Hot topics for 2018

The US dollar, yield curves, oil and all that …
A preview of the 2018 Outlook by Witold Bahrke, Senior Macro Analyst at Nordea Asset Management

What should we expect from the US central bank and how will it impact currencies?
In short, the Greenback is in for a bit of a comeback in the medium term, although we might see some more weakness short term if Trump’s tax plans disappoint. The Fed is tightening – both conventionally via higher rates and unconventionally via a balance sheet reduction. While the Fed is largely flying blind as it is reversing the biggest experiment in recent monetary history, we expect the USD to strengthen moderately relative to most other currencies over the coming months, also vis-a-vis the Euro. The Fed’s balance sheet reduction will result in less USD liquidity flowing to the markets. Both the ECB and the BoJ, on the other hand, are still expanding their balance sheets, pointing towards US dollar strength.

But there are also other factors at play. In the short term, the USD is benefitting from less excess liquidity in the US financial system as the US Treasury is rebuilding its cash balance after the debt ceiling has been lifted temporarily. Also, the relative macro picture does not favour Europe as much as it did just a few months ago. Case in point, the economic data is surprisingly less positive in Europa compared to the US lately (graph 1).

More medium term, the US business cycle is still much stronger than other G7 countries’ business cycles (graph 2). This has traditionally led to a stronger US dollar, amongst others via a tighter monetary policy. Therefore, we think it is too early to expect a downward trend in the USD. To the contrary, the recent US dollar weakness seems a bit overdone. Finally, the market seems very short positioned on the US dollar (graph 3). This suggests it is still a good time to position for a stronger US dollar in the medium term.

Which currencies are likely to weaken the most against the Greenback? We think EM currencies are most at risk (graph 4). The EM region as a whole has been a huge beneficiary of the weak US dollar YTD. Why? Because the USD is still the world’s number 1 funding currency and large parts of EM are still using big chunks of (so far) cheap USD funding. As liquidity growth dries up, EM is likely to see some capital outflows, weakening their currencies (and therefore revenues). Commodity intensive regions are especially vulnerable, since a stronger USD normally implies weak commodity prices, absent any significant supply shocks. 

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The US yield curve – one of the markets favoured business cycle bellwethers – is the flattest it’s been in over a decade. Signal or noise?
This is top of investor’s minds heading into 2018. If the difference between long- and short-term rates goes negative, it normally signals a recession further down the road, which in itself is the show stopper for the equity bull market (graph 5). We are not there yet. Still, the difference between 10 and 2 year US Treasury yields stands at the lowest levels in over a decade. We might only be 2-3 interest rate hikes away from an inverted curve. This is why the Fed’s own expectations of 3 hikes next year is too hawkish, in our view.

To us, the flattening of the curve is a powerful reminder that we are in the very late stage of the business cycle. Recession probabilities are currently low and the economy and markets can do very well even with a flattening yield curve. But if gets too “pancaked”, it is a signal of caution. There are plenty of reasons why this is worth watching and is such a good economic indicator. Economically speaking, a flattening curve basically means that funding costs have risen more than (expected) returns, which makes e.g. investments less appealing and hence is negative for growth in a wider sense. Therefore, the current flattening signals that the US business cycle is very mature.

Investors need to take note. In the late stage of the business cycle equities typically still deliver solid returns. Nevertheless, the air is getting thinner for high yield bonds, which typically is the first of the riskier asset classes to underperform as the cycle is getting long in the tooth. This is exactly why low rated corporate bonds also are considered bellwethers for the overall market. The recent jitters in this part of the market might be an early reminder of this.

We think the yield curve got it right in terms of navigating the cycle as such and expect more flattening in 2018, especially in the US, which is the most advanced in its business cycle. Therefore, we prefer investment grade bonds over high yield bonds heading into 2018. Also keep in mind that high yield bonds have been one of the main beneficiaries of quantitative easing and the resulting low volatility environment. The Fed has launched quantitative tightening and volatility is expected to bottom, which should be felt in the high yield segment.

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Politics has been one of the main themes in 2017. Do you think it will play a role in 2018 as well?
The market has been very quick to digest all kinds of political event risk in 2016-17 (graph 5). This has led many analysts to conclude that political noise is just that: noise. In their view, fundamentals are all that matters. We think it is too early to conclude that politics do not matter, although the short-term effects can be largely dismissed based on recent experiences. The example of the UK is a stark illustration of the potential economic impact of political events, (graph 6). It is just that it might not be the immediate effect that matters most. And of course, we agree that fundamentals matter the most. But here it is crucial to understand that it is exactly the weak fundamental macro picture that has caused political uncertainty and risks to shoot up in recent years (graph 5). The world is still stuck in a low growth environment, with low wage growth as a consequence. Together with the highly uneven wealth effects of ultra-loose monetary policy, this has created a huge tailwind for populists around the world. None of these drivers are going to reverse on a long term basis, so we better get used to this type of political climate.

