Originally published by AxiTrader
Please click here to read part one of this analysis.
WHAT'S IT ALL MEAN FOR MARKETS?
The biggest risk is this theme coalesces into a narrative which sees pressure on, and thus losses in, a number of markets from stocks, to high yield bonds, European sovereigns - in fact anything with a negative or near negative rate or a bond spread flat to Treasuries.
As I highlight, should growth see inflation lift and central banks accelerate the withdrawal of monetary accommodation valuation measures across many markets will be affected.
Indeed the top 10 of Deutsche Bank (DE:DBKGn)'s "30 risks to markets in 2018" are all in some way related to the theme and outlook I have articulated above (my annotation via the red box).
More directly though here are some potential impacts on specific markets.
FOREX
Commodity currencies like the Aussie, Canadian dollar, and kiwi stand to be the primary beneficiaries among the G10 from what could become a strong narrative around global reflation in 2018.
Of course, the US dollar should also benefit in that narrative because it suggests the Fed will continue to tighten while the ECB and BoJ are well behind in terms of timing given they have not even halted their balance sheet operations and quantitative easing let alone begun to raise rates or shrink their balance sheet.
Source: OECD Economic Outlook presentation November 2017
But in 2017 the forex pain trade has been long dollars and it seems the US dollar can't take a trick this year when it comes to the euro, and in many ways even the yen and other pairs. That's because in the absence of wages pressure or inflation in the US, traders are discounting what the Fed says it is going to do by not pricing to the dot-plot. At the same time more weight has been given to the uptick in growth across the Eurozone and the implications that will have for the ECB.
Interest rate differentials and bond spreads haven't really been big influences on the majors in 2017. But that may change in 2018.
As a result, the dollar should find its feet eventually and start to make headway once again. The question is from what level and when.
It speaks to continued forex market ranges.
STOCKS
Both the MSCI All-Country Index and the S&P 500 are about to complete their first year ever where each calendar month saw a positive return for the indexes.
That's a remarkable result. So it's no surprise that observed volatility and the price of same via the VIX has been low across the course of 2017.
But if bonds rates spike, or if any one of the many geopolitical risks manifests, then volatility both implied and realised could rise. That would not only harm the many sellers of vol - picking up pennies in front of a steamroller - but may lead to liquidation in other markets.
What's important here is that with such low levels in volatility and in bond rates it does not take much of a move to make a material move in the capital price - a capital loss. recently, and in fact for many years, spikes in vol, or rates, have been opportunities to fade the moves.
And while Wall Street analysts currently believe that the S&P 500 will end 2018 around 5% higher than where it is today there is an expectation of higher volatility in the year ahead as the Fed raises rates.
Higher volatility and its knock on effects is my base case for stocks in 2018.
But let's face it after such a quiet year of solid gains and no real or material pullback that's probably one of the easiest forecasts me or other strategists/traders/investors could make.
COMMODITIES
Commodity prices have had a solid rally in 2017.
But whether it is commodity prices relative to stocks or metals and mining shares relative to the overall market commodities and stocks associated with them have underperformed the overall market.
Of course, arguments of resource utilisation in an increasingly service-based global economy and the emergence of the tech giants - the FAANGS - who have been integral in fuelling this US and global stock market rally in 2017 can be made to suggest Commodities have lifted as much as they might.
But many markets are tighter than realised.
And with OPEC tightening supply in oil markets at a time of synchronised global growth for the first time in a decade there is a real chance oil prices, and further gains, are a real part of this global reflation, bond, central bank story.
Source: Twitter Screenshot @anasalhajji
Inventories have been drawn down materially and US EIA data suggests there is a surfeit of demand over supply in global "liquid fuels markets" over the first half of 2018. That will further tighten the market and support prices.
