Saxo Q2 Outlook: Europe - Can the centre hold?

“The euro could struggle to rally until a path towards EMU deepening opens up”, says Steen Jakobsen, Chief Economist and CIO, Saxo Bank. 

“The gulf between European valuations and their US counterparts remains high with Europe trading at a massive discount. Part of this lies with the composition of business – Europe has less technology firms and more privately-owned companies. In fact, the most truly successful companies in Europe remain in private hands, and for good reason as they refuse to cave to short-term, quarterly earnings report-centred strategies.

“The view from the outside is that Europe is a perennial basket case. This is an easy conclusion to reach if you don’t understand Europe’s history, its vested interests, the peace dividend and the need for government to sell the naive illusion of fiscal self-rule.

“We firmly believe that any macro change has to come from a breakdown or a crisis, and as such we see 2019 and 2020 as key years for Europe’s evolution. We foresee populist parties getting 20% if not 25% of the popular vote in May’s European parliament elections.

“The most important, factor, though is the collapse of German growth. We see a risk of recession there by Q4 even without a trade spat with the US. Germany, with its very successful “industry 3.0” model, is being left behind. Underinvestment in the technology sector leaves it unprepared as “industry 4.0” rolls in, and its internet speed ranking is just one of many symptoms. Germany needs to catch up in terms of digitalisation, in terms of programmes for working women, with new airports and more overall infrastructure spending.

“The lapse of Germany will reopen the Franco-German “hotline” as well as making the debt issue a pan-European issue, and not one of Germany versus the PIIGS, or austerity versus free spending. Investors long convinced by talk of basket cases would be unwise to count out Europe. It is, after all, perfectly positioned to benefit from automation, AI, digitalisation and a capital market that is cheap by any standard.

“Q2 will see the noise increase; the “basket case” narrative will be spread far and wide and the EUR, led by the ECB, will probably test 1.05 if not 1.03 versus the dollar. The next 12 months, however, will be 2000 all over again.“

Against this uncertain backdrop, Saxo’s main trading ideas and themes for Q2 include: 

Equities – the great divergence

Peter Garnry, Head of Equity Strategy, said: “We remain defensive on equities until there is evidence of a turning point as contracting economies with below-trend activity have historically delivered negative equity returns. Within Europe, this macro environment is typically bad for Europe’s cyclical equity markets such as Germany, Italy, the Netherlands, Norway and France. The equity markets that usually do relatively well in a poor economic environment are Denmark, Spain, Sweden, Switzerland and the UK.

“One of Europe’s biggest problems remains the banking sector. The total return on Europe’s banking sector is zero since January 2003; in real terms, it’s -28.5% over a 15-year period. This is an ugly parallel to Japan’s zombie banks after its meltdown in the 1990s. Europe has also agreed to implement costly banking regulations, driving up costs on an already weak sector. It has been 10 years since Lehman Brothers’ bankruptcy and Europe’s banking sector has still not healed; this will continue to be an anchor constraining growth and equity returns.

”The latest political attempt in Germany to merge Deutsche Bank and Commerzbank as a clear signal as to the current political system’s ability to understand the nature of the problem. Banks are already too big and complex, jeopardising the overall system, and Berlin wants to increase banking sector concentration despite popular outcry. A sensible approach would be to increase competition instead of limiting it.”

FX – Europe has most to lose and most to gain

Europe is in a potential lose-lose situation as we await the outcome of the US-China trade negotiations. The friendlier the deal, the more likely that China could shift some of its import demand away from Europe and towards the US. With or without a friendly deal, risks point to ongoing de-globalization and a growth slowdown that would be double trouble for the European Union, the world’s largest trade surplus economic bloc. 

Saxo believes that Europe deserves a considerable portion of our attention as Q2 will inevitably prove an important pivot point for the EU. Either we see escalating signs of further dysfunction or a more determined shift by EU governments to get ahead of the risks of rising populism and the unworkable fiscal/European Central Bank foundation of the EMU.

John Hardy, Head of FX Strategy, said: “Our least favourite currencies in a weakening global growth environment are the commodity dollar currencies, where housing bubbles are in various stages of unwinding, inevitably impacting the credit and therefore growth outlooks. Our longer-term bullish call on commodities should eventually offset downside risks, but these risks will prevail until central bank policy in these countries looks like it does for the rest of the DM – i.e. more or less ZIRP and central bank balance sheet expansion to clean up the private credit mess.

“Growth risks remain a concern for emerging markets, but we think China provides a backdrop of stability as it seeks to maintain a stable currency and attract capital inflows to deepen its capital markets and accommodate its transition to becoming a deficit country (a key step in shifting the CNY to an eventual reserve asset). The JPY could do well during bouts of risk deleveraging this year, but the Japanese government is perhaps the most ready to switch on the fiscal stimulus, with the Bank of Japan happy to cooperate as it seeks to avoid yen volatility.”

Commodities power ahead

The commodity sector delivered a surprisingly strong return during the first quarter of 2019 with the Bloomberg Commodity Index trading higher by 9%. This remarkable development relates to the fact that the rise was led by growth-dependent commodities such as energy (+17%) and industrial metals (+12.5%). 

Markets, including commodities, began the year on the defensive with growth concerns and US Federal Reserve-led liquidity tightening raising concerns about the prospects for 2019. 

