Sterling plunges most on Brexit risk

Transcription

1 OCTOBER 2016 The analysis of Thierry Masset 2016, the year of the dog? Everybody is talking about inflation Sterling plunges most on Brexit risk OPEC reversal is gift to Oil Majors As odds of Clinton victory rise, U.S. health-care sells off Less of less than zero yields OTHER ASSET CLASSES Sterling plunges most on Brexit risk On the foreign exchange market, the pound risks turning painful for the U.K. economy as Brexit negotiations near. Prime Minister Theresa May has pledged to trigger Article 50 of the Lisbon Treaty, the formal step needed to leave the euro zone, by the end of March That would start two years of formal discussions on an exit. Sterling, 2016 s worst performer among 32 major currencies (-17% against the dollar and -14% against the euro since Brexit), has plunged as the potential has become more real for a so-called hard Brexit that would see the U.K. settling for restricted access to the EU s single market. With the exact meaning of Brexit still unclear, traders are expecting more volatility for the sterling. The flash crash last month (the volatility of the U.K. currency has jumped by 90%) was more redolent of a frontier currency than the world s fourth-most traded, and only Sierra Leone s leone and the Mozambique metical have dropped more than the pound since the June 23 referendum. While the pound s weakness has helped cushion the economy in the immediate aftermath of the referendum (manufacturing has been supported by a weaker sterling and the exporter-heavy FTSE 100 index approached a record high), the latest slide of the sterling may carry more costs than advantages. The drop has caused companies to downgrade profit forecasts, threatened to fan inflation, and also hinted at a further fall from grace for what was once the global reserve currency. The risk is that a weaker currency results in price increases at home, while faster inflation may make it less likely that the Bank of England will be able to support a slowing economy via lower interest rates or more asset purchases - increasing the risk of stagflation. While stocks and bonds have become so costly relative to commodities that the case for real assets has strengthened last month, we should not forget that the vote for Brexit is a vote against globalization, against the free mobility of people and goods. This situation could result in a downward revision for China demand and have a negative impact

2 on commodity prices, especially if there is a US dollar appreciation. In this context, the fourth quarter of the year could be a story of an inability or perceived inability for commodities to move much higher because big supplies are still weighing on many markets (oil, industrial metals, and agriculture) and because traders see a 60% chance that the Federal Reserve will raise interest rates by year-end, sparking advances for the dollar (which is negatively correlated with commodities prices). Furthermore, many producers are still grappling to contain debt. One gauge of leverage among mining, energy and agriculture companies continued to rise since the beginning of the year and is more than four times year-earlier levels. That explains why we keep a careful approach on this asset class with a neutral weight. While raw materials have rebounded, they are still well below levels of even two years ago. To end the gluts that sank prices companies ought to be cutting more output, but many are still so deeply in debt that they need to keep churning out cash to stay above water. Cutting production is absolutely the last resort for any company because in this case they are basically shutting down their revenue generation. And then what? Unless commodity prices extend gains, the conundrum holds grim consequences for 2016 for some producers. The debt burden is growing for many miners and drillers no matter how hard they pump and dig. Corporate defaults will reach a six-year high, led by commodity companies, according to Moody s. The cure for low prices may just be low prices. Declining profit means producers cutting investments in mines and oil rigs. When gluts do finally ease, it will spark a rebound. For now, demand is being overshadowed by the amount of supply that we have. We are already seeing signs of the market re-balancing but it s just going to take more time before we see more sizable supply rationalization. 3.1 Precious metals: overweight Gold While the prospect for higher rates means enthusiasm for gold is waning (total net long non-commercial positions in gold futures and options fell by almost 40% last month), the increase in investment demand since the beginning of the year helped to make gold one of the best performing assets of the year (+18% in euro), comfortably outperforming many equity indices, bonds, commodities and real estate. For the record, investors bought record amounts of gold in the first half as concerns over Britain s vote on European Union membership and U.S. presidential elections drove demand for a haven. Slumping yields also reduced appetite for alternatives like stocks and bonds. Purchases of 1,064 metric tons smashed a 2009 record by 16% (in the second quarter alone, investor demand more than doubled to tons from a year earlier). Furthermore, demand for gold should be reignited as real interest rates, or yields minus inflation, remain low, keeping gold competitive with other assets. Gold, even at a yield of 0%, may prove to be a higher yield relative to other assets during a time when interest rates are eroding capital globally. Investors turn to gold when faith in their currencies and

