Saxo Q1 Outlook: Beware The Global Policy Panic
Europe is sliding back into recession, China has pushed back its 2025 plan by a decade and US market tremors have forced the Federal Reserve to make an embarrassing about-face in its first 2019 outing. Welcome to the Grand Finale of what Saxo’s chief economist Steen Jakobsen terms “the worst monetary experiment in history”.
As 2019 gets under way, Europe is sliding back into recession despite a negative ECB policy rate.
Strains in the US credit market reached a crescendo in the first trading days of 2019, as Barclay’s high-yield spread climbed more than 500 basis points above US Treasuries. This combined with a bear-market run in equities from the September highs saw US Federal Reserve chief Jerome Powell trotting out the latest version of the Fed in an interview where he shared the stage with his two bubble-blowing predecessors. There was plenty of egg on Powell’s face as his promise to “listen to the market” came barely two weeks after he put on a hawkish show at the December 20 Federal Open Market Committee meeting. So the Fed is already slamming on the brakes as the flows from corporate repatriation run dry and high-risk issuers have not been able to auction debt.
China is still contemplating its next stimulus – tax cuts, mortgage subsidies, a stronger renminbi – and is wondering how to proceed towards its 100-year anniversary in 2049 with its 2025 plan now pushed back to 2035.
The UK, meanwhile, has suffered the biggest credit impulse contraction of any country, leaving the first half of next year a major risk for UK assets.
One bright spot for the new year is that the price of energy in USD terms plummeted back to 2017 levels in Q4, though it remains very volatile. Still, it will take some time for this fresh stimulus to be felt after the highest prices since 2014 were registered a mere three months ago – particularly for emerging market currencies, which were likewise very weak at the time.
In Q1, a combination of the Fed pausing and signalling a climb-down from QT with China continuing to drive the CNY stronger toward 6.50 or better versus the USD could help. China can pay the price of a 5% stronger currency as it reduces the burden on state-owned enterprises' USD-denominated debt and could power a massive boost in resolving the trade impasse. At the same time, a strong policy move like this from China with a weaker USD backdrop could drive a considerable relative revival in EM assets.
The global economy is suffering, global markets are shaken after a terrible 2018, and China will do all it can for stability. The hunt for a solution is fully engaged, and the odds of one appearing are rising fast. In our view, a solution needs to show itself before February 5, the Chinese New Year – this is a top priority for both sides in the US-China trade dispute. The alternative is simply too dire. After Chinese New Year, we will see powerful support for the Chinese economy – it is needed, and it will come. Nonetheless, beware of incoming turbulence as the policy response everywhere is reactive rather than predictive and may come a bit too late. This means that Q1 is the riskiest period, and this is where the cyclical low in assets and the economic cycle will come. Q1 may see a significant market low for this part of the cycle.
That being said, early 2019 could merely mark the start of the cycle or the early innings of the next cycle of intervention. 2020 is more likely to prove the real year of change. That would fit the political cycle, and it might take an even bigger scare for central banks and politicians to get their acts together – unfortunately.
Welcome to the Grand Finale of extend-and-pretend, the worst monetary experiment in history.
Against this uncertain backdrop, Saxo’s main trading ideas for Q1 include:
Equities – Entering their final act
Last year was spectacular, starting with peak euphoria and ending with violent December drama of a type not witnessed since 1931. Equities and the current expansion are entering their final act, so risk-reward is not attractive. Saxo still believes that equities should be part of investors’ asset allocation, but with a low weighting of around 30%, and exposure should be mainly in defensive sectors (consumer staples and healthcare) and minimum-volatility stocks.
Peter Garnry, Head of Equity Strategy, said:
“We remain defensive on equities as the risk-reward ratio for 2019 looks bad. Short term, we could see a rally if China succeeds in its stimulus of the economy and the country strikes a deal with the US on trade. Our equity model has Japanese equities as its top conviction on a relative basis. EMs look fragile, and only Brazil is favoured in our equity market model, so in general we recommend investors either to underweight or stay out of this space. A potential option play on an industry level is call options on semiconductors, which will likely rebound if China and the US reach a deal.
“Japanese equities are our top tactical play in Q1. While it was a brutal quarter for Japanese equities, the momentum relative to other equity markets over the past 12 months is still high. Combined with a low valuation relative to historical terms, the Japanese equity market offers an attractive risk-reward ratio, especially if China manages to engineer a rebound in its economy and seal a deal with the US across market access, trade issues and intellectual property rights.”
FX – The Fed blinked, but the path to a weaker USD may be rocky
The last quarter of 2018 was clearly the worst quarter of what many have touted as a downright annus horribilis for global asset markets. Equity markets suffered their worst December in modern market history on concerns that weakening global growth, a tight Federal Reserve, poor USD liquidity and a US-China trade war all spell doom for the global economy.
The mood brightened in the first week of 2019 when Fed chair Jerome Powell pivoted from his tone-deaf performance at the December 20 FOMC press conference and made clear that the Fed is listening to the signals that the market is sending, even as he praised the strength of the US economy and argued that the barrage of Treasury issuance (made worse by the Fed’s balance sheet reductions, or quantitative tightening) was not a key part of the market turbulence.
