FOREIGNEXCHANGE OUTLOOK FOR FIRST QUARTER 2019 FOREIGNEXCHANGE

Disclaimer: This material has been prepared by Brown Brothers Harriman & Co. (“BBH”) and is intended for information purposes only. This communication should not be relied upon as financial, investment, tax or legal advice. This communication should not be construed as a recommendation to invest or not to invest in any country or to undertake any specific position or transaction in any currency. This information may not be suitable for all investors depending on their financial sophistication and investment objectives. The services of an appropriate professional should be sought in connec- tion with such matters. The information contained herein has been obtained from sources believed to be reliable, but is not necessarily complete in its accuracy and cannot be guaranteed. Sources used are available upon request. Any opinions expressed are subject to change without notice. Please contact your BBH representative for additional information. BBH’s partners and employees may own currencies in the subject of this communication and/or may make purchases or sales while this communication is in circulation. This communication has been prepared for use by the intended recipient(s) only.

BBH Foreign Exchange CONTENTS

Global Overview: The Conundrum Continues in 2019...... 2

Emerging Market Country Profiles ...... 6

Currency Forecasts...... 8

2019 First Quarter Outlook | 1 US What did the Fed tell us at the last FOMC meeting? The FOMC hiked the Fed Funds target range to 2.25-2.50%, as expected. We also got a dovish shift in the Dot Plots, but the overall message was clearly not as dovish as markets were expecting. Powell said balance sheet reduction is on auto-pilot, dashing hopes for some flexibility. Most importantly, Powell seemed to put little weight on recent equity market movements, supporting our view that there simply is no Powell Put.

What are markets telling us about the Fed? Despite Powell’s upbeat view on the economy, markets are saying that they think the Fed is making a mistake. That is, the Fed is too upbeat on the economy and so will continue to hike and likely push the US economy into recession. in 2019 We’ve been puzzled by the dollar’s recent performance, but it seems to be taking its cue from the bond and equity markets for now. That is, recession risk is seen as high and that is totally dollar-negative as the budget deficit would blow out and the Fed would cut rates. We don’t agree with this assessment about reces- sion but that’s what markets are pricing in.

Market expectations for the early 2019 FOMC meetings are low. According to Bloomberg’s World Interest Rate Probabilities (WIRP), the odds of a hike on January 30 are a miniscule 2%, while March 20 is a bit higher at 19%. By signaling one fewer hike next year, it seems unreasonable to expect another hike so soon in the following quarter. The May 1 and June 19 FOMC meetings become more interesting, especially if the US economy remains firm in Q1.

The implied yield on the January 2020 Fed Funds futures con- tract is currently around 2.55%, up from the 2.5% post-FOMC trough. That was the lowest since May 30 and down sharply from a peak near 2.95% on November 8. With effective Fed Funds likely to move to around 2.40% after this most recent hike, this current implied yield suggests that less than one hike is being priced in for 2019. Furthermore, the Fed Funds market is pricing in potential  Conundrum rate cuts in 2020.

A portion of the US yield curve inverted in Q4. While this is not the typical inversion that presages a recession, markets are

nevertheless on heightened alert. OVERVIEW: GLOBAL The Continues

2 | BBH Foreign Exchange There’s no doubt that the US yield curve has flat- Bottom Line: We continue to believe that markets tened significantly over the past couple of years. are underestimating the Fed’s capacity to tighten in The 2- to 10-year spread is currently the lowest of the 2019. We see at least two hikes, perhaps more. We three spreads at around 10 bp, the lowest post-crisis also believe the dollar rally is intact,but that it may take level and nearly at inversion. The 3-month to 10-year some time before the markets adjust their Fed outlook spread, which the San Francisco Fed has shown to be a to reflect a still-robust US economy that needs further better predictor, is by comparison at 38 bp and is getting tightening. closer to inverting. EUROZONE This US yield compression comes even though The ECB announced that QE will end this year at its the US economy remains relatively strong in Q4. December meeting. It also reiterated its intent to start Stronger than expected November retail sales and IP hiking rates after next summer and added new forward data boosted the Atlanta Fed’s GDPNow Q4 growth fore- guidance that balance sheet reinvestment would end cast to 3.0% SAAR from 2.4% previously. Surprisingly, after rates have started to rise. The ECB warned that the New York Fed’s Nowcast was steady at 2.4% SAAR risks were moving toward the downside but did not despite this latest batch of strong data. change its official balance of risks.

