Article / 01 June 2016 at 14:30 GMT

Investment Outlook: When the lie is so big...

CIO / Saxo Private Bank
  • Markets hit by slowing growth, falling profits, central bank woes
  • US corporate earnings trending higher; Europe likely to follow
  • Brexit vote "not a matter of overnight collapse"

By Teis Knuthsen

There is a clear pattern to the movements seen in the global markets over the past month. Equities and high-yield bonds have gained in value (global equities are 4.2% higher, measured in EUR), and the same goes for the US dollar and oil prices. 

By contrast, emerging market equities and currencies have given up some of their earlier gains, as has also been the case for gold. 

The common denominator is the growing likelihood of US monetary policy tightening that again has been driven by a turn for the better for the economic outlook.

Federal Reserve
Federal Reserve hawkishness reflects a steady economic recovery. Photo: iStock

Two out of three is not bad

I consider there to be three key problems for risky assets. In short, markets have been hit by a combination of slowing growth, falling profits, and declining confidence in central banks.

Declining economic activity in 2016 primarily reflects a traditional downturn in the industrial sector, which this time has been fuelled by plummeting oil prices. In today’s debate, much time is spent on whether we are in a “secular stagnation”. At its core, however, this is more a story about the level of growth (whereas financial markets typically respond to changes in growth). 

Therefore, it is worth keeping an eye on energy prices as well as early industry indicators. Many of these suggest that the current "macro-momentum" is positive and that the shock that hit world markets in the first quarter is now in decline.

While the slowdown in industrial activity is beyond doubt, it is at the same time important to note that labour markets in most Western economies have continued to improve. In Germany, the unemployment rate just dropped to the lowest level ever, and in the US the ratio of initial jobless claims to total employment is also at a record low. 

In Denmark, net unemployment is now just 3.5%, and wages are – not surprisingly – on the rise. My point is simple: the labour market is a key component of our economy. With employment comes wages, leading to consumption. 

Throw in ultra-low interest rates and the housing market recovery should not surprise.

Initial claims vs employment

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The Federal Reserve is now (again) on board with a more positive view on the US economy, and has in clear terms signalled that a rate increase is imminent. This time, the increased likelihood of a rate hike has been followed up by falling risk premiums and rising equity markets. In all its simplicity, markets seem to share the Fed's optimism.

US earnings on the rise

The third challenge this year has been sharply falling corporate earnings. However, there is reason to believe that the coming quarters will see earnings rise once again. For the S&P 500, weekly earnings estimates have risen steadily since March; the best one yet can say about Europe is that the estimates are no longer falling.

SP500 earnings
 Overall, I think the market direction from here will be dominated by an improvement in somewhat depressed growth expectations, as well as the Federal Reserve's ability to control the market around aa likely summer rate hike. Later this year, a more positive earnings trend could take over.

Brexit – totally honest now?

In the short term, the Brexit vote on June 23 takes centre stage for financial markets, at least in Europe. Although bookmakers are confident about the outcome, a victory for the "Remain" side cannot be taken for granted.

Personally, I cannot recall having witnessed such a massive scare campaign as has been the case this year. Politicians and institutions around the globe seem to be claiming that world peace is at stake and have all but threatened Britain with very substantial welfare losses in case of an exit. 

The Bank of England appears to have taken the lead in this regard, partly with a panic warning and partly by expressing in no uncertain terms that UK growth is suffering even before the vote.

All of this is probably wrong; at best it's terribly exaggerated. The most problematic factor, I think, is that European Union leaders are warning of "difficult negotiations" regarding the forthcoming trade talks. 

Yes, sorry, but Germany has a substantial trade surplus with the United Kingdom, and does anybody really think that politicians will want to put that in jeopardy? In that case the welfare loss will be shared with Germany. 

Furthermore, when EU leaders hint at punishing the UK in case of an exit they are surely not looking after the interests of their citizens as much as they are trying to conserve power.

You can add that this is exactly the same mechanism that seems to make it impossible for EU leaders to realise that Greece is insolvent and that the debt should be written down. Instead, a financially irrational solution is preferred – one that results in an overall wealth loss in for the EU.

Should the UK choose a Brexit, the fact is that the country has two years to negotiate a withdrawal from the EU from the time it chooses to submit an application. This is not a matter of an overnight collapse. From then, of course, much depends on which path the UK decides on: global free trade or Lilliputian parochialism.

Financially speaking, however, the Brexit is a risk-event, and everybody from day traders to macro hedge funds will press the sell button in case of a no. This will initially cause a decline in the pound and in British equities. As more and more people accept that it probably wind up being more problematic for Europe than for England, then European equities will also fall. 

Conversely, British bonds should rise, primarily in anticipation of monetary easing. A sharp drop in British equities and the pound should be seen as a buying opportunity.

Given the pent-up sentiment, the vote could prompt 
a sharp move in either direction. Photo: iStock

Invstment conclusions

I recommend an overweight in equities relative to bonds. This is partly based on an expected turn for the better for the global economy, where a diminishing energy shock should clarify that underlying growth is robust, albeit low. 

The shift to a positive phase in the cycle has always previously been rewarded with rising share prices, and I see no reason why it should be different this time.

Simultaneously, the expected return on bonds is low, and in some scenarios even negative. Government bonds cannot safely be assumed to fulfil their traditional role as a safe-haven in times of market turmoil. As an alternative, I recommend a small allocation to gold. 

Following the European Central Bank's move to purchase investment-grade corporate bonds this year it seems this asset class is no longer offering attractive returns. By contrast, global high-yield bonds can still play a role in balanced portfolios, together with emerging market government bonds.

Within the equity allocation I have moved from an underweight in emerging markets towards a more neutral stance, but with a focus on the low-beta ("min vol") segment.

Business cycle overview and asset allocation key

Total return, local currency, 6m
Source: Saxo Bank

— Edited by Michael McKenna

Teis Knuthsen is CIO of Saxo Private Bank
01 June
Juhani Huopainen Juhani Huopainen
Exactly my thoughs on the Brexit refendum, which is certainly over-hyped.
01 June
johnnyw johnnyw
'destructionism' is a good term to use for the EU's socialist policies of wealth destruction.


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