Powell will continue to listen to markets in 2019. He is rightly seen as a different breed from his more academically oriented predecessors, often stressing that financial stability risks are the most likely source of the next crisis, not overheating wages and inflation. That means he will be happy to resume hiking rates if the markets and data permit, and will only pause or reverse at a sufficiently high pain threshold.
Still, the direction change from the Fed towards the end of the year is a first key step in what could prove a drunken stagger towards a weaker USD, and one that will gain momentum once the Fed is forced into a full reverse by a weakening US economy in the coming quarters.
John Hardy, Head of FX Strategy, said:
“The Fed is slowly coming around to the reality that its own tightening regime and a strong US dollar are increasingly incompatible with financial stability, and it kicked off 2019 with a loudly dovish downshift in its rhetoric. But it may take some time for the Fed to execute a full reversal of its tightening course, and the lack of bright spots elsewhere in the global economy as the year gets under way may mean that the path to a persistently weaker USD is a rocky one in 2019.”
Macro – The Japan experiment: Abenomics or Abysmalnomics?
Global debt has gone from around $175 trillion to over $250 trillion – it just does not feel like it because interest rates are still lower than before the crisis. While we have seen the Fed shift from quantitative easing to quantitative tightening, and the European Central Bank start the process with a projected move to QT by mid-2019, the Bank of Japan has in many ways been the most extreme of the world’s major central banks.
It has kept its policy rate at minus 0.10% since its surprise move to negative rates in early 2016, which was not at all well received by the markets. It has continued to buy Japanese government bonds and is now the biggest holder of them. It has also added equity ETF purchases over the last few years – an area that almost all central banks have avoided, with the notable exception of the Swiss National Bank, which holds billions of dollars in Apple shares, which are now down by over one-third from the highs of last year.
The key question now for many people watching Japan is: has Abenomics – of which the BoJ has been a pillar – been a success or a failure for Japan, and what can we expect for 2019?
Kay Van-Petersen, Global Macro Strategist,
“In a world of monetary policy experiments, Japan is on speed. Although debt levels are far from sustainable, almost all the debt in Japan is in yen and held by the government or Japanese companies and citizens, which should make any debt restructuring, defaults or haircuts easier to manage in the future. That is a much different situation than that of, say, an emerging market country whose debt is in USD while revenue and earnings are in domestic currency. Japanese equities offer compelling opportunities, and not just on the fact that the Nikkei is down about 20% from the 24,448 highs of October 2018; many companies are sitting on a lot of cash.”
Commodities – Gold regains safe-haven status
Gold, which recorded its best month in two years in December, has re-emerged as a safe haven amid the turmoil elsewhere. A drop in US 10-year bond yields to a near one-year low, reduced expectations for further rate hikes, a dollar that has stopped rising and, not least, the turmoil in global stocks have all supported renewed demand for gold as well as silver, given its historical cheapness to gold.
Ole Hansen, Head of Commodity Strategy,
“We expect to see continued demand for gold as investors once again seek tail-end protection against increased volatility and uncertainty across other asset classes. Hedge funds only turned long gold in early December after having traded it from the short side for six months. This pickup in demand together with a continued accumulation from long-term investors through exchange-traded funds should provide enough support for gold to break higher towards the key area of resistance between $1,360 and $1,375/oz where consecutive highs were set between 2016 and 2018.”
Fixed Income – Bonds shine in baby bear market
2019 will be a year of profound changes, so we believe that investors should take urgent measures to preserve capital and prepare for a downturn. They should look at the bond market as a way to diversify their equity portfolios and use bonds as a buffer against market volatility.
Althea Spinozzi, Bonds Specialist, added:
“The biggest driver in the bond markets in 2019 will be a slowdown in the global economy combined with high political and economic uncertainty, which will lead many investors to flee to safety and to favour sovereign debt that has already undergone tightening, such as US Treasuries. The bottom in the equity market has not yet been reached, and that should push investors into safer assets. Investors should take urgent measures to preserve capital and prepare for a downturn.”
Macro - That sinking feeling
Global credit impulse, the second derivative of global credit growth and a major driver of economic activity, is falling again, running at 3.5% of GDP versus 5.9% in the previous quarter. Currently, half of the countries in our sample, representing 69.4% of global GDP, have experienced a deceleration in credit impulse.
With some notable exceptions, such as the US, Japan and the UK, lower credit impulse is mostly observed in developed markets while emerging markets experience a significant increase in the flow of new credit.
Christopher Dembik, Head of Macroeconomic Analysis, said:
“The global credit impulse is falling again, mainly in developed-market economies and due largely to the normalisation of monetary policy. The message from the slower credit impulse is that growth and domestic demand are headed for a slowdown, unless the world’s largest economies launch a massive coordinated intervention in 2019.
”We expect that credit impulse will remain strong in coming quarters as China’s focus is moving towards greater economic support to mitigate the impact of trade war. A large-scale fiscal and monetary stimulus is probably off the table given policymakers’ worry about yuan stability. However, the likelihood of new market-opening policies, including tariff cuts on more goods and a cut in banks’ reserve requirement ratio, is high in the first quarter of 2019. ”