3DCM Trading Views and Comment 2010
The Dawn of a new decade…………..
As we enter the new decade the overriding theme of global financial markets seems to be one of ‘cautious optimism’. This may seem only a small step on from the much criticised ‘aggressive prudence’ that we have experienced here in the UK, but it is nonetheless an important step on the road to recovery.
Equity markets have opened the year on a very positive note following a strong round of industrial surveys and pent up demand from a surplus of cash as we move out of the year that ‘was’ into the year that ‘could be’.
This positive equity environment is likely to prove resilient in the short term at least with growth momentum high, upward pressure on global yields mixed, global interest rates low and stable, and inflation moderate and likely to fall back.
Incomes have risen over the last couple of months and disposable incomes for both individuals and businesses have improved. That is not to mention the ‘witchcraft’ of anecdotal evidence that suggests a positive equity market in the first 5 days of the year is very highly correlated to a positive equity market for the whole year! (S&P rose 2.67% in the first 5 days of 2010).
The big picture view is one of global recovery and the continued dominance of China and other ‘emerging economies’, although how much longer we will be referring to the world’s largest exporter and arguably second largest economy as an ‘emerging’ economy may be the question after 2010. G7 has already given way to the G20 as the key forum for global economic decision making.
In 2009 the global economy contracted by 1.1%, the largest decline since World War II. This was split between a 3.4% drop in ‘major’ economies and a 1.7% rise in emerging economies. After the unparalleled global economic stimulus and rebalancing of corporate and consumer balance sheets, green shoots of recovery are apparent (though still treated with scepticism by most economists). Indeed as we move into 2010 the Bloomberg Global economic confidence index rose to a record in January.
3D have a very strong view that there will be considerable opportunity in FX in 2010, yet there will be a number of very distinct dynamic changes throughout the year. Before giving our dominant trade views for 2010, below we have outlined our thoughts and views of the major global economies at the current juncture.
UK – The situation in the UK is very interesting. Britain continues to be viewed at best as deeply troubled fiscally and dogged by the political wrangling that an imminent general election could cause at this stage of the recovery and fiscal cycle. However the broad macro economy is showing signs of catching up with the positive survey evidence and carries a good amount of momentum into 2010.
“in 6 months time the UK economy will be regarded as the strongest (of the G7)… above the Euro zone and the US as they will fall back and we recover…” [ Prof. C. Goodhart ]
Q3 GDP figures did not quite show it but most of the components were consistent with a recovery having started some months ago, we have had no turnaround in the inventory cycle, unlike almost every other major country and net exports and the current account are finally beginning to come right.
The BoE is markedly more upbeat about the expectations that a bottom has been reached and with lenders expecting to make credit more available to households and businesses in Q1 that momentum should continue. There is a strong likelihood that Q4 GDP is above expectations and that is likely to boost GBP in the short term. Overall however, GBPUSD is likely to trade in a range until there is more clarity on the political front in the UK.
The combination of £178B of government borrowing, an upcoming election and the spotlight of the ratings agencies and the markets mean that the next couple of months could be nervous and volatile for GBP, but from that point onwards the headwinds will start to die down and the relative value of GBP will generate significant appreciation against a broad range of currencies.
US - The US macro economic data continues to improve and the perception that the US will lead the industrialized world (bar Australia) out of recession is gaining traction. Officials are keen to play down the optimism (Bernanke’s ‘Formidable Headwinds’) but the interest rate market is pricing in a steeper US rate curve, with 2s 10s at a record. This is likely to see the USD benefit on foreign exchange markets, but less against GBP than other currencies as GBP should also find some support from macro and inflation data in spite of the political woes.
The US economy expanded 2.8% in Q3, led by a rebound in personal consumption and private investment. Recent data suggests that this recovery has continued into Q4, with the big question mark over the ultimate normalization of Fed policy continuing to be the verification that a turning point has been reached in the US unemployment rate.
Consumer spending is critical to the US outlook for 2010 as government stimulus and inventory moves fade.
Australia - Australia is showing signs of stabilization in the rapid, China induced growth of 2009. Business confidence remains strong but after the 75bp increase in interest rates over the past 3 months the consumer mood is becoming more fragile and home sales have fallen back from the stimulus induced growth of earlier in the year.
Despite avoiding technical recession last year, Q3 GDP disappointed with the rate of growth slowing to just 0.2% q/q from the 0.6% in Q2. Retail sales however reached a 4 month high in October and consumer data will be watched closely going forward.
The employment situation in Australia has dramatically outperformed expectations as the growth rebound in China continues to soak up the Australian commodity yield
Relative interest rate advantage will continue to benefit AUD in the short term but into Q2 2010 and beyond, as the world emerges from the slump, the comparative advantage of AUD will be reduced.
Canada – Canada carries a decent amount of momentum, with the monetary and fiscal stimuli, lower risk premia and trade situations benefitting capital flows, all a positive for the CAD going into 2010.
On the flip side the BoC strategy to hold interest rates at 0.25% to a pre defined end Q2 deadline has been widely criticized as fuelling a housing bubble and the strength of the CAD is also a concern to the BoC and Canadian government alike. Whilst we expect GBP to outperform CAD over the longer term, in the near term CAD has the upper hand.
