Saxo Bank has published its Quarterly Outlook for global markets and key trading ideas for Q3 2018 with focus on waning global growth, falling credit impulses globally, and massive complacency on the risks of a trade war as we enter one of the most dangerous periods for the global economy since the Berlin Wall fell in 1989.
Talk of ‘trade wars’ is widespread and Saxo points to the short-sightedness of the world’s governments as escalating trade tensions ahead of the November 6 US mid-term elections, where President Trump must prove he is getting the US ’a better deal’, are potentially leading to a more severe crisis.
Saxo’s Q3 Outlook covers the bank’s main asset classes: FX, equities, currencies, commodities, and bonds, as well as a range of central macro themes.
Commenting on this quarter’s outlook, Steen Jakobsen, Chief Economist and CIO, Saxo Bank, said: “There are no winners in a trade war, and the trend is pointing in the wrong direction as nationalist agendas erode the status of global institutional frameworks. History teaches us that this can end badly. If the loser is a big economy or a strong political power, they may impose restrictions – tariffs, for example – to counter the competitive disadvantage.”
“What makes trade issues more challenging today is that currencies no longer follow the paths that current account dynamics imply they should. A country running a current account surplus is supposed to see a strong/higher currency, but in today’s world, the big current account surplus economies all seek to avoid currency strength versus the global dollar standard to maintain competitiveness and avoid the risk of deflation.”
“It’s not just about Trump, either – it also has a lot to do with China’s move to raise its global profile along every axis. China’s chief approach to this vision is so far a mercantile one via its commitment to the One Belt, One Road plan. Beijing may have already given up on the US as a long-term export market – the longer it keeps its market share, the better. The US, of course, is now actively breaking down the very international organisations that have supported growth and globalisation since the end of World War II and after the fall of the Berlin Wall.”
“Consensus still holds that an outright trade war will be avoided, but this ignores the mid-term election in the US.
Equities – Technology is a unique sector
While global equities have experienced trouble this year, the technology sector continues to print solid returns for investors, thereby enhancing its attractiveness even more. An interesting feature of technology companies is their low debt leverage (net debt is minus 0 .62 for the MSCI World Information Technology index), which makes the sector the least sensitive to changes in monetary policy.
Peter Garnry, Head of Equity Strategy, said: “The technology sector has the highest return on invested capital and uses less capital expenditure compared to others. The combination of these factors has pushed the valuation premium over global equities to 27%, which is a fair aggregate premium to pay for the only sector that delivers on growth every earnings season.
“Information technology is by far the most dominant sector in the US equity market but globally the sector is still second to financials with a market cap weight of 15.8%. Measured as industry groups, the group Software & Services is very close to overtaking Banks (9.9%) as the most important industry group in the world. The technology sector has changed from being dominated by hardware to being dominated by software which has much more attractive features for shareholders. We recommend investors stay overweight software.
“The biggest risks to the technology sector are regulation and global semiconductor disruption from an escalating trade war. At this point, the probabilities for both scenarios having major impacts on the technology sector in the short term are low.”
FX – A US dollar-negative trade war
The Trump administration’s aggressive stance on trade could prove a significant USD-negative as trade disruptions will also reduce the recycling of reserves into the greenback as US trade partners look to avoid adding to US dollar reserves or seek to avoid the currency entirely. The latter is particularly the case for China, which clearly has a long-term strategy aimed at raising the profile of its currency in its trade relationships.
John Hardy, Head of FX Strategy, said: “As China’s energy import volumes mount steeply, the launch of the yuan-denominated oil contract in Q1 is arguably a gambit to eventually supplant the petrodollar with a petroyuan. As well, let’s recall that Trump’s picking of trade fights has been as frequent with traditional geopolitical allies like those within NAFTA and the EU as it has with those further afield.
“Trump focusing on Bank of Japan or European Central Bank policies and their implicit aim to keep the JPY and EUR weak could suddenly turn the tide in USDJPY and EURUSD. Admittedly, the flip-side risk is actually one of CNY weakness and USD strength versus Asian EM currencies if China chooses to abandon its strong yuan policy.”
Macro – Only China can save us
So far, China has only responded to the US measures by using the same tools, and without seeking escalation. If China really wanted a full-blown trade war, the most efficient method would be to send sanitary inspectors to local companies key to the US production chain and shut them down for a few weeks or months. The impact would certainly be much more devastating for US companies than any rise in tariffs decided by Beijing.
Christopher Dembik, Head of Macroeconomic Analysis, said: “China seems inclined to play the appeasement card and be ready to support the global economy. On the back of weaker economic data and higher trade tensions, China has decided to ease its monetary policy for the third time this year. The country is doing what is has always done in instances of economic slowdown: it is stepping in to strengthen the economy and push credit impulse back into positive territory. China credit impulse is still in contraction, evolving at minus 1.9% of GDP, but it is slowly rising from its lowest point since 2010 and might be back above zero sooner than we think if the Chinese authorities consider that it is time to further support the economy against the trade war.
