissions granted to financial firms will be lost given EU law already provides for recognition of non-eu regulatory regimes for

3 GBPUSD Sterling continued to rally over the last week, fueled partly by the Supreme Court s decision that the government requires parliamentary approval to begin Brexit negotiations. In addition, speculation that the UK will most likely be first in line for a trade agreement with the US, placing the UK in a much stronger position than was feared in June. In the US, GDP and inflation numbers were mixed but durable goods were worse than expectations. Furthermore, Trump s comments that the dollar is too strong at current levels for the US to remain competitive with China promoted further dollar weakening. Key events for this week are: Wed 1 Feb: FOMC Rate Decision Thurs 2 Feb: BOE Bank Rate, Asset Purchase Target and Inflation Report Fri 3 Feb: US Non-farm payrolls Horizon Primary Indicator Score Short-Term Momentum Extremely Bullish Mid-Term Carry Bearish Long-Term PPP Valuation Extremely Bullish Technical View 1 GBPUSD continued to rally for a second week, breaking the two previous resistance levels and reaching a high of However, the pair struggled to maintain ground above for long and currently trades back around at the time of writing. 3 As previously discussed, in order to justify a sustained bullish outlook, the pair needs to hurdle the recent high at Support Resistance Level 1 Level 2 Level 1 Level FX Forecasts PPP Valuation Validus Bloomberg Poll Avg Q (revised ) 1.21 Q (revised ) 1.21 Q (revised ) 1.23 Q (revised ) 1.25 Hedging Cost* Tenor Today 1M Ago 12M Low 12M Avg 12M High 6M Y Y Y (*Annualised Basis Point impact to sell GBP Forward) According to Purchasing Power Parity, GBPUSD is currently 14.6% undervalued. 3

4 GBPEUR The volatility in GBPEUR over the last week was mostly a result of sterling s strength but comments from Ted Malloch, tipped to be the next US ambassador to the EU, did little to help the euro s case when Malloch announced that he would short the euro, claiming that the single currency could collapse in the next 18 months. Meanwhile the sterling rally was fuelled partly by the Supreme Court s decision that the government requires parliamentary approval to begin Brexit negotiations alongside talks that the UK will most likely be first in line for a trade agreement with the US, placing the UK in a much stronger position than was feared in June. Key events for this week are: Tues 31 Jan: Eurozone CPI Inflation Tues 31 Jan: Eurozone GDP Thurs 2 Feb: BOE Bank Rate, Asset Purchase Target and Inflation Report Horizon Primary Indicator Score Short-Term Momentum Bullish Mid-Term Carry Bullish Long-Term PPP Valuation Bullish Technical View 1 In line with the overall strength in sterling over the last week, GBPEUR rallied for the second consecutive week, breaking beyond the first previous point of resistance and reaching a high of Nevertheless, the pound struggled to maintain highs beyond and has since fallen back towards As previously highlighted, the pair will have to maintain moves beyond in order to open up further bullish risks in the near term. Support Resistance Level 1 Level 2 Level 1 Level FX Forecasts PPP Valuation Validus Bloomberg Poll Avg Q (revised ) 1.18 Q (revised ) 1.18 Q (revised ) 1.18 Q (revised ) 1.18 Hedging Cost* Tenor Today 1M Ago 12M Low 12M Avg 12M High 6M Y Y Y (*Annualised Basis Point impact to sell GBP Forward) According to Purchasing Power Parity, GBPEUR is currently 3.2% undervalued. 4

5 EURUSD EURUSD closed last week in an almost unchanged position as factors in the US and the Eurozone have broadly balanced each other out. In the US, GDP and inflation numbers were mixed but durable goods were worse than expectations. Furthermore, Trump s comments that the dollar is too strong at current levels to remain competitive with China promoted further dollar weakening. However, comments from Ted Malloch, tipped to be the next US ambassador to the EU, hurt the euro when Malloch announced that he would short the single currency, claiming that it could even collapse in the next 18 months. Key events for this week are: Tues 31 Jan: Eurozone CPI Inflation Tues 31 Jan: Eurozone GDP Wed 1 Feb: FOMC Rate Decision Fri 3 Feb: US Non-farm payrolls Horizon Primary Indicator Score Short-Term Momentum Extremely Bullish Mid-Term Carry Extremely Bearish Long-Term PPP Valuation Extremely Bullish Technical View 1 There has been little change in EURUSD in the last week from a technical perspective; closing in broadly the same position to the previous week. 2 As previously highlighted, if the pair could sustain a recovery back above and find a fresh base, the technical outlook would improve significantly. 3 Regular readers will be all too aware of our bearish forecast and for now, there is little here to alter this view. Support Resistance Level 1 Level 2 Level 1 Level FX Forecasts PPP Valuation Validus Bloomberg Poll Avg Q (revised ) 1.04 Q (revised ) 1.03 Q (revised ) 1.05 Q (revised ) 1.05 Hedging Cost* Tenor Today 1M Ago 12M Low 12M Avg 12M High 6M Y Y Y (*Annualised Basis Point impact to sell EUR Forward) According to Purchasing Power Parity, EURUSD is currently 12.9% undervalued. 5

