Saxo Q2 Outlook: The end of a cycle like no other
Saxo Bank, the leading Fintech specialist focused on multi-asset trading and investment, has today published its quarterly outlook for global markets and key trading ideas for Q2 2018. The focus of the report is how we are nearing the end of the largest monetary policy experiment of all time in a backdrop of ascendant nationalism, staggering inequality and a widespread loss of hope among the younger generation.
In its Q1 report, Saxo Bank highlighted bubbles in financial markets and now wants to alert investors to the fact that we are at the end of a cycle like no other. Central banks have replaced politicians as decision-makers and their maintaining of low and negative interest rate policies and quantitative easing – for far longer than the normal business cycle would dictate – was necessary and kept markets in a good mood, but with the unfortunate side effects.
Today’s capital markets are in a zombie-like state, with low volatility and extreme valuations in all assets with no net increase in growth and productivity, and a massive increase in inequality.
Saxo Bank’s Q2 Outlook covers the bank’s main asset classes: FX, equities, commodities and bonds as well as a range of central macro themes and tactical asset allocation models.
Commenting on this quarter’s outlook, Steen Jakobsen, Chief Economist and CIO, Saxo Bank, said:
”The benefits from the globalised system and particularly from the central banks’ asset-pumping response accrued near-entirely to the already wealthy, while the average economic participant lost out. This is the process that drove the advent of Brexit and Trump. So now we have our first great new showdown since the Cold War, which saw the victory of capitalism over communism. Now comes the fight between nationalism and globalism. Nationalism is winning big, as country by country the outlook is turning inwards, with an increase in placing the blame on external forces from immigrants to the real and imagined misbehaviour of trade partners. Talk of trade policy and protectionism is now labelled ‘trade wars’.”
”In our view, the implications of a global trade war and the world possibly having reached peak globalism have super-cycle implications. On the interest rate front and due to the excess of central bank policy, we are likely about to see the end of the 35-year downward trend in interest rates, the price of money. This has enormous implications, as the world has amassed $237 trillion of debt with little growth to show for it. At the same time, we have seen an information technology revolution in which technology companies have become monopolies of a size not seen since the 19th century, with their dominance of the market and downright scary data-gathering capacity more powerful than that of governments.“
”This is now changing with the European initiative to both enforce GDPR, the General Data Protection Regulation, and the 4% turnover tax applied to technology companies. This will reprice technology, as (at a bare minimum) growth is now taxed higher with more spending needed on data protection, which is not ‘sales’ but costs.”
Tactical asset allocation in economic cycles
As this current economic cycle draws towards its close, preserving capital becomes an increasingly important metric. But how to achieve this? One method is tactical asset allocation and the key to success here is to identify the asset classes which relatively outperform during the different periods of an economic cycle. One strategy is to construct a framework in which portfolio weights deviate from the asset allocation policy throughout the economic cycle, also called tactical asset allocation. The key to success in tactical asset allocation is to identify the asset classes which relatively outperform during the different periods of an economic cycle.
Anders Nysteen, Quantitative Analyst, said:
”It is important in this environment to have a portfolio not just with “soft” assets but to be prepared for sudden market changes with a more diversified portfolio including some of the “hard” assets such as commodities, real estate, and emerging market exposure. With the current slightly negative credit impulse and highly indebted financial system, minor events could trigger increased uncertainty in the market, leading to a further expansion of the corporate spreads. A potential trade war between the US and China could increase the risk premium in credit markets. This would trigger a slowdown in the economy as companies would face higher financing costs.
”Saxo Bank’s forecast is that credit spreads will widen and the yearly change in gold prices will stay positive. However, the consensus is looking for credit spreads to remain low and not expanding much while inflation will pick up.”
Macro – Credit impulse is heading south
As we enter the second quarter of 2018, the hopes of synchronised growth are vanishing quickly as the global economy suffers a loss of momentum (global PMI has plunged to a 16-month low) and warning signs of an imminent slowdown are popping up in the US. Economic indicators ranging from Saxo Bank’s proprietary credit impulse to the yield curve and credit card delinquencies all point in a single direction – the US is heading for recession.
Christopher Dembik, Head of Macroeconomic Analysis, said: ”Based on up-to-date domestic nonfinancial loans data, such as C&I loans in the US, there is every reason to believe that the sluggish momentum will remain in place in both China and the US on the back of deleveraging and monetary policy normalisation. In a highly leveraged economy like the US, credit is a key determinant of growth. The main risk for investors is the increasing mismatch between the optimistic view of the market that considers the risk of recession as being less than 10% and what recession indicators are saying about the economy. These indicators suggest that the US is at the end of the business cycle – which is not much of a surprise – and hint that recession is just around the corner and Trump’s economic policy does not seem able to avert it.
FX – The US dollar is a time bomb
Ten years after the start of the global financial crisis, President Trump has turbocharged the search for a replacement for the US dollar as the world’s chief reserve currency with his total abandonment of fiscal discipline at what could prove the tail end of the US recovery. The USD is destined for pronounced weakness in purchasing power as reserve status begins to slip away – now sooner than before. But the real devil is in the detail of how we get there.
