Saxo Q4 Outlook: A new easing cycle based on ugly realities

Saxo Bank, the online trading and investment specialist, has today published its Q4 2018 Quarterly Outlook for global markets, including trading ideas covering equities, FX, currencies, commodities, and bonds, as well as a range of macro themes impacting client portfolios.

“We are clearly at a crossroads on many fronts: globalisation, geopolitics and economics”, says Steen Jakobsen, Chief Economist and CIO, Saxo Bank. 

“The next quarter will either see dampening of volatility by a less aggressive Fed, more active easing in China, and a compromise on the European Union budget… or a further escalation in tensions between all three areas. I would not bet against the latter into Q4, but I remain confident that we stand only a few months away from the beginning of a new easing cycle based on ugly realities, not the hope expressed by politicians and often market consensus.

”For now, we estimate that the US economy has peaked – the powerful expansionary cocktail of unfinanced tax cuts, repatriation of capital, and fiscal spending ramped up growth in the US, but these one-off effects will peter out as the year ends. Already the US housing market is showing signs of strain as the higher marginal cost of capital (the higher yield on mortgages, more specifically) is starting to have a material impact on future growth.

”As certain as we are about the US having peaked, we are less certain as to how soon China will reach the bottom of its deleveraging process and begin to expand more forcefully again.”

Against this uncertain backdrop, Saxo’s main trading ideas for Q4 include: 

Equities – Setting the stage for a comeback in value stocks

Throughout 2018, Saxo has constantly said that investors should be defensive on equities and avoid the semiconductor and automobile industries due to the escalating trade war between the US and China. Valuations – especially in US equities, which are half of the global equities index – have reached levels where the risk-reward ratio is too low. 

Meanwhile, the Federal Reserve continues to normalise the Fed funds rate, communicating that rates are far from neutral. As the most important discount rate is lifted, it changes the dynamics, making growth stocks vulnerable and maybe setting the stage for a comeback in value stocks.

Peter Garnry, Head of Equity Strategy, said: ”The likelihood is quite high that US equities will achieve just 0-1% in annualised real return over the next 10 years. If inflation exceeds expectations, the outcome could be considerably worse. Making things worse for US equities, there are finally attractive alternatives due to the Fed’s recent rate hikes.” 

FX – Nothing will end a strong USD faster than a strong USD

The reaction of the US dollar to developments in US yields has been an on-again, off-again affair, but a sharp rise in US yields in late Q3, after strong wage inflation data were reported for August, resulted in a weaker dollar for much of September. From here, whether rising US yields continue to squeeze global USD liquidity and especially emerging markets, could depend on China’s intentions for the renminbi. 

Regardless, if US rates and the USD both rise further, the first would quickly break US markets and eventually the US economy, and together would likely break the global economy, particularly the emerging markets that most indulged in USD-denominated borrowing via the Fed’s zero interest-rate policy years after the global financial crisis.

John Hardy, Head of FX Strategy, said: “The direction of the US dollar remains the key driver of action as we go from a late US monetary policy cycle to potentially the end of that cycle in a more concentrated and immediate timeframe than the market or the Fed anticipates. The US dollar and US rates can only rise so far from here before something – or rather more things – break.

“US long yields have crossed the Rubicon in technical terms, and a further aggravated rise in yields cannot be excluded in Q4. But higher rates will eventually put the brakes on the US recovery, something that may already be happening as Q4 gets under way. Q4 may be the quarter in which the USD finds a local top, if it hasn’t already, and then is toppled into reverse as the market figures that the Fed has taken things too far. Timing is the chief risk as we must deal in probabilities and the risk that we are a quarter or more too early.”

Macro - China opens the credit taps

Since last May, when the trade war intensified, there has been a shift towards looser policy and stimulus efforts. Chinese markets have been flooded with cheap central bank liquidity when the Shibor plunged, leading to a pick-up in credit growth.

So far, the most significant impact of monetary easing is that it has contributed to push the credit impulse – the “change in the change” in credit and a key driver of economic growth – back into positive territory. The magnitude of the impulse is still very limited, but it should increase in coming months and be sufficient to sustain local investment and expansion.

Christopher Dembik, Head of Macroeconomic Analysis, said: “China’s global importance is likely to increase further as the US economy is succumbing to the siren song of protectionism and central bank liquidity injections are falling. In previous periods of lower liquidity or slowing growth, China acted as an adjustment variable by pushing credit upwards as in 2012-13, thereby mitigating the effects of the Fed’s tapering. It seems that China is willing to step in to restimulate the economy once again. The current divergence of monetary policy between China and the rest of the world may still represent a chance for the global economy.”

