Saxo Q4 Outlook: This Time, Inflation Outcomes Will Be Different
Saxo Bank, the online trading and investment specialist, has today published its Q4 2021 Quarterly Outlook for global markets, including trading ideas covering equities, FX, currencies, commodities and bonds, as well as a range of central macro themes impacting investors and markets.
“The size and nature of the pandemic policy response will show that this time, inflation outcomes really will be very different from anything we have experienced in decades,” says Steen Jakobsen, Chief Economist and CIO at Saxo Bank, in the introduction to the Quarterly Outlook:
“To avert an immediate crisis, the pandemic response brought fiscal stimulus on the scale of war mobilisation, supporting basic incomes and MMT-like direct transfers to nearly every sector of the economy. It was a massive demand stimulus at a time when the economy was shutting down the supply side to deal with the virus. And even as we open up from the pandemic, the new fiscal dominance will continue as we face three generational challenges simultaneously: inequality, infrastructure, and climate change policy, or the green transformation.”
The economic results of this new focus will be: ever-bigger government, more intrusive regulations, supply chain disruptions, inflation, no price discovery, a general hard swing to the left in the western world and―not least―the increased “channeling of capital” into small pockets of investable resources and assets. This could be the 1970s all over again, except this time it’s all about the political imperative of the decarbonisation of the economy, whatever that means for real growth.
- ESG is the biggest political project ever
“Decarbonisation is needed, absolutely, but the current palette of technologies doesn’t fit the bill, as solar and wind scale poorly because of intermittency”
Steen Jakobsen, Chief Economist and CIO, continues: “The ESG push, and related green transformation effort have so much political capital behind them that failure is simply not an option.”
“The ESG and green transformation is the single largest policy bet ever undertaken, and the main consequences will be inflation and ever lower real rates. Inflation in this case will be a function of the physical world not able to deliver the supply relative to the quantity of money and demand, and negative real rates tell us the future is one of low real growth through low productivity growth.
We investors need to embrace, understand and act on this. There are two major assets classes that will do well under this regime: Government-sanctioned assets, and assets with price discovery. This means green and, ironically, commodities have the best odds of producing long-term excess returns.
- The mysterious dissonance in equities
Equities have entered a new paradigm as a function of the pandemic with valuations and real yields reaching levels we have not seen in recent history. Profit margins are at all-time highs in the US while commodities are close to new all-time highs. At the same time, the UN’s food price index is already flirting with the highest levels in six decades and Europe is at the cusp of an energy shock. The delta variant has caused global growth to slow and added more bottlenecks across manufacturing hubs in Asia. For now equities are shrugging it all off, with the second-longest rally with a drawdown of 5% or less since 1999.
Meanwhile capital expenditure in the mining and energy sectors is historically low, the developed world is doing an accelerated decarbonisation, excessive ESG focus is increasing costs for companies and global manufacturing is being reconfigured creating a less smooth supply side in the global economy.” says Peter Garnry, Head of Equity Strategy at Saxo Bank.
“The biggest risk to economies, financial markets and equities is inflation. It holds the key to upset the entire structure in place since 2008. Policies are being implemented globally as if we have a demand shock, but we are currently facing a supply side shock due to the pandemic, lack of investments in the physical world, and an accelerated decarbonisation through electrification and renewable energy. These forces are putting enormous pressure on commodity prices and our view is that the green transformation combined with the current policy trajectory will sow the seeds of a commodity super-cycle that will last for a decade.”
“Equities are priced for perfection and a world that will not change, extending the trends for the past 10 years. But if this time is different, then equity investors are about to undergo outcomes none have seen in many decades. We will end our equity outlook with the words that, while equities are expensive, there are no attractive alternatives for the long-term investor. Inflation and interest rates are the real risks now for equity investors and we recommend that equity portfolios think about equity duration and lower it now while equity markets are calm.”
- Negative real rates’ house of cards might soon collapse – and what it means to bond investors
Real rates are going to be a central theme of the investment narrative in the upcoming months. Since the Covid-19 pandemic, financial markets have grown heavily dependent on the loose financing conditions that negative real rates provide. In order to avoid a loss in real terms, investors have been encouraged to take on more risk, causing junk bond spreads to tighten to levels seen before the 2008 global financial crisis. However, as central banks begin to consider less accommodative monetary policies, it is inevitable that real rates will rise and risky assets will suffer.
“Currently, the bond market depends entirely on how central banks look at inflation and how they decide to deal with it. So far, the Federal Reserve has decided that inflation is transitory, providing ample support for bonds broadly. However, we cannot ignore the fact that the Fed’s reluctance to taper adds to the inflationary upside risk. Indeed, even if the central bank begins to taper purchases under its bond-purchasing program, inflation will inevitably be stimulated until purchases go to zero.