John Hardy, Head of FX Strategy, said: “As we look to the rest of 2018 and beyond, we suspect we are nearing the beginning of the endgame for the USD’s role in the global economy. The financial world risks another liquidity crisis linked to the US dollar if we see another financial panic or turn in the global credit cycle. Some new reserve asset will have to be at the centre of that new system – some have argued for a Special Drawing Right, a gold-backed SDR or similar. Otherwise, a new USD crisis could overwhelm the financial system without a coordinated response, risking a mass of defaults, unprecedented exchange rate volatility and a Balkanisation of the global financial system with no single reserve asset and division of the world into spheres of influence.
“The question is whether global elites can move to short circuit the inevitable USD crisis in launching such a monumental reconfiguring of the global financial system without the permission/consent/direction of political authorities in countries with democratic leaders.”
Equities – The battleground in Q2 will be that of fundamentals against the outlook
Equities are under pressure on many fronts, ranging from a potential trade war to disappointing macro numbers and technology regulation. Caution is critical in such an environment and portfolio diversification and defensive choices therefore make sense. Saxo Bank believes that the battleground in Q2 will be fundamentals against outlook.
Peter Garnry, Head of Equity Strategy, said: “Our dynamic asset allocation has gone moderately defensive in February and as a result we remain negative on equities as the risk-reward ratio seems low at this point. We recommend investors to be overweight defensive sectors such as health care and consumer staples, as well as interest rate-sensitive sectors including utilities and telecoms as rate expectations could take a hit in Q2 while markets digest the changing landscape. Portfolios should be more balanced and tilted towards defensive industries in the portfolio’s equity exposure.”
Commodities – Investors will continue to see safety in gold
The turbulent turn that geopolitics took in recent weeks has had a severe impact on commodities. But while crude oil and gold benefitted from these tensions, industrial metals suffered on the outlook to lower economic growth. The agriculture sector, meanwhile, was ruled by the weather.
Ole Hansen, Head of Commodity Strategy, said;
”Commodities got off to a strong start in 2018 but have since come under heavy pressure as rising trade tensions threatened to further undermine already slowing economic growth momentum. The focus on a commodity-supportive rise in inflation has also faded with current and forward projections not showing much sign of a pickup in global price pressure.”
”Against these developments we are facing multiple sources of geopolitical risk including Russia and the West on opposing sides in Syria, as well as Iran against Saudi Arabia and the US. While increasing the level of uncertainty, these simmering tensions have also been providing some underlying support for crude oil and, to a certain extent, gold. For this reason, these two commodities are among the very few cyclical commodities currently showing a plus on the year. Given our worries about the outlook for global growth and inflation potentially not meeting expectations, we are turning our attention to the non-cyclical agriculture sector, which has underperformed almost against all other asset classes for several years.”
Bonds – Time for bonds to join the volatility party
The economy is witnessing a gradual degradation of corporate credits, and an increase in bond market volatility appears likely over the coming months. With the Congressional Budget Office now saying that the US deficit will rise above $1 trillion by 2020 and warning of dangerous implications such as a sudden increase in interest rates, reduced policy flexibility and ultimately even a financial crisis, Saxo Bank cannot help but stay cautious. It believes that Q2 will see intensifying signs of distress in the corporate space which may provoke confined periods of volatility, but a more severe sell-off will not happen until the end of the year.
Althea Spinozzi, Fixed Income Specialist, said:
”We believe that investors’ focus will remain on inflation and the supply/demand of Treasuries, and any surprise in this data may cause volatility within the sovereign space. However, this will most likely not cause a sell-off in the corporate space until the 10-year Treasury yield hits the 3% psychological level or there is a more significant sell-off within the equity market. In Q2 we will see increased, yet limited, episodes of volatility which will provide investors with a window of opportunity in which to carefully select risk ahead of the stormier waters to come.”
Currency – A regime change lower in AUD
In the long term, Asia’s enviable demographics see the APAC region enjoying some of the best returns across asset classes compared to its global peers. Not only does the populous region have more economic “chips on the table” in weighted terms, but it also has more time to place those chips, employ its strategies, and – perhaps most importantly – make mistakes.
Kay Van-Petersen, Global Macro Strategist, said:
”For the first time in nearly 20 years, we see a yield differential between the Reserve Bank of Australia and the Federal Reserve that actually favours the Fed. At present, the Federal Funds rate sits at 1.75% versus the RBA’s 1.50% – a 25 basis point premium towards the Fed, USD, and US assets versus their Australian counterparts.”
”Policy divergence between the Fed and other central banks is projected to increase as well, particularly given the likelihood of another Fed rate hike on June 13. The RBA, by contrast, has been in neutral-to-dovish mode for well over 18 months and this is unlikely to change. After all, Australia is an economy flush with high levels of consumer debt, a fragile and over-extended property market, stretched bank balance sheets, and the risk that comes with not having endured recession in more than 25 years.
Are cryptocurrencies entering a new cycle?
Cryptocurrencies fell back to earth with a bang in the first months of this year, having enjoyed exponential growth in 2017. The situation remains fragile, given the outlook to increased regulation and social media advertising bans. That said, we can’t rule out the possibility of a comeback.
Jacob Pouncey, Cryptocurrency Analyst, said:
“If there is a significant pullback in the equity markets, there will be an inflow of money into uncorrelated assets, or assets that lie outside the reach of the traditional financial system in which cryptocurrencies are a potential alternative. The inflow of institutional capital to the cryptocurrency market due to the increase in regulation and investor protection could lead cryptocurrencies to a positive quarter.”