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Is the Emerging Market (EM) rally going to last?
The global growth picture seems as good as it gets to us. As mentioned above, we believe that less liquidity (and therefore money growth) is likely to dampen global growth as such over the coming quarters (graph 7). This will affect EM countries in particular, traditionally being a high-beta region. In recent years, central banks have flooded markets with a wall of liquidity, with EM as a region being one of the main beneficiaries of this liquidity flow. This year, a weak USD YTD has turbocharged these benign liquidity conditions to the next level, as it has made rich liquidity much cheaper for everybody receiving revenues in non-USD currencies. As Developed Markets’ central banks are tightening liquidity—even the Chinese leadership is seeking to limit leverage risks—liquidity flows are likely to be much more moderate in the future, leading to tighter monetary conditions. The EM rally is therefore expected to be much more moderate in 2018 across asset classes. The USD is key here: If it becomes even stronger than we currently think, the EM rally might even go into reverse.

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The Macro perspective: Where is Oil heading?
The key question for oil markets is: what will be in the driver’s seat over the coming quarters – demand or supply? More recently, the latter has explained most of the price moves. We expect this to change. Accordingly, oil should weaken slightly over the coming months. The primary reason is that global growth should slow as the wall of money is being reduced by central banks, resulting in less money growth, leading global demand lower (graph 7).

To be sure, oil has recently been driven more by supply than demand. This is reflected in the low correlation with other commodities as well as the US dollar (graph 8). As most commodities are quoted in dollars, a stronger US dollar normally implies weaker commodity prices—as long as demand is the dominating driver of prices. Not so this time around, despite the dollar’s renewed strength since September. Supply side concerns dominated, driving the oil price above 60 USD/ brl.

OPEC’s production cut has been surprisingly effective with the petro states complying or even exceeding the targeted production cut as of October. After all, this is nothing one can expect ex-ante. Impressed by the effectiveness of the cuts, markets are already pricing a continuation of the self-imposed production cut well into 2018. Nevertheless, with OPEC cuts “priced to perfection”, there’s also room for disappointments from a risk-reward perspective. In addition, geopolitical risks with the recent political turmoil in the world’s largest producer, Saudi Arabia, are fuelling supply side worries. Lastly, rig counts in the US – now perceived as the swing producers for the market – are turning lower again after having risen since spring 2016.

Going forward, we expect a monetary-induced slowing of economic activity driven by the US and China to make demand the dominating driver behind oil prices. Remember that China still has an extremely commodity intensive growth model. Slower money growth should not only be reflected in slower global growth, but also in weaker oil prices (graph 10). In price terms, this should imply a move back towards the 50-60 USD/brl. range over the coming quarters. This, however, is expected to happen in a moderate fashion, as our indicators are not pointing towards a steep decline in growth or a significant tightening in monetary conditions. From a short-term perspective, the market seems very long oil, increasing the odds for a downside move. If we are right in our view that demand will become more important, the US dollar also becomes a key risk to the price of oil. We expect the US dollar to stabilise or strengthen marginally over the coming months, as the business cycle is stronger in the US than in most other regions (see also graph 1) and the Fed is leading the rest of the central bank pack in terms of tightening. If, however, the US dollar where to appreciate more forcefully, oil could breach 50 USD/brl. to the downside. And, as always, political risks are a wildcard for oil. Nevertheless, we think enough analysts have burnt their fingers trying to predict political events, so we abstain from incorporating something that has been inherently difficult to “guesstimate”.

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About Nordea Asset Management
Nordea Asset Management (NAM, AuM 221.5 bn EUR*), is part of the Nordea Group, the largest financial services group in Northern Europe (AuM 330.9 bn EUR*). NAM offers European and global investors exposure to a broad set of investment funds. We serve a wide range of clients and distributors which include banks, asset managers, independent financial advisors and insurance companies.

Nordea Asset Management has a presence in Cologne, Copenhagen, Frankfurt, Helsinki, London, Luxembourg, Madrid, Milan, New York, Oslo, Paris, Sao Paulo, Singapore, Stockholm, Vienna and Zurich. Nordea’s local presence goes hand in hand with the objective of being accessible and offering the best service to clients.

Nordea’s success is based on a sustainable and unique multi-boutique approach that combines the expertise of specialised internal boutiques with exclusive external competences allowing us to deliver alpha in a stable way for the benefit of our clients. NAM solutions cover all asset classes from fixed income and equity to multi asset solutions, and manage local and European as well as US, global and emerging market products.

*Source: Nordea Investment Funds, S.A., 30.09.2017

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