6 USDCAD USDCAD sold off last week as President Trump s executive order allowing for the building of the Keystone XL pipeline spurred buying of CAD, pushing USDCAD down from the Monday high to a low of on Thursday, before rallying slightly to close the week. Key events for this week are: Tues Jan 31: November GDP data Thurs Feb 1: FOMC Rate Decision Horizon Primary Indicator Score Short-Term Momentum Bearish Mid-Term Carry Neutral Long-Term PPP Valuation Bearish Technical View 1 USDCAD is currently stuck between the 50% retracement level of the move from to (the 2016 range) at and the October 2016 low of The rising channel shows support at Support Resistance Level 1 Level 2 Level 1 Level FX Forecasts PPP Valuation Validus Bloomberg Poll Avg Q (revised ) 1.35 Q (revised ) 1.35 Q (revised ) 1.36 Q (revised ) 1.36 Hedging Cost* Tenor Today 1M Ago 12M Low 12M Avg 12M High 6M Y Y Y (*Annualised Basis Point impact to sell CAD Forward) According to Purchasing Power Parity, USDCAD is currently 6.9% overvalued. 6

7 Economic Data & Market Indicators Economic Matrix GDP CPI Unemployment Industrial Production Retail Sales Current Account % GDP Budget Balance % GDP 10 Year Yield US 1.90% 2.10% 4.70% 0.51% 4.10% -2.55% -3.10% 2.49% EUR 1.80% 1.10% 9.80% 3.20% 2.30% 3.23% -1.60% 0.46% UK 2.20% 1.60% 4.80% 2.00% -2.00% -5.05% -3.67% 1.48% CAN 3.47% 1.50% 6.90% 1.36% 3.00% -3.53% 0.10% 1.79% Central Bank Bias Current Rate Last Change Date of Change Next Meeting Likely Next Move UK 0.25% -0.25% 4 th August 16 2 nd February 17 Unchanged US 0.50% - 75% 0.25% 14 th December 16 1 st February 17 Unchanged CAN 0.50% -0.25% 15 th July 15 1 st March 17 Unchanged EUR 0.00% -0.05% 10 th March 16 9 th March 17 Unchanged 7

8 Appendix - Primary Indicator Methodology 1. Momentum The momentum indicator is based on four metrics - 1 week change, 1 month change, 8/15 day moving average and 10/25 day moving average of the spot rate. We look at the direction of movement of each metric in the previous week (increase or decrease) and then assign a final score. For example, if all metrics moved up, we assign an Extremely Bullish score. Movement in metrics Score Extremely Bullish Bullish Neutral Bearish Extremely Bearish 2. Carry We calculate carry based on the difference between interest rates in two respective countries for each currency pair. See below for score assignment: Carry Score > 1% Extremely Bullish < 1% and > 0.5% Bullish < 0.5% and > -0.5% Neutral < -0.5% and > -1% Bearish < -1% Extremely Bearish 3. PPP Valuation In order to determine whether a currency pair is over or undervalued, we use CPI, PPI, OECD, Goldman Sachs and IMF fair values, calculate their average, and compare it with the spot price. Depending on the magnitude of divergence of the spot from the fair value, we assign a specific risk score (see table below): Valuation Score > 15% Extremely Bearish < 15% and > 5% Bearish < 5% and > -5% Neutral < -5% and > -15% Bullish < -15% Extremely Bullish Disclaimer: The Information is not intended to be a complete statement or summary of securities, markets or developments referred to in the document. Validus does not undertake to update or keep current the Information. Any opinions expressed in this document may change without notice and may differ or be contrary to opinions expressed by other business individuals or groups of Validus. Any statements contained in this report attributed to a third party represent Validus's interpretation of the data, information and/or opinions provided by that third party either publicly or through a subscription service, and such use and interpretation have not been reviewed by the third party. Nothing in this document constitutes a representation that any investment strategy or recommendation is suitable or appropriate to an investor s individual circumstances or otherwise constitutes a recomendation. For advice, trade execution or other enquiries, clients should contact their representative. 8