Therefore, the question that should press investors is what is the amount of inflation that central banks are willing to tolerate, and at what pace may they pull support. We believe that the later support is pulled, the more aggressive central banks need to be, provoking an unexpected rise in real yields that will increase market volatility and put weaker corporates at risk” says Althea Spinozzi, Fixed Income Strategist at Saxo Bank.
“What has played in favour of corporate spreads this year is the economic recovery, which saw earnings improving amid the reopening of the economy. However, things can change fast if inflationary pressures become persistent and central banks need to taper more aggressively than the market forecasts. Currently the market isn’t pricing aggressive monetary policies at all, providing ample support to all corporates, including those with weak balance sheets.”
“If we expect inflation to remain sustained and the yield curve to steepen amid stable monetary policies, the banking and financial sector could provide exciting opportunities. Banks borrow short term to lend money long term. Thus, a steeper yield curve would improve their net interest rate margins. Additionally, banks will continue to benefit from the reflationary environment as the economy reopens and demand for loans and investments increases. Financial brokers and insurers will also benefit as a healthy economy increases investment activity.
Cyclical industries can also perform well in such an environment, and it is important to pick those that can easily pass the rise in costs to their customers. So far, basic materials and commodities producers have been able to do so amid soaring commodity prices.”
- The US dollar could make life miserable for the bears in Q4 before rolling over
Currencies were quiet in aggregate in Q3—certainly the majors—but there were a number of entertaining single stories such as the weak AUD, and the strong NZD and NOK. It’s perhaps too easy to suggest that volatility is set to rise, but if that is what we do see, it would mark the first rise in volatility since the pre-US election quarter last year. Given uncertainties in the US fiscal outlook, the Fed withdrawing accommodation, EU political uncertainties, spiking commodity prices and a tectonic shift in China’s policy focus, the energy level should be set to pick up sharply in the quarter ahead.
“In Q4 the US dollar may fail to continue the “tick-tock” pattern we otherwise saw in the USD this year—strong in Q1, weak in Q2, strongish in Q3. The spectacularly complacent liquidity and risk sentiment conditions in the Q3 failed to see the US dollar weaker, in part aided by a mostly very dovish Fed after the one-off June FOMC semi-shock. If almost ideal conditions for USD weakness were insufficient to bring down the greenback during the last quarter, a modest brushback of an upside breakout aside, how are we supposed to drum up an outlook for a significantly weaker US dollar when the backdrop in Q4 could prove far less supportive?
In Q3, peak dovishness for the Fed relative to the rest of the world in Q3 came with the late August Jackson Hole speech from Fed Chair Powell, who stoutly defended the Fed’s belief that inflation will prove transitory, and that further progress would be needed on the employment side of the Fed mandate before the Fed would even consider lift-off.” says John Hardy, Head of FX Strategy at Saxo Bank.
Shifting to Q4, we expect the market to read the Fed differently as Powell and company are set to continue the direction of change toward withdrawal of accommodation that was established, however gently, at the June FOMC meeting. Payrolls should see significant gains on the confluence of a screaming demand for labour and job openings at record highs, with the expiry of pandemic job benefits that stopped for millions in early September. Our sincere hope is that the Delta variant outbreak that clearly impacted sentiment in Q3 will also wane but if anything, our confidence in understanding how long the virus effects will linger has declined with every wave and surprise the virus has thrown our way.
- Real yields a boon to tightening commodity markets
After what has already been a strong year for commodities, we maintain a bullish outlook into Q4 and beyond. The strong rally seen across many key commodities this year has been driven by surging consumer spending following the Covid-led economic contraction—the biggest in living memory. As the impact of government spending and handouts from governments in Europe, China and the US begins to taper off, the market has started to cool a bit. However, supply constraints will, in our opinion, continue to support prices despite a slower growth trajectory.
Ahead of the final quarter of 2021, the Bloomberg commodity index—which tracks a basket of major commodity futures evenly split across energy, metals and agriculture—had risen by 25%, with gains seen across all sectors except precious metals.”
Ole Hansen, Head of Commodity Strategy at Saxo Bank, said: “Precious metals led by gold remain stuck in a range that by now has prevailed for more than a year. Besides silver’s unsuccessful attempt to break above $30 during Q1, both metals have been stuck in ranges, with gold currently struggling to find a way out of its 200-dollar-wide range between $1700 and $1900. During the past quarter one of the interesting developments was gold’s inability to shine despite a renewed drop in Treasury yields, not least ten-year real yields which at one point hit a record low at -1.2%.
