Article / 01 March 2016 at 16:21 GMT

Investment Outlook: Beware the honey trap

CIO / Saxo Private Bank
  • Market turmoil in February casts doubts over recent uptick in sentiment
  • Economic fundamentals remain more negative than neutral
  • Corporate earnings outlook is declining, confidence in monetary policy is low
  • Central banks are in a fight to weaken their currencies
  • European growth shows signs of fatigue, US may have reached growth bottom
  • ECB expected to ease further; I am looking for a rate cut as well as more QE
  • Brexit referendum poses big risks for the GBP and equity markets
  • My business cycle model points to further loss of momentum for global economy
  • US recession remains unlikely; lower energy prices will eventually help globally
  • Improvement in short-term business cycle could lead to a substantial risk-on wave.

Winter storm
 February was a stormy month in the markets, casting doubts over whether we're facing a genuine improvement in sentiment or a mere honey trap. Photo: iStock

By Teis Knuthsen

Finding a foothold in financial markets wasn’t easy in February. Global equity markets fell by up to 7% measured in local currency in the first half of the month, only to claw back to a total loss of just 1%. The pattern was a repetition of what we saw in January, and day-to-day movements were often considerable and often in sync with oil prices. 

Currency markets also showed significant swings, and the Japanese yen rose as much as 7.5% against the dollar and 10% against the British pound. 

In the bond markets, long-term yields continued to decline significantly, and a 10-year German government bond is now trading at a yield of just 0.12%. 

Perhaps not surprisingly gold prices rose by up to 10% during the month.

Siren song

Equity price increases in late January proved to be just a false of recovery. As in early February, we must again consider whether we are facing a genuine improvement of sentiment or just a honey trap. 

Julius Caesar learned the hard way to take heed of this month, when he belittled warnings of his demise on the Ides of March. Others will point out that large corrections often come in waves of three, of which we still seem to be missing the last leg.

If the markets are on shaky ground, it is not least because the economic foundation remains more negative than neutral. Leading industrial indicators point to a persistent decline of global activity, and this decline now seems to be dragging down services and consumption. 

Europe, which long appeared more robust, is beginning to show signs of fatigue. By contrast, there is evidence that the US reached a growth bottom in the fourth quarter, and economic surprise indices indicate some positive momentum in indicators.

It is clear that the global economy has been caught in a negative feedback loop centred on the energy sector. And before that connection is broken, the ice below any bull market is thin. Better economic indicators appear to be essential if risky assets should develop positively here.


Earnings and policy disappointments

When cyclical sensitivity is as high as it is now, two other explanations can be given. 

First, expectations for corporate earnings are declining. S&P500 earnings in the fourth quarter dropped by 3.5% year-on-year, and without increasing economic growth or a falling dollar, the outlook for 2016 is at best neutral. Despite low interest rates, a weak currency, falling energy prices and rising consumer confidence, earnings growth is also negative in Europe.

Second, confidence in economic policy— and especially in monetary policy — is low. It has begun to dawn on the markets that several years of low (and negative interest rates) and quantitative easing have had no detectable economic effects.

That the US QE programmes apparently worked better is probably due partly to a better mix with fiscal polic, and to the fact it had initially stood alone. 

Today almost all central banks are united in a fight to weaken their currencies as much as possible, so the overall effect is close to zero. Sweden, with nominal economic growth around 6% and negative interest rates, is a example of a policy experiment that should have been stopped long ago.

In March, the European Central Bank is expected to ease monetary policy further, and I suspect there will be a rate cut as well as an expansion of the QE programme. Unfortunately, the economic impact will probably be negligible, and the banking sector will be handed yet another challenge.

New normal?

There is no doubt that economic growth has been disappointing in the years after the financial crisis. At the same time, labour markets have improved, providing much-needed support to domestic demand.

Nevertheless, this development has worrying aspects, as it highlights an almost total absence of productivity growth, which will ultimately undermine a sustained recovery. The development is compounded by weak growth in business investment. 

A technological shift towards a more digital production model is possibly playing tricks on the economic statistics, but the most likely explanation is that the combination of low growth and improved labour market expresses a significant drop in the potential economic growth rate. This is a general problem in Denmark, in Europe, in the US and in Japan. We have, in other words, need for a new economic model.

British referendum set for June
 Brits will vote in June on their future in or outside the European Union. Image: iStock

Brexit woes

Brits will vote in a referendum on European Union membership on June 23. For all parties involved, much is at stake. A "No" vote could eventually be beneficial for both the EU and the UK if it pushes both towards a more dynamic and decentralised economic model, which has historically been to Europe's advantage. 

In the short term, however, a "No" could result in considerable turmoil, and at least the pound could be expected to fall significantly. Sterling is somewhat overvalued fundamentally against the euro, and a full correction could weaken the pound by 15-20%. 

Short-term capital outflows could also lead to significant falls in equity markets. 

Although the EU is known to develop through its crises, a British vote to leave would come at an inconvenient time, since Europe is simultaneously faced with an unresolved refugee crisis. Policy paralysis is not an option.

Investment conclusions

My economic business cycle model still points to a further loss of momentum for the global economy, which is a large part of the reason that financial markets are on shaky ground. Poor confidence in economic policy and a weak trend for corporate earnings highlight the current challenges for a turn for the better.

Markets are indeed pricing in a fairly negative view of the future, and many risk premiums have risen considerably. Contrary to what many seem to believe, a US recession is quite unlikely and falling energy prices will eventually almost certainly have a positive effect on the global economy.

A turn for the better for the short-term business cycle could lead to a substantial risk-on wave. As an investor, I also find it hard to accept having to buy bonds with a negative yield, and will only do so in expectation of short-term capital gains. Herein lies the challenges for the coming months.


— Edited by John Acher

Teis Knuthsen is CIO of Saxo Private Bank


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