“China has still many options to counter the impact of trade tensions. It can resort either to more accommodative monetary policy through the RRR or scope for fiscal stimulus. Rising credit impulse should offset at least part of the effect of US tariffs on Chinese imports and is also expected to provide support to declining economic sectors, such as Chinese real estate, from 2019. It is complicated at this stage to second-guess the evolution of US trade policy but it is almost certain that China will do its best to avoid a full-blown trade war and related volatility because financial and monetary stability are crucial to its future economic development.”
Currency – The AUD could benefit from Chinese tariffs on US goods
Australia has a deep relationship with China. Over 36% of the country’s shipments last year went to China, accounting for 8% of GDP. Rising tensions between the US and China are a concern for Australia as the economy is heavily reliant on exports of coal, iron ore, and education to China. But it is also a longstanding ally of the US. Chinese demand is not just for base metals – services exports to China from Australia have been rising on average 15% annually over the last decade. Additionally, tourism is on the move – last year there were 1.4 million Chinese tourists with Chinese visitors accounting for about 25% of total visitor spending. Consumer goods like wine, vitamins and other quality Australian food produce have also seen significant growth in value of exports of approximately 40% per year.
Eleanor Creagh, Market Strategist, said: “Australia is well known for quality produce and some producers stand to gain as they could find that their products become more competitive for export to China. The agriculture sector has underperformed against almost all other asset classes for several years. We are in the midst of the second-longest economic expansion in history and the US has a growing twin deficit, household savings are low, and liquidity is contracting, which could pose problems in the long run. Given worries about the outlook for global growth and inflation potentially not meeting expectations, the sector could present an opportunity, particularly in Australia. In fact, commodities have never been so cheap relative to US stocks and commodities tend to rally later in the business cycle prior to a recession.
“Chinese tariffs on US agricultural products could provide an opening for Australian exporters to fill and for Australia to expand its economic imprint. If 25% tariffs are imposed on US suppliers to China, Australian beef exporters would offer a far more competitive price with Australia having an advantage of maritime trade routes through the APAC region.”
Commodities – Challenged commodities await outcome from developing trade war
Following a strong start to the year, the outlook for commodities has become increasingly challenged as multiple headwinds have started to emerge. In crude oil, a multi-month rally ran out of steam after the Opec+ group of oil-producing nations agreed to increase production to stabilise the price. Precious and semi-precious metals, meanwhile, were challenged by continued dollar strength and the diverging direction of central bank rates. Industrial metals wobbled on emerging signs that some of the world’s biggest growth engines, not least China, showed signs of slowing.
Ole Hansen, Head of Commodity Strategy, said: “The second half of 2019 could see crude oil initially supported by strong demand as well as continued geopolitical risks related to supply concerns from Venezuela and Iran as the deadline for the implementation of US sanctions approaches. These concerns may, however, eventually be replaced by a shifting focus towards demand growth which could begin to slow down among emerging market economies.
“Gold’s performance turned sharply lower during June as the yellow metal struggled to find a defence against the stronger dollar and Fed chair Powell’s hawkish stance on continued normalisation of US rates. Three quarters of gains were reversed after traders grew frustrated following the yellow metal’s inability to break key resistance above $1,360/oz on multiple occasions. The deteriorating outlook during June has challenged but not destroyed our positive outlook for gold. Gold’s negative correlation to the dollar remains a key challenge in the short term, but given the short-to- medium-term dollar-negative outlook, we believe this headwind will fade over the coming quarter.
“Silver remains stuck within a narrowing trading range that has been in place for the past 18+ months. Two attempts during the past quarter to break above its 200-day moving average helped trigger two major corrections. Sentiment on that basis remains challenged into Q3, especially if the latest signs of economic slowdown begin to translate into further weakness among industrial metals. Gold, however, holds the ultimate key to silver’s direction and given our views on the yellow metal, we see silver continuing to challenge resistance before eventually moving higher.”
Bonds – With fear and volatility comes opportunity
Q3 will be a transitional period where there will be a continuous worsening of credit spreads that will ultimately lead to an inversion of the yield curve by the end of this year or the beginning of 2019. Although an inverted yield curve does not cause a recession in and of itself, Saxo believes that the combination of an increasingly hawkish Federal Reserve and an overheated economy may accelerate the path towards recession.
Althea Spinozzi, Bonds Specialist, said: “Positioning in riskier assets will continue to be light; investors will steer away from so-called supply chain economies and sectors sensitive to tariffs such as information technology and energy so long as there is no clarity regarding the rumbling trade war. Political noise in the EU area will also be monitored closely with a particular focus on Italy as we get closer to October, when the 2019 budget will be presented.
”At the same time, a volatile environment such as the current one still offers good opportunities. The sell-off that we have seen in the previous two quarters led to a progressive widening of credit spreads, hence value can be found in US investment grade bonds and selective high yield corporates. However, it is important to keep an eye on diversification and stay short on duration as credit spreads continue to be under more stress amid uncertainties and central bank policies.”
Average citizens are the real losers during trade war altercations
Trade tariffs set by Trump have primarily been used primarily to affect China’s exports with additional products and possibly countries in the pipeline under the current administration. China is the number one trade partner globally for the United States, accounting for an average 45% of the US trade deficit since 2009 and 36% since 2001, when China joined the WTO.