The Fed has come under unprecedented political New staff forecasts were also released that marked pressure in 2018 to stop hiking rates. At the December down the growth and inflation outlooks modestly. press conference, Powell pushed back against potential Given how poorly the data have come in Q4, there are interference, stating rather clearly that political consid- downside risks to these forecasts. PMI readings for erations play no role in policy. He added that nothing France and Italy suggest that two of the largest euro- will deter the Fed from doing the right thing. If the Fed zone economies will enter 2019 teetering on the edge continues to hike in 2019 as we expect, criticism of the of recession. If weakness continues into 2019, the ECB Fed will likely continue. On a technical note, the Fed will have to seriously consider changing its official bal- will now hold press conferences after every meeting. It ance of risks. This would add to market doubts that the will continue to issue its Dot Plots and forecasts every ECB can actually start to lift rates in 2019. Furthermore, other meeting. weakness in the peripheral banking sectors is forcing the ECB to contemplate another Targeted Long-term Michelle Bowman was recently confirmed as a Refinancing Operations (TLTRO) in 2019. member of the Fed’s board of governors. She brings the total number of Dot Plot contributors up to 17. As Draghi’s term at the helm of the ECB concludes at 2019 begins, that group is made up of five members the end of October 2019. He has seen and accom- of the board of governors (Powell, Clarida, Quarles, plished much during his single 8-year term. However, Brainard, Bowman), five voting regional Fed presidents he will likely hand off the decision to hike rates to his (Williams, Bullard, Evans, George, Rosengren), four successor even as the eurozone economic outlook is alternates (Harker, Kaplan, Kashkari, Mester), and three deteriorating. Some, like us, would argue that the ECB non-voters (Barkin, Bostic, Daly). Governor nominees may have missed its chance to hike when the eurozone Goodfriend and Liang still need to be confirmed by the economy was on firmer footing. Senate before all 19 contributors are fully represented in the Dot Plots.

2019 First Quarter Outlook | 3 Who will replace Draghi? Bundesbank President would seem to be an obvious choice. Yet there are reports that Germany is pushing to have one of its own replace Jean-Claude Juncker as head of the European Commission (EC). As such, Germany would have to accept a non-German at the head of the ECB.

More importantly, who will replace Angela Merkel? She has stepped down as leader of the Christian Democratic Union (CDU). While she plans to serve out her full term as Chancellor, she may not be able to do so and faces challenges from both the right and the left. Merkel is considered to be the leader of an inclusive Europe and so her replacement will likely set the tone for Europe going forward.

It’s worth remembering that the ECB has never been headed by a German national. Since its inception, the ECB has been led by Wim Duisenberg (Netherlands), Jean-Claude Trichet (France), and Draghi (Italy). Other names being bandied about are Benoit Coeure, Philip Lane, Erkki Liikanen, and Francois Villeroy de Galhau.

The EU will reportedly hold off on starting excessive deficit procedures against Italy. Reports suggest that the two sides have accepted Italy’s compromise deficit equal to -2.04% of GDP next year. EU officials noted, however, that the solution is not ideal and that the budget still raises concerns. However, it’s clear that both sides made some compromises in order to avoid roiling the markets.

France now replaces Italy on the list of fiscally irresponsible eurozone countries. President Macron backed down in the face of the Yellow Vest protests. Not only did he rescind the planned fuel tax, but Macron announced new spending measures and tax cuts. The budget deficit was already forecast at -2.8% of GDP in 2019, and this fiscal stimulus will likely push it over the -3% threshold. If the economic slowdown worsens, then France’s deficit could easily approach -4%.

UK Prime Minister May called off the Parliamentary vote originally planned for December 11. Whilst surviving the Tory leadership challenge, May must now gather support for her Brexit plan. The math says that May still doesn’t have the votes to pass it. She traveled to Brussels this month to ask EU leaders for better terms regarding the Irish backstop, but to no avail as it was basically “take it or leave it” from the EU.

Clearly, the odds of a no-deal Brexit are rising. Some senior European officials have said that minor details may be modified but wholesale changes are out of the question. We do not think the EU will make enough concessions to change the math. Parliament

4 | BBH Foreign Exchange goes on recess December 20 and returns January 7. May hopes to hold the vote during the week of January 14. She has ruled out any extension of this deadline, as well as a second referendum.

Opposition Labour has sharply criticized May but has yet to call a no confidence vote in the Tory government. We cannot rule this out, nor can we rule out Labour somehow coming to power if we get a no deal Brexit and fresh elections are then called. Quite simply, this combination would be a worst-case disaster for the UK.