KEY MARKETS I'M WATCHING AS A RESULT OF ALL THIS
- Volatility: I'm a student of Mandelbrot and Minsky and as such I believe that low volatility sows the seeds for a spike in volatility. Equally, when that lift in volatility happens it is likely to prove self-reinforcing and a little sticky - just look at Bitcoin in the last two weeks of 2017. So with selling vol in bond and stock markets still a profitable trade attracting a wall of money the risk is that should bonds and the economy act as anticipated we see a material volatility expansion in 2018. That's likely to aid the Swiss franc, the Japanese yen, and gold. Throw in the many risks associated with the Mueller investigation, North Korea, tensions in the Middle East, regulatory scrutiny of the tech giants, NAFTA, and the withdrawal of stimulus, and we end up with a cacophony of potential catalysts for this volatility spike and expansion.
- The US dollar: As we enter 2018 there is little sign that the arguments I've made above have any resonance with forex traders. Indeed the euro is up near the highest level of 2017 and a break could precipitate a rally of another 5-7 cents toward 1.2750/1.2820. Whether traders behaviours and buying and selling patterns means the US dollar can benefit from the above argument, or not as has recently been the case, is as important for the outlook as the fundamental drivers beneath the market. Are we on the cusp of a new leg in the US dollar bear market, or is the worm about to turn?
- AUD/USD: 2017 saw the AUD/USD trade around 9.5 cents against an average since the float of around 15 cents. That was a result of many competing forces and a lack of overall market volatility tempering its usual swings. Looking forward to 2018 the setup articulated above would suggest the Aussie dollar trading up and through the 2017 high toward 82 cents. Yes, the bond spread to the US is a handbrake on the AUD/USD. But no currency is a result of a single factor input model. So when I look at the other key drivers of the Aussie in the year ahead they are supportive of upward pressure on the terms of trade, Australian economic growth, and thus employment and wages as well. That will also change the narrative around the RBA and Australian rates if things play out positively.
- Copper: Copper has had a stellar rise in 2017 as tightness in the current market converged with expectations about use in EV's in the future, and an overall positive global backdrop. Copper is the commodity with a PhD after all. Looking ahead the charts suggest a real chance of a run toward $3.70. $3.55 is the current top of the uptrend channel copper is in and like 2017 this could be a volatile trend. But a trend is your friend - as they say.
- Crude: Yes, crude is sharply higher this year. But as articulated above there are reasons to believe the market is tightening and will stay tight. The Suadi's and many of their allies in OPEC need the money for their domestic budgets and while the Russians are already talking about the post-production cut environment it seems the chance of higher prices still seems high. The recent Saudi budget assumes a price of $75 a barrel in coming years and the technical outlook suggests this is a reasonable chance. Of course US shale is still going to be a factor. BUt I have been struck by the change in tempo from US producers and of BP (LON:BP) boss Bob Dudley's comment in late December that “I don’t think [US shale] will be the perfect swing producer now. For a while, I was worried. But I think it is going to be less solid”. Prices can rise.
- Ranges and Technicals: If 2017's lack of single overarching global markets narrative and the rise of (Bitcoin) prove anything it is that traders will often resort to technicals as their roadmap, or guide, to value. That's important in what could end up being a more volatile year ahead. The Asian crisis in the 1990's taught me, and Bitcoin has rem minded me this year - as if I needed it - that Ranges, technical formations, trendlines, and Fibonacci patterns are good indicators of support and resistance in uncertain markets. I can't see why the year ahead would be any different.
One thing worth noting about this outlook is that there are many self-reinforcing or dampening interconnections throughout the global economy and markets. Indeed at the first sign of ructions, there is every chance central banks will revert to type and back off. Just like as the Fed did after the taper tantrum a few years back.
So when looking forward there are, by necessity, "degrees of maybe" in any outlook.
For me, those "degrees of maybe" evolve and shift probabilities on a daily, weekly, and monthly basis. A degree here, a hald a degree there. It's these subtle shifts and what they mean for markets which drives my reasearch for and is reflected in my daily note "Market Mornings". It's these subtle shifts which end up moving the the outlook as the global economy and markets evolve.
You are welcome to join me in this fascinating journey that 2018 promises by reading my daily note each morning. It's the first and best thing I do each day.
Have a great year's trading.