In the wake of an astonishingly calm 2017, Saxo Bank’s strategy team sees a market full of potential hazards as we head into the first quarter of 2018 and beyond. From central bank policy normalisation to rising inflation expectations, from fiscal deficit expansions to cross-asset correlations, the signs are all there.
Saxo’s Q1 Outlook covers the bank’s main asset classes: FX, equities, commodities, bonds as well as a range of central macro themes.
Will the speculative mania around cryptocurrency continue?
2018 will be a make-or-break year for the burgeoning crypto asset market. The optimists are looking for the market cap to top $1 trillion while pessimists foresee increased regulation and even the outright banning of cryptocurrencies as monetary authorities decide that the space is out of control.
Jacob Pouncey, Cryptocurrency Analyst, said: “Crypto assets are behaving like the dot-com stocks of the late 1990s. We expect more companies to announce blockchain pivots before this speculative phase is over. Q1’18 will see more projects hitting the market, each touting itself as the next crypto revolution in its particular sector. This, again, will only drive further speculation in this nascent market.”
“If the crypto space is to see a new leader; Ethereum seems to be one of the assets with real-world utility that goes beyond its standard function. It is now processing over 1.25 million transactions/day and tens of billions of dollars in volume.”
Bubbles – A technical approach
More than a simple metaphor, a bubble is a distinct mathematical form in which super-exponential growth causes a departure from fundamentals and an eventual sharp correction. Of all concepts to keep front-of-mind into 2018, this may be one of the most crucial.
Anders Nysteen, Quantitative Analyst, added: “When considering a rapidly rising stock such as Amazon, the log-price corresponds to a straight line. This indicates an exponential price rise which is fast, but not extraordinary. In contrast, the price of a Bitcoin has continued to grow even faster every year since 2015 in a super-exponential fashion. In the presence of a bubble, the risk of a crash or at least a major correction is significantly increased. Theories have been proposed for when and how bubbles evolve and burst, but in the end nothing is certain until after the pop.”
FX – Currencies eye a bubbly 2018
With strong momentum from an extraordinary risk-taking year in 2017, this year should prove to be dynamic, with many subplots and increased volatility.
John Hardy, Head of FX Strategy, said: “Looking ahead, we see clear “known knowns” that are quite likely to disrupt the one-way complacency of 2017 at some point in 2018, whether already in Q1 or not until the second half of the year.”
“A number of leading inflation indicators point to the risk of a strong pickup in inflation already in the first half of 2018. The US budget deficit widened in 2017 for a second consecutive year and should widen aggressively in 2018 as a result of the funding shortfalls from President Donald Trump’s rushed tax reform policy. With a possible deficit of $1 trillion for 2018 looming, who will step in to finance when global FX reserves are not building as they have in the past?”
“EM and riskier currencies could enjoy some further upside on the global growth upswing story but gathering headwinds will arrive if volatility picks up notably, which is one of our base assumptions. The only perceived path to a surge of strength in the greenback is if some sort of real liquidity crisis develops at some point – the perennial fat-tail risk. That risk may only materialise if we see the much-discussed global market melt-up risk unfolding first.”
Equities – The most important year since 2008
Equities might be at record highs, with sentiment overextended on nearly all fronts, but this does not necessarily point to a bubble. It does, however, mean that a correction is likely and investors should be watching price action for signs of super-exponential growth, as well as central bank policy and of course inflation.
Peter Garnry, Head of Equity Strategy, said: “For Q1 we acknowledge the strong price momentum and upbeat expectations together with what will likely become a strong earnings season. This is causing us to believe that equities can push higher in the very short term, but that in the second half of Q1 macro data will begin to disappoint against expectations causing an equity correction above 7%.”
“Investors are expecting almost 20% growth in EBITDA in the S&P 500 this year, something that has not been realized since 1991. Hopes are understandably high given the end we saw to 2017, but the low implied volatility should not cause investors to doze off – quite the opposite. A policy mistake in China or the US is still possible and inflation, whether it under-or-overshoots, will be the most important trigger in global markets for 2018.”
“Sentiment is so overextended that investors can only be disappointed. Many indicators are elevated, often to an unprecedented degree, which increases the likelihood of a larger setback should macro data disappoint.”
Commodities – Inflation in focus as gold bulls gather strength
Commodities in general are benefiting from an increased focus on inflation as the current expansion cycle moves toward its late stage, where price pressures tend to build. With OPEC and Russia having promised to keep production capped, the three key questions that are likely to determine the price of oil in 2018 are the production response to higher prices (not least from US shale oil producers), the potential from new supply disruptions, and the continued strength of the global economy.
Ole Hansen, Head of Commodity Strategy, said: “Barring any geopolitical upsets, the record 1 billion barrel oil long held by funds at the beginning of 2018 could pose a potential challenge to the current bullish momentum. Given the impact on the price of oil of a few hundred thousand barrels per day in changed supply or demand, we see the risk – especially during the coming months – skewed to lower prices, with Brent crude oil at risk of returning to $60/b.”
“After almost hitting our year-end target of $1,325/oz last year we maintain a bullish outlook for gold into the early stages of 2018. The dovishDecember 13 Federal Open Market Committee rate hike and the US tax reform agreement both helped signal another low point for gold with inflation once again emerging as a key driver for gold support.”
“Our trade idea for Q1 is to be long gold against WTI crude oil – we favour using WTI over Brent given the lower cost of holding a short position in WTI.”
Bonds – Deepwater horizon
2017 saw some of the smoothest bond markets in memory, with volatility resting at record lows throughout the year. A flow of continually sideways macro data created the perfect condition for bond yields to stay at low levels for the core segments.
Simon Fasdal, Head of Fixed Income Trading, said: “When we speak of bubbles we should note that bond markets would have a very hard time coping with a sudden spike in US and global 10-year core yields. I’m also concerned that as the EM bond space and the DM corporate bond market have seen significant growth, the primary marketplace for these same bonds has diminished due to regulatory downscaling from banks.”
“Take a look at the 10-year Treasury yield, where we are at 2.57. Q1 is a time to be cautious.”
Macro – Housing bubbles are popping up everywhere, so what now?
The most risky real estate markets we currently see are Australia, London, Hong Kong, Sweden, and Norway. All of these markets share these two features: home prices are decoupled from local incomes, and the real economy is experiencing distortions linked to monetary policy, such as a surge in lending and / or a boom in the construction sector.
Christopher Dembik, Head of Macro Analysis, said: “Despite the global financial crisis, real estate prices kept increasing in these five areas. Based on BIS data, since 2007, the boom ranged from 45% in London and its suburbs to more than 200% in Hong Kong. In the long term, however,the riskiest market is Norway.”
“The lack of inflation combined with high indebtedness and a high home ownership rate in such a highly leveraged economy means that the housing correction will have ripple effects on the economy and will halt credit and growth.”
“Among major economies, investor worries have mostly focused on China where property prices have inflated massively due to excess liquidity. The bright side is that the government’s first measures to better regulate the real estate market seem to be paying off as for the first time since 2015, new home sales contracted. It is too early to draw conclusions, though, and will strongly depend on the economic targets unveiled by the Chinese government at the annual parliamentary meeting in March 2018.”