Saxo Q2 Outlook: A social contract in tatters fuels anti-establishment voices and volatility

Saxo Bank, the online multi-asset trading and investment specialist, has today published its quarterly outlook for global markets and key trading ideas for the second quarter of 2016, the Essential Trades:

Political uncertainty and the rising anti-establishment sentiment seen around the U.S. election and in the run-up to the Brexit vote in June are two of the major risks facing financial markets in Q2 2016. Their importance is further exacerbated by the convergence of similar forces seen around the world which signal a fundamental rejection of the elite and the status quo. In this outlook, Saxo Bank’s strategists give their view on how to trade this across asset classes.

Steen Jakobsen, Saxo Bank’s Chief Economist, said: “Eight years into the financial crisis, employees take home their lowest pay cheques–to–GDP in history, meanwhile, corporations enjoy their highest earnings before tax compared to GDP ever. We also have the lowest capital expenditure in history together with the lowest level of productivity. This unhappy trinity explains the rise of the far left and the far right as they represent the furthest distance you can travel from the political elites.”

“Voters seem to think that chaos is better than ‘more of the same’. We are calling this new paradigm ‘the breakdown of the social contract’.”

Set against this context, Saxo’s outlook for major asset classes in Q2 2016 is as follows:

Forex

Entering the second quarter, we expect our theme of the broken social contract to be felt most intensely in sterling as the UK barrels toward a potential Brexit. What that means in practical terms is far from certain, but in immediate currency terms, it will likely have great ramifications – particularly with regard to the volatility of sterling exchange rates.

It also appears as if Q2 may be the timeframe in which the market begins to ponder the likelihood of a Trump presidency and what it would mean for the U.S. economy and more specifically, the dollar. There is a strong risk of USD weakness going into the election if polls show a strong likelihood of a Trump victory, merely due to the fact that Trump is the definition of an unknown quantity – again, volatility is virtually the only guarantee.

Further out, the social contract may next be under fire in Japan. Bank of Japan Governor Haruhiko Kuroda will easily achieve his 2% inflation target, but it will likely be minus 2% or worse in real terms.

Bonds

The pressure building on Europe to solve some of its imminent problems could easily flood into bonds once again, with Brexit fears and anti-austerity movements on Europe’s periphery potentially leading to market disquiet. We remain cautious on financials going into Q2 on account of very low yields, increasing (and still unknown) regulation, higher non-performing loan ratios and most of all, low-tech business models.

Commodities

Commodities are finally showing signs of stabilisation following the brutal selloff over the past couple of years, with gold and oil leading the charge. The buying of gold was almost non-stop during the first quarter with hedge funds going from record short to their biggest net-long positions in 13 months - strong momentum should see gold bugs reach but not breach $1,310/oz.

Fast forward one quarter and sentiment has also improved from the dark days in mid-January when Brent crude hit a 12-year low. Our preferred range for the coming quarter remains unchanged from Q1 at between $35-40/b but no longer with the risk skewed to the downside.

Equities 

The volatile start to 2016 has negatively impacted global equity markets, sending some sectors into cheap territory based on our new valuation model for the MSCI World sector indices. As a result, cyclical sectors such as consumer discretionary, materials, and financials have become cheap relative to their standardised valuation metrics - we are overweight these sectors going into Q2.

Macro

In a macro sense, there are several key backloaded event risks in the second quarter, including the Federal Open Market Committee meeting on June 15, a Brexit referendum on June 23, and a new general election in Spain. However, even if we will sail smoothly through the anticipated FOMC rate hike in Q2, developed equities do not look cheap at the moment – with the roughly 10% rebound  from the February through weighing on valuations.

We expect Italy to produce a sharp jump in earnings as the nation’s finance industry recovers while delivering a dividend of around 3.5%. At the other end of the scale, the UK remains overvalued as tailwinds from the housing sector fade.