The year, however, was only a few weeks old before global policy panic set in. In early January, the Fed hit the pause button before abandoning it at the end of the quarter while calling a halt to further quantitative tightening. The Bank of Japan and the European Central Bank followed suit with their own measures, while in China the government stepped in with various initiatives to stabilise the economy as the chance of a trade deal between Washington and Beijing helped sentiment further. 

Ole Hansen, Head of Commodity Strategy, “The dramatic recent turnaround at the Fed is seen as bullish for gold as the return to a dovish stance highlights the risk of a gold-supportive recession within the next 12 months. The second quarter, however, may not yet provide the spark gold needs to break strong resistance between $1,360/oz and $1,380/oz. Into the second half, however, a formidable challenge could be seen amid support from a weaker dollar, stable to lower bond yields and concerns about global stocks’ ability to forge higher amid raised growth concerns.”

Macro – You can’t fight gravity

There has been a huge shift in the global macro backdrop over the last six months and it has huge structural significance for both Asia and the world as a whole. The crux of the matter is that central bankers, led by the Federal Reserve and European Central Bank, have unequivocally failed to attain escape velocity from quantitative easing. The gravitational pull of addiction to lose money has led to pampered stock and bond markets, as well as some remarkable events.

Saxo believes that we shouldn’t be surprised about escaping this QE world, particularly given debt levels are now north of $250 trillion as compared to $175 trillion before the financial crisis. The bank does feel though that the speed with which we have been pulled back in, was surprising. The implication is now that, until a “great debt reset” (read: haircuts, restructuring and a debt jubilee) that could still be five to ten years away, it’s back to QE for life.

Kay Van-Petersen, Global Macro Strategist, “Taking the world back to looser monetary policy and lower yields will be bullish for bonds and equities. Expect new cyclical lows in bond yields for example, and as we have long mentioned, Australian 10-years are already taking out the 1.81% lows. Structurally speaking, I also expect a much weaker USD over the course of the year. The world needs a weaker USD to flourish and what the world needs, it tends to eventually get.

“It’s also worth noting that while we are not far from all-time highs in US equity indices, we have already seen new all-time highs in certain stocks, Shanghai at around 3,100 is still around 40% lower than its 2015 high of 5,180. We also have huge China equity inclusions in the MSCI EM index coming that will take us from 5% to 20% (in +5% increments slated for May, August and November. The bounce in Chinese equities is likely telling us that, for now at least, we’ve seen the worst in the underlying Chinese economy and could be in for some positive surprises, particularly in Q2’19 growth data.” 

Bonds – Why sovereign bonds are Q2’s investor favourites

The first quarter of 2019 saw a U-turn in central bank policy. With data pointing to a global slowdown, policymakers do not wish to take chances. Saxo believes that is why we have seen the Federal Reserve stall its rate hike plans, the European Central Bank commit to whatever support measures are needed and the People’s Bank of China push stimulus in the form of fiscal policy.

Althea Spinozzi, Bonds Specialist, added: “We believe that this global policy panic will play in favour of global sovereigns. Credit spreads will also be supported, but investors should remember that dovish central bank policies may prolong the late-cycle period. They will not, however, be sufficient to entirely avoid the recession we believe is coming in Q4’19 or early 2020. This means that while credit valuations will be supported for longer, credit risk will remain very high; in this context, investors should stay cautious and avoid picking up unnecessary risk, especially in the high-yield and emerging market spaces.

“The global policy panic sparked by the December selloffs has seen the Fed turn away from quantitative tightening and its own rate hike schedule. A dovish Fed is good news for bond investors even amid muted economic growth. Treasuries will gain from the unconditional support even though if it is now clear that recession is coming.”

Macro – A reality check for the euro area

Large declines in core European industrial production data can be observed, especially in Germany, which accounts for one-third of European industrial activity. This slowdown came as a shock for many policymakers, but Saxo feels that it was predictable. Over recent quarters, leading indicators – notably credit impulse - led us to warn clients and investors against the risk of lower growth in Europe.

As economic data will continue to disappoint in the coming months, Saxo believes that a new consensus for looser fiscal policy will emerge in European countries in H2’19. An accumulation of negative German data could be the perfect trigger to set off expansionary fiscal policy in Europe.

Macro – Debt financed spending versus rising populism

From Trump and the China-US trade war to Brexit and the gilets jaunes, the threats of this regime shift are evident. The tectonic plates are shifting, even if we are yet to feel the consequences of the extremist versions of these movements, like a hard Brexit. After a 30-year spate of deregulation and laissez-faire economics, this new paradigm will create a different business and investment environment and the implications will be far-reaching, creating fresh headwinds and therefore risks.

Eleanor Creagh, Market Strategist, commented: “As the backlash intensifies, so will the battleground, making it increasingly difficult to price risk and determine the policy response against a complicated and polarising backdrop. Aside from reactive or palliative redistribution policies, any response that will bring real improvement and tackle the misfortunes of those caught on the wrong side of globalisation seems a long way off. The current new political era is the result of decades of societal shifts and the solution could itself take decades to work though.” 

To access Saxo Bank’s full Q2 2019 outlook, with more in-depth pieces from our analysts and strategists, please go to: www.home.saxo/insights/news-and-research/thought-leadership/quarterly-outlook