3 financial systems is shaken. History shows that, in periods of low rates, gold returns are typically more than double their long-term average, the World Gold Council. Over the long run, negative interest rate policies may result in structurally higher demand for gold from central banks and investors alike. Countries seeking to weaken their currencies turn their population into gold buyers, as has been the case in China, Russia and other Emerging Markets. Gold is used as a currency, one that cannot be directly changed by central bank whims. We are also positive on gold because the precious metal is set to benefit from the potential for further market instability. Chinese/global slowdown, political turbulence in Europe, low commodity prices and doubts regarding the effectiveness of monetary easing could increase volatility on financial markets, keep risk appetite in check and U.S. dollar rates low, supporting gold. Central bank gold sales historically resulted in a market surplus, World Gold Council data shows. But from the second quarter of 2009 through 2015 net gold purchases by central banks absorbed most of the surplus, which may continue as reserve portfolio diversification is pursued. Bloomberg estimates that central banks accumulated more than 2,448 tons of the metal versus gold exchange-traded fund outflows of about 270 tons in the period Silver Silver s bull run looks like it has legs. The metal with one of the best return this January of any in the Bloomberg Commodity index is poised for more gains, investors, traders and market data suggest. The metal is up more than 32% (in euro) since the beginning of the year after underperforming gold in the first quarter on concerns slow Chinese growth would curb demand in the biggest consumer of commodities. Silver hasn t been so cheap relative to gold for more than seven years and with mine supplies forecast to contract this year that may be a sign it s ready to come out of the yellow metal s shadow. An ounce of gold bought about 72 ounces of silver last month, more than any time since the financial crisis of Mine production of silver will probably drop in 2016 (-2.4% to million ounces, according to CPM group) for the first time in over a decade and demand is set to outstrip supply for a fourth straight year. Much of the world s silver is extracted from the ground with other minerals, and output cuts announced by the biggest miners will hurt supplies of the metal as well as others such as copper and zinc.

4 For investors who believe gold will keep climbing on worries about a global economic slowdown, and negative interest rates, silver could become a profitable alternative. Typically the metal outperforms when the price of gold is rising and generally underperforms only when both are falling. More than 50% of silver (a by-product in mines that produce zinc, lead, copper and gold) demand comes from industry, including about a quarter from electronics, and to some extent silver s fortunes follow those of industrial raw materials such copper, zinc and lead. The London Metal Exchange index of six metals has climbed about 12% (in euro) since slumping to the lowest level in more than six years in February. Assuming the world economy avoids a sharp downturn and prices of industrial metals continue to stabilize, silver could outperform gold. 3.2 Crude oil (Brent): neutral The Organization of Petroleum Exporting Countries (OPEC) tossed a monkey wrench into the futures market, with an announcement that the major OPEC oil-producing nations would cap production - the first oil production cut in eight years. Overall, the proposed deal would reduce production by anywhere from 200,000 to 700,000 barrels per day (to 32.5 to 33 million barrels a day). Even if the production curb happens, analysts say it won't matter much, anyway. As OPEC is at or close to its maximum production, agreeing to a small cut is not much of a concession, especially given the history of the Iranian/Saudi relationship (Iran, Nigeria and Libya are exempt from the deal) and potential additional supply which could come on line (through non-opec production and inventories). Critics also alluded to OPEC's decision to delay the official announcement until November 30, when the organization meets again in Vienna. It is challenging for the group to follow through on the cuts and, historically, there has been a credibility problem. The market has rewarded the OPEC rhetoric (Brent futures increased 16%, in euro, to $47 a barrel). Let s see if their deeds match their words. The real significance of last month s framework OPEC production agreement is not the size of the implied or actual output cut, but the fact that Saudi Arabia and OPEC have returned to active market management. While it is difficult to overstate the importance of this change and while it is unclear how the plan will be implemented, Goldman Sachs calls for oil prices to climb between $7 and $10 per barrel in 2017, and possibly higher if the OPEC production reduction deal goes through. We still believe that the 2016 likely oil price range is $40-55 per barrel with risk to the upside and the likely 2017 range is $55-70 per barrel, as the OPEC s decision should help to reduce oversupply in global oil markets. Nevertheless, we keep our neutral positioning on Brent as, in reaction to the OPEC s decision, the U.S. oil supply glut is failing to clear. The issue is that once prices go up, American drillers start to produce more. Natural gas and oil drilling is coming back in a big way: the Federal Reserve oil & gas-drilling index has surged almost 18% end June. Instead of falling victim to the Saudi-led battle for market share, a cohort of shale producers are ready to boost output when prices rise could cap any recovery at about $60 a barrel for the next couple of years, regardless of any OPEC moves to cut production. For OPEC, there is thus cause for both celebration and concern. After a two-year war downturn that wreaked economic havoc in several member countries, oil is trading at the highest level in more than a year and the prospect of a return to $30 or lower seems remote. While the group can claim that it has successfully set a floor for prices, the resilience of its rivals means the ceiling may not be too far away.