Switzerland – The Swiss economy grew by 0.3% q/q in Q3 emerging from technical recession after 4 consecutive quarters of contraction. Consumption continues to hold up surprisingly well despite the continued weakness in employment and inflation is returning to positive after a brief bout of deflation in the second half of 2009.
Following the break of 1.5000 in EURCHF the initial focus will be on whether the SNB are likely to show their hand at any point soon to prevent further CHF appreciation. In the long run the CHF is dramatically overvalued against both GBP and USD and we expect that the cash rich Swiss may go on a buying spree in M&A markets over the coming months.
Options gamma in EURCHF however is likely to prevent any short term bounce in the EURCHF rate being sustained and GBPCHF should therefore underperform GBPEUR.
Euro zone – The Euro zone economy exited technical recession in Q3, with an expansion of 0.4% q/q. However the concern going forward in the Euro zone outside of the disparity between member states (French and German growth vs. Spanish renewed decline, Greece fiscal frailties and Portugal and Ireland ratings cut threats) is that the return to growth is as a function of the more volatile components of growth (i.e. the snap back in global exports and inventory rebuild) rather than solid fundamentals or domestic demand.
Next year Germany plans a record EUR86B in borrowing (up 75% year-on year), with Angela Merkel suggesting that the German situation will deteriorate before improving. On a broader scale the ECB has raised its estimate for write downs by European Banks significantly. 2010 is likely to see the relative value of GBP vs. EUR questioned and the quiet strength of the European Banking system may well be reviewed to have been secret weakness.
In Q1 there are still many reasons to expect the EUR to remain strong in the short term as the global trade rebound remains in force, but in a longer term context the value of GBPEUR is likely to increase significantly. A breach of the 1.1904 2009 highs is the first target.
Japan - The current environment in Japan is at its most fragile in a while and despite being one of the first major economies to exit technical recession, deflation has become an increasing concern and domestic demand has yet to gain traction despite a dramatic turnaround in manufacturing.
In Japan, the country with one of the worst fiscal situation in the global community, the predominant focus is on fiscal austerity and the government assurance that it won’t breach its JPY44trn debt issuance for fiscal 2009. There were several instances of conflict between the government and the BoJ, on the best way to deal with persistent weakness in the economy culminating in an assurance by the BoJ that they will act decisively in the face of renewed financial market turmoil and that they “will not tolerate zero inflation or falling prices” (a sign that they intend further stimulus measures.). The BoJ also introduced further quantitative easing in the form of a 3m refinancing facility at a fixed rate of 0.10%. USDJPY broke to 15 year lows at the end of November in the fall out from the Dubai debt standstill, but ground higher throughout December.
The stimulus induced boost to global trade that has seen a marked jump in industrial production and a bounce back to positive (if marginal) GDP growth in Japan (as exports rose the most in 7 years) has waned of late. Prices are still showing clear risks of prolonged deflation and consumer and business sentiment are fragile through weak domestic demand.
USDJPY hit a 15 year low at the end of November but since then the tone of the JPY has altered. The improved US data has pushed up US yields and put the JPY back in the ‘funding currency of choice’ spot and this is likely to be exaggerated as the year progresses as influences such as political rifts and the concerns over the countries debt burden continue to keep the yield curve flat out to 2 years.
Trade views 2010
1 Long GBPJPY
Japan has one of the worst fiscal positions in the industrialised world and despite the fact that their sovereign credit rating is somewhat protected by their strong external balance, this year the balance of risks is skewed in favour of JPY weakness.
On the GBP front we are very positive on the UK and on GBP. The short term political and fiscal concerns will give way to better than expected growth and a dramatic turnaround in the global negative sentiment towards the UK and we will see significant GBP gains over 2010.
On the other side of the exchange rate the JPY will suffer markedly from its distinct and growing interest rate disadvantage and the JPY carry trade will return in force.
Deflation and politicising between the BoJ and the government will create an uncertainty and negative yield differential that will weigh heavily on the JPY as the year progresses. The first target in this currency pair for the year will be 180.00.
2 Short EUR (trade weighted)
The EUR benefitted largely by default in 2009. The dominant theme of USD as the ‘safe haven’ currency of choice combined with the EUR translation of foreign currency reserves as the global markets sought to diversify out of the USD at various points all pushed the EUR to above its sustainable levels against a number of alternative currencies. In H1 2010 those currencies likely to outperform the EUR are {AUD, CAD, NZD, SEK, USD} and in the second half {GBP and to a lesser degree USD}.
Next year Germany plans a record EUR86B in borrowing (up 75% year-on year), with Angela Merkel suggesting that the German situation will deteriorate before improving. On a broader scale the ECB has raised its estimate for write downs by European Banks significantly. 2010 is likely to see the relative value of GBP vs. EUR questioned and the quiet strength of the European Banking system may well be reviewed to have been secret weakness. In Q1 there are still many reasons to expect the EUR to remain strong in the short term as the global trade rebound remains in force, but in a longer term context the value of GBPEUR is likely to increase significantly. A breach of the 1.1904 2009 highs is the first target.