The Bank of England must remain in wait and see mode until March 29, when the UK exits the EU, deal or no deal. The BOE recently set forth a possible no-deal scenario in which the UK economy contracts 8% and sterling plunges 25%. Governor ’s 8-year term was originally set to end June 30, 2021 but Carney planned to step down by mid-2019. He has since agreed to Market expectations stay on until January 2020 in order to see the UK through Brexit. for the early 2019 FOMC meetings Japan’s economy struggled in Q3 under the weight of natural disasters. Can it bounce back? Q3 GDP contraction was revised to are low. According -2.5% SAAR from -1.2% previously and -2.0% expected. The main drivers were softer private consumption and business spending, to Bloomberg’s but distortions due to natural disaster have to be factored in. There World Interest Rate are downside risks from the planned consumption tax hike from 8% to 10% in October 2019. The IMF forecasts Japan to grow 0.8% Probabilities (WIRP), in 2019 vs. 1.4% in 2018. the odds of a hike Soft data overall in H2 2018 have led the to underscore its commitment to maintain stimulus until 2021. on January 30 are a It has committed to Quantitative and Qualitative Monetary Easing miniscule 2%, while (QQE) with Yield Curve Control (YCC) since September 2016, when it modified the previous incarnations of QQE and QQE with March 20 is a bit a Negative Interest Rate. higher at 19%.” QQE with YCC commits the BOJ to control the yield curve with a negative interest rate at the short end and with bond purchases to keep the 10-year JGB yield near zero. The BOJ also committed to allowing inflation to overshoot its 2% target. YCC is now the primary policy goal and so the BOJ is likely to continue tweaking its bond purchases as needed across the curve to keep rates within the targeted ranges.

Governor Haruhiko Kuroda’s 5-year term ends in April 2019. He has presided over the entirety of Prime Minister Shinzo Abe’s “” experiment, and reports suggest Kuroda is favored for a second term. The BOJ is expected to maintain current stimulus policies until at least 2021, the earliest that inflation is expected to reach the 2% target.

2019 First Quarter Outlook | 5 Emerging Market Country Profiles

EM remains vulnerable to periodic (and seemingly more frequent) bouts of risk-off sentiment, and next year should be no different. We think markets are overemphasizing US recession risks and expect the yield curve to steepen in the coming weeks. If so, this would most likely be negative for EM. In a sense, it’s a lose-lose situation for EM no matter what happens to US rates.

Meanwhile, trade tensions are likely to continue in 2019. Despite the 90-day truce between the US and China, many thorny issues CHINA. The world’s second remain unresolved. Looking elsewhere, the so-called USMCA largest economy continues to set (NAFTA 2.0) may be reopened by the incoming US Congress. Outside of the US, global growth is at risk. While we remain the tone for the rest of EM. constructive on the US, it appears that China and the eurozone, the Q4 data suggest that growth is slowing much more than previously second and third largest economies in the world, are clearly slowing anticipated, which means more stimulus measures are likely in more than anticipated. Japan also posted a weak Q3, though data 2019. Weak Chinese growth has ripple effects throughout EM, was distorted by natural disasters. While 2018 began with notions whether directly (via trade links and the supply chain) or indirectly of a synchronized global upturn and robust global trade, it seems (via lower demand for energy and industrial raw materials). the exact opposite is true for the start of 2019. President Xi is walking a fine line at home. US-China trade ten- The five worst EM currencies in 2018 have been ARS, TRY, BRL, sions are likely to remain unresolved. As of this writing, there has ZAR, and RUB. A negative global backdrop, coupled with idiosyn- been a slight thaw. While Xi cannot appear weak in dealing with cratic risks, has fed this underperformance, and we think this is the US, neither can he sacrifice growth. We do not think China’s likely to continue in 2019. policymakers will weaponize the yuan, and so we think it will trade largely in line with wider EM in 2019. Further stimulus is likely to be seen in 2019, both fiscal and monetary.

6 | BBH Foreign Exchange Weakness in the peso and resulting inflation has forced Banco ARGENTINA. Despite de Mexico to hike rates even as the economy remains slug- gish. Low oil prices are another headwind ahead, as recently doing all the right things, President announced OPEC+ cuts have yet to have a significant impact on Mauricio Macri faces a tough the oil market. Lastly, there are downside risks to the economy if there are any significant revisions to the USMCA that could reelection campaign ahead of impact trade flows. the next vote in October 2019. The crisis has eased, but tight monetary policy is still needed to SOUTH AFRICA. fight inflation and that will lead to a second recession under Macri’s watch. The peso has stabilized with the help of an IMF program, but The ANC goes into an election year it remains vulnerable to swings in market sentiment. under new leader Cyril Ramaphosa. To Macri’s credit, he has taken tough measures that will undoubtedly harm him at the polls. He will be challenged by The ouster of former President Jacob Zuma has helped the ANC the Kirchner/Fernandez wing of the Peronist party, whose populist get better traction with the populace, as recent polls are showing policies may appeal to a disillusioned electorate. If Macri does not around 56% support, up from 52% in September. The opposition win a second term, then there is a significant risk that his reforms has been unable to build on its recent electoral successes, as will be reversed by the incoming administration. the two major parties have often been at odds with each other.