Eleanor Creagh, Market Strategist, added: “The US-China trade war continues to escalate along with Washington’s shifting perception of China. There remains some hope of keeping these powers aligned, however, as US president Trump and Chinese president Xi Jinping meet in late November at the G-20 summit. Although a deal may be struck, the probability of this outcome seems low given the marked deterioration in diplomatic dialogue and the increasing probability of a new “cold war” fought via technological supremacy.

“Given the likelihood of a trade war escalation over the next few months, the Chinese equity market could experience another leg down. For longer-term investors, short-term market noise should not detract from the fundamental opportunity. The attractive valuations are indicative of the potential for future returns once the extremely negative sentiment mean reverts.”

Commodities – Trump, sanctions and tariffs

The direction of many major commodities will continue to be influenced by the decisions taken in Washington during the past six months. Apart from the weather, which has delivered challenges as well as opportunities across the agriculture sector, President Donald Trump’s trade war with China and sanctions against Iran will keep setting the tone for the rest of the year. 

Ole Hansen, Head of Commodity Strategy, said: “The trade war, especially with China, shows no signs of easing. At least not before the November midterm elections, with Democrats generally favouring Trump’s tough stance towards China. Accepting this fact, China has shown little interest in trying to find a solution before the US elections. While growth and demand-dependent commodities, such as industrial metals, have been left reeling, energy prices have risen sharply in response to the November introduction of US sanctions on Iran’s oil trade. 

”With the risk of a prolonged trade war and rising oil prices due to sanctions, the global economy may struggle to maintain its long-held positive momentum. The combination of rising energy prices and the hitherto strong dollar, not least against many emerging market currencies, will act as an unwelcome tax on consumers. ”

Fixed Income – Preparing for the slowdown

The fragility and contradictions of the financial market are starting to surface, and although credit spreads will be put under considerable stress in the fourth quarter, we do not expect to see an overwhelming sell-off until the US economy slows and gradually turns into a recession. This should give investors plenty of time to assess their risks and position themselves for a possible downturn in 2019-20. The current market still provides opportunities, especially in the short part of the curve, and investors can use episodes of volatility to enter solid assets at a better price.

From the financial crisis of 2008 until today, emerging markets have taken advantage of low interest rates and yield-deprived investors to issue more and more debt in hard currencies, the majority of which is in US dollars. 

Althea Spinozzi, Bonds Specialist, added: ”We believe that Q4 will see the performance of European sovereigns put at risk by the demands of the Italian government to the European Commission, which will not only be confined to discussion of the 2019 budget but could even see an escalation of tensions as Italy makes it clear that it is not willing to abide by Brussels’ rules.

”Although the Italian government will be a tough cookie to deal with, we believe an ‘Italexit’ is not possible. The Italian economy is highly dependent on the euro area economy, and the single European currency complicates things regarding a possible exit. This makes it impossible for the parties to pursue this without losing the bulk of their voters, who would find themselves in a weaker position than they had while in the EU.”

Macro – Young demographics cannot be ignored

Since the tail end of 2017, Saxo believes that emerging market central banks were skewed towards hawkish surprises – whether they liked it or not. The two key standouts against this tide were Russia and Brazil, which were cutting rates to combat domestic problems. They have since stopped, and in Q3 the Russian central bank surprised everyone with a rate hike.

Kay Van-Petersen, Global Macro Strategist, said: ”The only thing Brazilian investors have to smile about is that at least they have fared better than investors in Turkey and Argentina whose currencies were down 29% and 44% respectively by the end of Q3, when the BRL was down 15%.

”With inflation ticking up over the summer, we could see a more hawkish Central Bank of Brazil being forced to move despite the country’s lacklustre growth and unknown fiscal policies of the future government.

”It will be crucial to see whether or not China steps up the stimulus, which so far has not been significant enough to stop the pressures on EM (for example, August’s new loan figures were worse than expected and PMIs, while still in expansion mode, are trailing down towards 50). The official line from the People’s Bank of China will be that it is not interested in a weaker renminbi. Unofficially it is dampening the tariffs from Team Trump, and the degree of combativeness from the US will be symmetrical to the eventual weakness in CNH. 

”The most interesting and profitable aspect of the trade tariffs between the US and China is their unintended consequences in the long term. Washington wanted to curb China’s 2025 plans, but the result is likely to be that Beijing moves those plans forward to 2022 or, in some cases, 2020.”

To access Saxo Bank’s full Q4 2018 outlook, with more in-depth pieces from our analysts and strategists, please go to:
 https://www.home.saxo/insights/news-and-research/thought-leadership/quarterly-outlook