As the era of credit expansion comes to an end, investors should not discount a return to recession
THE END OF MONETARY POLICY EXPERIMENTATION COULD BE IN SIGH, BUT NOT YET
After 10 years of monetary policy experimentation, the withdrawal of credit from the global markets is becoming a reality. Led by US Federal Reserve rate hikes, central banks around the world are exploring exits from their quantitative easing programmes (Bank of Japan) or beginning talk of tapering (European Central Bank), while credit growth is turning negative.
With credit expansion having been the basic premise of monetary and economic policy since the low of 2008, a combination of monetary policy tightening, coupled with the decline in the so-called “credit impulse” led by the US and China, and the absence of new reforms or tax breaks, we enter the third quarter of 2017 with the real possibility of a significant slowdown by the end of this year.
Commenting on the outlook, Steen Jakobsen, Chief Economist and CIO, Saxo Bank, says: “While we put the odds of a global economic recession at 60%, it is worth noting that since the 1920s, the cost of recession to investors has been 33% on average. With credit the sole ingredient use to stimulate the global economy over the past 10 years, investors should pay attention to any changes to the price of money (increasing), the credit impulse (decreasing) and the price of energy (decreasing) to understand the direction of the global economy. With recession risk increasing, we expect the rate hike cycle to end and inflation to be lower, leading to excess returns for fixed income and gold, with some incoming risk for equities.”
EUROPE: SO FAR, SO GOOD.
Lower political risk and good economic performance in the euro area have created a shock of confidence, leading to increasing capital inflows in the euro area. Investors’ return to European assets is also explained by the fear of a correction in the US market. However, a capex renaissance is still not a reality since companies are waiting for further clues about the direction of the global economy.
Christopher Dembik, Head of Macro Analysis, says: “Despite the prevailing optimism in the euro area, markets do not believe that central banks can deliver on inflation and wages. As a consequence, the ECB is likely to struggle to make its taper announcement in September, a further proof that euro area economic activity remains fragile. For investors, the real question is how long the euro area will be able to resist the global credit impulse deceleration, and whether it will be able to convert the current optimism into growth gains to prevent the end of the US business cycle from shortening the European recovery.”
EQUITIES ARE NOT IMMUNE TO SLOWDOWN
Signs are emerging of a slowdown in global equities, linked to the drop in the global credit impulse which started in China but also affecting the US. With the market not buying into the US Fed’s projections of an interest rate rise, a slower trajectory for interest rates will continue to be positive for sectors utilising the most debt. Valuations of energy stocks still reflect excessively high expectations for a recovery in oil prices. The tech sector remains one of the few pockets of growth in the current macro environment but the valuations are getting stretched and the multiples expansion will not continue.
Peter Garnry, Head of Equity Strategy, says: “If our Q3 slowdown is right, then healthcare, consumer staples and utilities will likely be the best performing sectors over the next quarter. Furthermore, with a slowdown in China we expect emerging market equities to finally underperform and the material sector to be under pressure. Similarly, we expect a slowdown in the US and India where credit impulse is negative, while in Europe, where the credit impulse remains positive, we expect equities to continue to buck the trend with further inflows. Lastly, we are overweight Japanese equities supported by improving macroeconomic data and attractive valuations.”
FX: PEAK GOLDILOCKS
The predominant Q3 risk in forex markets is rising volatility. At present, the “Goldilocks combination” of weakening inflation and a softer USD reigns, but this will weaken as central banks retreat from their hyper-accommodative stance.
John Hardy, Head of FX Strategy, says: “Trump’s inability to move the policy needle and his unsuccessful confrontation with the Washington establishment have seen the market nearly entirely write off the potential of the ‘Trump trade’. The USD is still expensive and will likely face further headwinds as long as the Goldilocks trade is ascendant in Q3, but a bumpier road ahead and more volatile asset markets would likely see the USD’s traditional safe-haven role providing solid support.
“Europe, on the other hand, has enough momentum from hyper-stimulative ECB policy to stay on a positive trajectory in Q3, although rising global growth concerns will eventually impact the Union at its core, especially Germany as global exporters are most exposed to changes in global growth. Euro upside may fizzle when market volatility picks up, partly because much of the enthusiasm for the single currency has been built on a positive story, and our more negative themes for the quarter don’t dovetail with that. Still, EURUSD may manage a serious test of the 1.1500-plus that defined the resistance in 2015-16, but we don’t look for a major extension.”
LACK OF CREDIT IMPULSE IN CHINA
Our major topics for the second quarter were election risk factors, which we believed were exaggerated, and the failure of global yields to move higher. Major components of this Q2 scenario did materialise and have brought nice returns to riskier asset classes due to low volatility and continued sideways global yields and inflation. Viewed from this positive backdrop entering the third quarter, one could be tempted to extrapolate a positive development in riskier assets – that is, global equities, high-yield and emerging-market bonds. However, other risk triggers have emerged and are drawing uncomfortably close.
Simon Fasdal, Head of Fixed Income Trading, says: “We are concerned about the lack of credit impulse in China and the fact that markets seem to ignore that 35% of global growth is derived from the region. A potential lack of growth in China would, of course, be painful, but in fixed-income terms the major concern is related to the price slump in commodities potentially caused by such a slowdown.
”Caution is needed especially towards EM bond exposure, as challenges related to credit quality, lack of credit impulse, and the overall uncertainty of EM countries’ ability to cope with external shocks could lead to a sudden credit crunch, sending currencies and assets into turbulence and potentially stoking fears of market illiquidity that could activate fund selling.”
‘MAKE OR BREAK’ FOR OPEC
The second quarter of 2017 proved to be very challenging for oil as technological developments in the US and reduced tensions in Nigeria and Libya helped trigger a strong rise in global production. This helped offset production cuts from other Opec members and Russia, thereby further obstructing progress towards a balanced market.
Ole Hansen, Head of Commodity Strategy, says: “Opec’s ability to maintain exports should be tempered by the need to keep more oil at home to meet increased domestic demand during the peak summer months. In the US, production growth during Q2 fell by more than half compared to Q1, a potential first sign that US producers are not prepared or able to keep up production at any price. These developments have left Opec with a window of opportunity; if successful, the price of Brent crude oil is likely to rally back towards $55/b during the coming months before renewed weakness sets in as the focus turns to 2018 and the potential risk of additional barrels hitting the market if Opec and Russia fail to extend the production cut deal beyond Q1’18.”
As regards gold, Hansen added: “We maintain a bullish outlook for gold in the belief that the risk to the US economy is currently skewed to the downside. This has the potential of leaving the US Federal Open Market Committee too optimistic on rate hikes, something the bond market is already signaling through a flatter yield curve as longer-dated bonds remain in demand.”
To access Saxo Bank’s full Q3 2017 outlook, with more in-depth pieces from our analysts and strategists, please go to: https://www.tradingfloor.com/publications/quarterly-outlook