3 UK house prices
Although still an overgeneralisation the housing market must be separated into at least two distinct entities, London/South East and the rest of the country. The supply and demand dynamics and the availability of funding influence these markets in very different ways.
Under supply, cash buyers and overseas investors exploiting the weak pound will continue to drive the market in London and the South East (in addition to the resumption of bank bonuses in 2010!). Here we expect an annual rise of 7% with ebbs and flows in the numbers caused by a likely revaluation of Sterling and uncertainty surrounding the general election.
The rest of the country will be more dependent on local buyers and the availability of good value mortgages. Supply and demand pressures still exist in the rest of the country but these are likely to ease as unemployment bites and cash reserves are exhausted.
Assuming a phase of greater stability in the banking sector new buyers and movers will again enter this market once funding is more widely available. This may take some time and will not be helped by the timing of the election. We expect the annual rise in the rest of the country to be in the region of 5% with the focus being on H2 growth.
4 Long UK banking stocks
Whilst in the fragile situation of being pressured to increase lending whilst their debt books (particularly on the commercial property front) remain a concern, there may be a continuation of the dramatically increased volatility in the banking sector in the short term.
Housing data is likely to outperform market expectations this year and as the economy gains traction having rebounded from ‘technical’ recession in Q4, risk appetite will return to the markets. We are overall very positive for equities in 2010 and for investors that are uneasy about buying back into the index at such high levels the attractiveness of those sectors that are still relatively cheap will be difficult to ignore. Significant gains are likely for those with the patience and the belief to hold a relatively long term view in the UK banking sector.
5 Long UK rates (potentially relative to AUD rates)
The extent to which rates rise in the UK in 2010 are likely to be largely impacted by the general election results and the conviction and fiscal austerity of the incoming / or continuing political party. Either way UK rates will rise this year. The market is currently pricing in approximately three, 25bp hikes for the UK this year taking the Base rate to 1.25%. With CPI only getting to a low of 1.1% throughout the turmoil and quickly bouncing back to around target in 2 months the underlying dynamic is supportive. Economists will argue that the slack in the economy will generate a significant drag on inflation in H2 with unemployment still rising. Our view however is that the rebound in the UK will be stronger than anticipated and the lagged inflationary impact of QE on the UK economy is yet to come. UK rates will be at 2.00% by the end of the year.
For those not wishing to take an outright view on interest rates, the spread between Australian rates and UK rates looks far too wide. Australia’s pace of normalisation will slow just as the pace of UK hikes picks up and the relative differential will narrow dramatically from the current AUD hawkish, GBP dovish stance that the market is currently adopting.
6. Short Gold
Despite the significant rise of gold in 2009, driven by a falling USD, high risk aversion and rising inflation expectations on the back of extraordinary global stimulus, we now feel that the current level of Gold is unsustainable and are looking for a decline.
Our overall view of the macro economic picture for 2010 is positive and as we move further into 2010 we will begin to see currencies trading on a differentiation and relative value theme, where the currencies of countries that are deemed to be entering self sustained growth coupled with a higher pace of monetary policy normalization will benefit accordingly in FX markets. At the current juncture we see the USD at the forefront of the move for policy normalisation and as such expect to see USD appreciation and the attraction of gold as a store of value to temper.
For those not wishing to take an outright view we also see value in selling gold versus industrial metals where the price of the commodity is less driven by ‘historic’ correlations and more driven by quantifiable industrial utility. Our first target in gold for 2010 would be $800.
7. Sell UK CDS protection vs. Safeway Ltd CDS
The market implies a view that UK corporates are less likely to default than the UK sovereign. The anomaly is driven by the extraordinarily accommodative policy response to the crisis and the consequent rapid increase in public sector debt, which is perceived as a significant socialization of credit risk.
Our view is that sovereign credit risk is qualitatively different to corporate risk and should provide a floor for corporate credit spreads. Sovereigns are able to raise taxes, print money, borrow from the IMF, or even invalidate private contracts by changing the law, as was the case with the recent ban on short selling equities. In the event of a crisis the government could plausibly argue that their funding costs are being artificially raised by speculators in the CDS market causing the short protection leg to knock out, which would work in favour of this trade (whilst not being a major motivating factor).
A reasonable first target for profit taking could be parity, although in the long run it is not unreasonable to expect a return to near pre-crisis levels, i.e. target sovereign ~50bps tighter than Safeway Ltd.
The trade earns 35bps per year for the 5 year term, unfunded and assuming no credit events.
Trade Summary;
| Trade | Current Level | Target | |
| 1 | Long GBP/JPY | 148 | 180 |
| 2 | Short EUR (TWI) | 103.5 | 95 |
| 3 | UK House Prices | 7.00% | |
| 4 | Long UK Bank Stocks | 173.25 | 250 |
| 5 | UK Rates – Year end (base) | 0.50% | 2.00% |
| 6 | Short Gold ($) | 1135 | 800 |
| 7 | Sell UK CDS vs Safeway CDS | 35bp (p.a.) | 0 |
DISCLAIMER
The above trading views are for information purposes only and should not be used for making investment decisions.
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