5 3.3 Industrial metals: neutral The world s two largest mining companies are planning to raise capital expenditure from decade lows as a rebound in commodity prices (the World Bank forecasts commodities will rebound next year after hitting the bottom of the cycle) and the improved cash flow outlook pave the way for at least $12 billion of growth projects. BHP Billiton, the No. 1 miner, expects to raise spending by 15% in fiscal 2018, while Rio Tinto forecasts it will boost expenditure from next calendar year. Any significant rise in the oil price could mean mining companies boost spending further. However, we see capital expenditure remaining lower than at the height of commodities boom. BHP s annual spend peaked at about $21 billion in fiscal Furthermore, mining executives may be placing too much confidence in China s ability to support economic expansion, a factor that has lifted demand and commodities prices this year. China s growth remains set for a long-term, slow decline. While they are unlikely to repeat the selloff seen last year, price weakness will continue in industrial metals, owing to a combination of excess supply and soft demand. The outlook for metals continues to be bearish as supply curtailments come off in China and elsewhere. Many producers are still grappling to contain debt. Another year of belt-tightening hasn t kept pace with an earnings slump after prices collapsed. One gauge of leverage among mining, energy and agriculture companies continued to rise and is more than double year-earlier levels. 3.4 USD (neutral), Yen (positive => neutral) and GBP (negative) As the yen failed to breach 100 per dollar even as it temporarily rallied following decisions taken by the Bank of Japan (the BOJ shifted its focus to targeting the yield curve and away from currency- weakening monetary expansion), which was seen as bullish for the Japanese currency, we reduce from overweight to neutral our positioning on the Japanese currency which has surged 20% this year (the best performance among 10 major developed peers and its biggest annual advance since 2008).

6 While we expect the U.S. dollar could strengthen through the end of the year, we are no sure that it will move appreciably beyond the end of this year. While the Federal Reserve is likely to tighten in December, June and the end of 2017, there is a risk the central bank will move at a more gradual pace because of political uncertainties, including the U.S. elections and Brexit. We keep our neutral positioning on the U.S. currency. We remain also careful on euro as there has been speculation that the European Central Bank will began to reduce its bond purchases next year. The pound risks turning painful for the U.K. economy as Brexit negotiations near. Prime Minister Theresa May has pledged to trigger Article 50 of the Lisbon Treaty, the formal step needed to leave the euro zone, by the end of March That would start two years of formal discussions on an exit. Sterling, 2016 s worst performer among 32 major currencies (- 17% against the dollar and -14% against the euro since Brexit), has plunged as the potential has become more real for a socalled hard Brexit that would see the U.K. settling for restricted access to the EU s single market. With the exact meaning of Brexit still unclear, traders are expecting more volatility for the sterling. The flash crash last month (the volatility of the U.K. currency has jumped by 90%) was more redolent of a frontier currency than the world s fourth-most traded, and only Sierra Leone s leone and the Mozambique metical have dropped more than the pound since the June 23 referendum. While the pound s weakness has helped cushion the economy in the immediate aftermath of the referendum (manufacturing has been supported by a weaker sterling and the exporter-heavy FTSE 100 index approached a record high), the latest slide of the sterling may carry more costs than advantages. The drop has caused companies to downgrade profit forecasts, threatened to fan inflation, and also hinted at a further fall from grace for what was once the global reserve currency. The risk is that a weaker currency results in price increases at home, while faster inflation may make it less likely that the Bank of England will be able to support a slowing economy via lower interest rates or more asset purchases - increasing the risk of stagflation.

7 Central banks in developing economies are taking advantage of the biggest rally in their currencies since Led by Turkey and Thailand, they are using stronger exchange rates to build up foreign reserves for the first time in two years, replenishing shortfalls created as they attempted to prop up their currencies during recent routs. International reserves have grown by $154 billion, or 1.4%, since the end of March to $11 trillion, according to data compiled by Bloomberg. Turkey s cash coffer expanded the most during the period, increasing more than 6%. Thailand s currency pile rose 5.5%, while Indonesia s climbed 3.6%. Bigger defences mean they will be able to better ride out destabilizing plunges as they make their economies more appealing for traders. The increase marks a reversal since 2014 when capital outflows prompted central banks from China to Saudi Arabia to burn through hoarded cash to stem declines in their currencies. Global reserves peaked at $12 trillion in August that year and had been declining until recently when capital started to flow back into Emerging Markets. With more than $10 trillion of bonds in Europe and Japan yielding below zero, developing-nation assets are becoming attractive for yield-starved investors just as their economies show signs of recovery. More and more money is being put into Emerging Market bonds and equities and it s giving them opportunities to buy dollars and replenish reserves.