Friday, November 18, 2016

"Goldman Reveals Its Top Trade Recommendations For 2017" (#1 GBP/USD at 1.14 and EUR/USD at parity at end-2017)

EUR/USD 1.0639; GBP/USD 1.2332.

From ZeroHedge, Nov. 17:
Last November, when Goldman released its list of Top trade recommendations for 2016, we had one simple recommendation: "the best trades for 2016 will be to... do the opposite of the Top 6 trade recos" for obvious reasons. Less than three months later, following a dramatic swoon in the market following the China reserve liquidation scare of late 2015 and early 2016, Goldman capitulated and closed out 5 of its 6 top trades at a loss.
Fast forward to today, when the time for Goldman to unveil its "top trades" for 2016 has come again. In a report by Francesco Garzarelli, Goldman presents "the first six of our recommended Top Trades for 2017. These trades represent some of the highest conviction market expressions of the economic outlook we laid out in the latest Global Economics Analyst and the related investment themes we discussed in our Global Markets Analyst."
Summarized, the 6 trades - which are largely a thematic recap of Goldman's top failed trades for 2016 - are the following:
  • Top Trade #1: Transatlantic economic divergences and political risks: Long US$ vs GBP and EUR
  • Top Trade #2: RMB weakening: Long $/CNY
  • Top Trade #3: Earning the ‘good carry’ in EM, hedging the China (and CNY) risk: Long BRL, RUB, INR and ZAR, short KRW and SGD
  • Top Trade #4: Long EM equities with insulated exposures to growth: Long Brazil, India and Poland, FX un-hedged
  • Top Trade #5: The 'reflation' theme broadens: Long 10-year US$ and EUR inflation
  • Top Trade #6: Long equity-like 'carry' with little duration risk through dividends: Long EURO STOXX 50 2018 dividends
Goldman, still smarting from the egg on its face from its last "top trade" recos, prefaces the current edition of best ideas by hedging that the level of uncertainty has never been this high:
It is an unusually uncertain time in which to outline our strategic markets views and recommend a first batch of Top Trades for 2017.

  • In the US, the unexpected outcome of the Presidential elections has kicked off a debate as to whether the economic policies under Mr Trump’s tenure will support aggregate demand (via lower taxation and higher public spending on infrastructure) or ultimately stifle potential output (through protectionism). Also more uncertain is what the response of the Federal Reserve might be given that the economy is already operating close to full capacity. The FOMC will have the first opportunity to eventually adapt its policy guidance to the new scenario when it next meets on 14 December. A clearer picture of the new Administration's economic plans will only be available early next year. 
  • In Europe, investors are waiting to hear from the ECB on 8 December, specifically on how much longer, at what pace and under which modalities the central bank intends to continue conducting asset purchases. The ECB’s bond buying programme, alongside the BoJ's, has been a significant force behind the decline in the term premium across developed markets, and has kept EMU spreads largely in check. Changes to the stock and flow of the central bank buying could have repercussions on how the Euro area asset complex, including the single currency, perform entering the new year, and beyond. The result of the Italian referendum on constitutional reform, scheduled for 4 December, is also under the spotlight. Investors' anxieties over this poll and its potential political repercussions have increased since the Brexit vote in June. 
  • The OPEC meeting on 30 November will be important for the near-term inflation outlook and for Emerging Markets. There are several moving parts affecting the oil supply outlook: producing countries’ incentives not to comply with the agreed production cuts, the Trump Administration’s energy policy and its stance towards Iran, and the cost efficiency gains of US shale producers.
In formulating our market views and the trade ideas listed below, we build on our economics team's central outlook for the economy and for policy, summarised in the Global Economics Analyst, 'A Catalyst for Tighter Fed Policy', 16 November 2016, and seek to exploit asymmetries in potential pay-outs resulting from the level of risk premium embedded into asset prices.

For example, we still find it harder to envisage economic scenarios where the risk premium on inflation and nominal bonds will return to the depressed levels it reached this past Summer.
Similarly, one of our strong views at this juncture is that both the ECB and the BoJ will try to counter a premature increase in domestic rates stemming from higher policy uncertainty in the US, and continue to offer their respective Treasuries ample 'fiscal space'. Similarly, we expect the Fed to proceed cautiously when increasing real policy rates given that inflation is just returning to target rate after undershooting it for several years, and in recognition of the international spill-overs of its actions. This has important implications for our moderately constructive views on Emerging Markets and Metals
So, with these considerations in mind, below are Goldman's first six recommended Top Trades for 2017. As the bank notes, "some of them are a continuation of themes already in play in the second half of this year, others are new."

Top Trade #1: Transatlantic economic divergences and political risks: Long US$ equally weighted against EUR and GBP, with a basket indexed to 100, a target of 110 and a stop at 95. Annual carry on this basket is 1.3%.

A building theme in global markets is the populist shift in politics, as evidenced by the Brexit vote in the UK and the recent US elections. In the US, events have moved in a USD-positive direction, between the rising likelihood of fiscal stimulus, more protectionism and immigration controls, all of which add up to a more inflationary mix and tighter-than-otherwise monetary policy setting. In Europe, ongoing uncertainty over the Brexit process will likely weigh on the Pound, while the slew of elections, including the Italian political fallout after the constitutional referendum on 4 December and general elections in France, Germany and the Netherlands, will weigh on the EUR (Exhibit 3). 
Meanwhile, behind the scenes, divergence in growth and inflation has continued to play out, giving an underlying boost to the Dollar (“Dollar Reset”, FX Views, 10 November 2016). Markets are debating where populist forces are stronger and more negative – in the UK or the Euro area. Either way, they are material and we think it is best to split the difference, in essence taking out moves in EUR/GBP. Our first Top Trade consists of going long US$ versus EUR and GBP equally weighted. The position is indexed at 100 with a target of 110 and a stop at 95. As part of this, we are revising our GBP/$ forecast lower to 1.20, 1.18 and 1.14 in 3-, 6- and 12-months from 1.20, 1.21 and 1.25 previously. This is consistent with our analysis that Sterling needs to fall around 20-40% from pre-Brexit levels (Exhibit 4). We have kept our call for EUR/$ parity on a 12-month horizon unchanged.

The principal risk to this trade is a premature tapering from the ECB, which could cause EUR/$ to rally, but this is not something we anticipate given the difficult political calendar and the fact that the ECB will want, in our baseline case, to shield European rates from the increase in their US counterparts. A risk is also that the triggering of Article 50 is delayed, which could buoy Sterling. That said, UK Prime Minister May has if anything strengthened her rhetoric on this since the US election and her political fortunes are closely tied to moving forward on Brexit at this point. As a result, even if a delay occurs, we think the course is ultimately set.

We forecast GBP/USD at 1.14 and EUR/USD at parity at end-2017 
Sterling remains overvalued based on our models
Top Trade #2: RMB weakening: Long $/CNY: Long $/CNY via the 12-month NDF, currently at 7.07, for an initial target of 7.30 with a stop at 6.75.