Saxo Q2 Outlook: Europe Mispriced

Opportunities for investors as the gap between perception and reality of asset prices and liquidity widens

Saxo Bank, the online multi-asset trading and investment specialist, has today published its quarterly outlook for global markets and key trading ideas Q2 2017.

Europe to Outperform the United States

European assets, with the exception of German fixed income, enter the second quarter of 2017 with small or large discounts, based on nervousness about the French and German elections, and expectations over the end outcome of Brexit. With our base scenario that the European economy will outperform the US economy over the next four years, we see a wide gap between perception and reality when it comes to European assets, which will present significant buying opportunities for investors in Q2 2017. 

Commenting on the outlook, Steen Jakobsen, Chief Economist and CIO, Saxo Bank, says: "As we head into the second quarter of 2017, it is increasingly apparent that the European instability narrative may be overblown as the continent prepares to outperform the US which is overly dependent on the Trump-trade. 

"What non-Europeans often fail to add to their assessment is the massive amount of political capital invested in Europe and the euro. With little or no chance of France leaving the euro – regardless of whether Marine Le Pen wins or not - we expect a significant move in the euro's value once the elections are done in Q3. 

"Europe runs a big current account surplus, the ECB is moving towards a less accommodative policy stance and the CEE region continues to outperform with average growth levels above 3%. However, while all this points to the fact that Europe will do better than the US in Q2, we maintain that recession is still likely in the 12-18 month period as we see the credit pulse peak simultaneously with the global inflation,” adds Jakobsen. 

France Could Become Ungovernable

With the French Presidential election likely to be one of the most closely watched events of Q2 2017, Saxo Bank urges traders and investors to look at the legislative elections in June which will provide a more accurate view of the future direction of France. 

Christopher Dembik, Head of Macro Analysis, says: "There are essentially two possible outcomes here. Either Le Pen is elected President but she is deprived of real powers by not winning the legislative elections, or Macron is elected President but he has difficulty dealing with his overly-heterogeneous majority.

"For the first time since 1958, parliamentarians could make their great return which, given the experiences of the Third and Fourth Republic, is not a positive signal. In the end, France could become ungovernable,” added Dembik. 

European Equities will Outperform us and Japanese Equities

The reflation trade that started before Donald Trump's victory in the US presidential elections accelerated in Q1 as global economic data improved and surprised against expectations. Saxo Bank points out that the reflation trade could end in Q2 with a healthy correction in global equities.

Peter Garnry, Head of Equity Strategy, says: "While investors are focusing on Europe's political landscape with upcoming elections in France and Germany, they seem to have missed the fact that Europe's GDP growth has surged to almost 3% annualised, estimated by the euro-coin indicator from Bank of Italy. 

"The drivers are improving financial conditions, upward pressure on prices and increasing business confidence. This improved economic picture and outlook is at odds with the valuation discount to US equities and one of the main reasons behind our overweight Europe and underweight US theme. If Macron wins the French election we believe French equities will outperform in Q2 against other European equity markets.”

A More Volatile FX Market

Q2 could well see much of the uncertainty lifting on the EU political front and greater sense on whether Trump can rally the rare majority he holds in the House and Senate to pass policies that could boost the US dollar. In any case, the remarkable lull in volatility in Q1 could yield a more volatile market as we sort through important themes and after global complacency levels reached extremes in Q1.

John Hardy, Head of FX Strategy, says: "Risks are two-way for the USD in Q2, mostly depending on Trump, thought the upside potential has increased due to the market's growing scepticism. We expect the euro will continue to be supported by the strength of incoming data from across Europe and the ECB eases off on fretting the downside risks. An important caveat though beyond the Q2 is how the weakest peripheral countries, most importantly Italy, will deal with an ECB taper.

"A discounted sterling may be justified given the UK's still large twin-deficits and the overhanging Brexit uncertainty, although as the process could take many years to unfold, this could see the market gradually unwind the uncertainty discount. Lastly, Chinese liquidity withdrawal could weigh on the outlook for EM currencies in Q2 and beyond, likewise tempering enthusiasm for the reflation trade. "

Relative Stability in the Bond Market

With the largest proportion of political risk disappearing after the French election, we expect a relief rally in riskier assets, but also an elimination of safe-haven premium in core markets like the German, Dutch or Danish bond markets, sending the overall core-yield levels higher.  In September, the German election can restart another round of moderate risk-off, although we do not see the same market concerns regarding this election, at this point in time.

Simon Fasdal, Head of Fixed Income Trading, says: "This could be the quarter that sees relative stability in global bond markets, with inflation and yields moving higher, but a dive in the oil price or geopolitical risk could be the rock on which the steady ship founders."

Sharp Reality Check for Oil, and a Bonus for Gold

Commodities bulls may have entered Q1 on a wave of enthusiasm spurred by the great reflation trade, but there has been a sharp reality check that looks like being a bonus for gold and negative for oil.

Ole Hansen, Head of Commodity Strategy, says: "When it comes to oil, what became increasingly apparent during the first quarter was the lack of price momentum to justify this bullish build-up in speculative bets. We believe the best the market can hope for in Q2 is for Brent crude to stabilise around $50/b but cannot rule out a temporary drop to $45/b. We lower our year-end forecast to $58/b in the belief that demand growth and supply cuts eventually will positively impact the price.”

"Gold, where investors have maintained a lukewarm attitude with rapid build-ups of speculative longs reflating quickly ahead of FOMC, needs to see the bullish dollar and bond yield expectations face more that they have already. We maintain our end of year forecast at $1,325/oz and based on a pick-up in industrial metals, we could see silver reaching $19/oz. "

To access Saxo Bank's full Q2 2017 outlook, with more in-depth pieces from our analysts and strategists, please go to: https://www.tradingfloor.com/publications/quarterly-outlook