Growth remains sluggish and unemployment remains near record highs. Yet the South African Reserve Bank has been BRAZIL. President Jair forced by the weak rand and rising inflation to start a tightening Bolsonaro inherits a weak economy cycle. With commodity prices languishing, the headwinds to the economy are strong. that needs to be jump-started by structural reforms. While 2018 began with notions After some initial exuberance, markets have come to realize that of a synchronized global upturn... the job ahead will be very difficult, if not impossible. Some minor reforms may be pushed through, but we suspect the more difficult it seems the exact opposite is ones will languish in Congress. true for the start of 2019.” Inflation remains low, tilting the to a more dovish stance in recent months. This has helped push out tightening expectations into H2 2019. However, incoming head of the central bank will have an opportunity to choose his TURKEY. The economy own path. The dovish outlook along with low commodity prices is appears headed for a hard landing, likely to keep the real trading with a softer bias next year. as tight monetary policy is still MEXICO. President Andres needed to stabilize the lira. The monthly current account has moved into surplus as imports Manuel Lopez Obrador (AMLO) has collapse, helping to lessen the need for foreign capital. Yet there are had an inauspicious start to his term. growing concerns that the central bank will be strong-armed into cutting rates prematurely. There has been no implementation of Markets have come to realize that AMLO is unlikely to be the structural reforms and so the medium-term outlook remains poor. savior that many expected. Even before he was inaugurated, President Erdogan continues rule the nation with an iron fist. AMLO sent some bad signals to the market (the Mexico City Recently, Turkey has launched military operations against US-backed airport fiasco, among others) that he has tried unsuccessfully Kurdish rebel forces in both Syria and Iraq, which risks further to walk back. inflaming tensions with the US. Erdogan still blames cleric Fethullah Gulen for the attempted coup in 2017 and continues to press the US for his extradition.

2019 First Quarter Outlook | 7 CURRENCY FORECASTS* Major Markets In US Dollar Terms Current Q1 2019 Q2 2019 Q3 2019 Q4 2019 Euro 1. 15 1. 12 1. 10 1.08 1. 10 Ye n 111 112 113 115 115 Sterling 1.27 1.20 1. 15 1. 10 1. 15 Canadian $ 1.35 1.37 1.39 1.41 1.40 Australian $ 0.71 0.70 0.68 0.65 0.67 New Zealand $ 0.68 0.67 0.65 0.61 0.64 Swedish Krona 8.98 9.38 10.00 10.19 9.55 Norwegian Krone 8.69 8.93 9.32 9.72 9.32 Swiss 0.99 1. 0 0 1.02 1.05 1.02 In Euro Terms Current Q1 2019 Q2 2019 Q3 2019 Q4 2019 Ye n 127 125 124 124 127 Sterling 0.90 0.93 0.96 0.98 0.96 Swiss Franc 1. 13 1. 12 1. 12 1. 13 1. 12 Swedish Krona 10.29 10.50 11. 0 0 11. 0 0 10.50 Norwegian Krone 9.95 10.00 10.25 10.50 10.25 Emerging Markets In US Dollar Terms Current Q1 2019 Q2 2019 Q3 2019 Q4 2019 Chinese Yuan 6.89 6.95 7.05 7. 1 5 7.05 Hong Kong $ 7.83 7.84 7.83 7.80 7.80 Indian Rupee 69.70 72.00 74.00 76.00 74.00 Korean Won 1128 1150 1175 1200 1175 Indonesian Rupiah 14473 15000 15500 16000 15500 Malaysian Ringgit 4.18 4.20 4.25 4.30 4.25 Philippine Peso 53.15 54.00 56.00 57.00 56.00 Singapore Dollar 1.37 1.40 1.42 1.45 1.41 New Taiwan $ 30.81 31.00 31.50 32.00 31.50 Thai Baht 32.66 33.00 33.25 33.50 33.25 Brazilian Real 3.85 4.00 4.25 4.50 4.25 Mexican Peso 19.89 20.50 21.00 21.50 21.00 Czech Koruna 22.52 23.21 24.09 25.00 24.09 Hungarian Forint 281 295 305 315 305 Polish Zloty 3.74 3.93 4.09 4.26 4.09 Russian Ruble 68.27 70.00 75.00 80.00 75.00 S. African Rand 14.36 14.50 15.00 15.50 15.25 Turkish Lira 5.26 5.50 5.75 6.00 5.75 Israeli Shekel 3.77 3.85 4.00 4.25 4.00 In Euro Terms Current Q1 2019 Q2 2019 Q3 2019 Q4 2019 Czech Koruna 25.79 26.00 26.50 27.00 26.50 Hungarian Forint 322 330 335 340 335 Polish Zloty 4.29 4.40 4.50 4.60 4.50 *There is no assurance that future forecasts will be attained.

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2019 First Quarter Outlook | 9 FOREIGNEXCHANGE

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