“Surging gas and power prices have also been felt outside Europe with hot weather–related demand not being met by a similar response from producers. Add to this the worst quarter for wind power generation in years, and the pressure on traditional fuels such as gas and even coal has been elevated. As a result we are heading into the northern hemisphere winter with stock levels, both in the US and especially in Europe, well below the average seen in recent years. If not arrested by a milder than normal winter or increased flows, either from LNG or from Russia through the soon-to-open Nord Stream 2 pipeline, a bleak—and expensive—winter could await Europe’s consumers and energy-heavy industries. “
“We maintain the view that the rising cost of everything will keep inflation levels elevated for longer, and with peak growth possibly already behind us, the outlook for equities looks more challenging. Add to this the prospect of less aggressive central bank action, and the foundation for another period of safe-haven and diversification demand could emerge. Gold needs to break above $1835 to reconnect with investors, and once it does this the signal for a return to an all-time high will have been given.”
- Crypto traders chasing high returns in decentralised applications
The number of global crypto users has doubled in the first half of 2021, with a lot of new players in the game. Some of the new traders have a very high risk appetite with highly leveraged positions, vulnerable to even minor market downtrends. The flash-crash on September 7 saw more than $3.5bn of these positions liquidated in the crypto derivatives market within 24 hours. Despite aggressive trading in parts of the crypto community, a recent survey shows that fewer crypto traders are buying cryptos as a gamble in 2021 than in 2020, and more see crypto as an alternative to mainstream investments.
Anders Nysteen, Senior Quantitative Analyst at Saxo Bank, said:
“With the rapidly evolving applications for smart contracts, Bitcoin is again challenged as the dominating cryptocurrency since it was challenged for the first time during the initial coin-offering boom in 2017. The market capitalisation fight has several combatants: Bitcoin as the first mover with its status of “digital gold” and renown as store of value; Ethereum as technically superior to Bitcoin and a first mover among the cryptos with smart contracts, although with scalability limitations in its current version; and newer generations of cryptos as they are technically superior when it comes to scalability, the green agenda and interoperability-wise, although many of these are still in the rollout/development phase. It is way too early to call a winner in this battle, but the tendency this year has clearly been in favour of the new generations of cryptos.”
“As we see it, the rest of 2021 will be driven by the expectation of smart contract applications and decentralised protocols. We expect an increased risk appetite for decentralised protocols in the hunt for large returns, and this will add value to the amount locked in DeFi protocols. However, investors in the crypto market should keep an eye on several risks. The big moves in the crypto market and particularly in the minor cryptocurrencies may not be driven by an underlying boost of fundamentals; it may merely be bubble-like movements where traders are buying solely to ride the price uptrend.
On the regulation side, the decentralised protocols are lacking a regulatory framework and there’s no lawful protection of the investor; a single hacker attack can wipe out the whole investment. Many government agencies are pushing for increased regulation of DeFi, and it may have a significant impact on Ethereum and other DeFi blockchains, while Bitcoin should be less affected. On the other hand, an additional focus on the global green agenda may prove a drawback for Bitcoin due to the large power demands for running the Bitcoin blockchain, whereas only a minor impact may be seen in the less power-demanding, “greener” cryptocurrencies.”
- The sad reality of the green transition
As hopes rise that the pandemic is almost over in the developed world, visions of a second “Roaring Twenties” to match last century’s post-pandemic decade have proliferated. In the Jazz Age of the 1920s, consumerism and mass culture took shape. Innovations emerged: automobile, radio, motion pictures and labour-saving electric appliances, for instance. It’s tempting to ask whether history will repeat itself. The automobile and the radio have been replaced by the green transformation as the major driver of change. But today’s secular stagnation will be tough to overcome. In our view there’s no sign at this stage that the worldwide transition to a carbon-free society will translate into higher productivity growth and higher GDP growth over the long term.
“The natural disasters hitting the world in 2020 served as a wake-up call to governments and the private sector on the urgent need to tackle climate change and accelerate the transition to a carbon-free world. Companies have invested massively to reduce their carbon footprint. Governments have unleashed billions to stimulate investments in green energy. But there’s little sign it will lead to much higher average growth and productivity than before the pandemic. The prevalence of negative real interest rates is an indication that decarbonisation and sustainable investing is unlikely to improve productivity and thereby economic growth, at least in the short and medium term.” says Christopher Dembik, Head of Macro Analysis at Saxo Bank.
- In a global black hole of negative real rates, Emerging Market Asia is one of the few beacons offering positive real rates for investors
“Negative real rates seem to be a function of developed markets that have lost the ability to have true price discovery and are instead influenced by synthetic pricing as a result of extraordinary credit growth. A key inflection point was seen in 1971 when Nixon took the US off the Gold Standard and with it, accountability. Also, after the 2008 financial crisis, the predominant response from the US and most of the world was one of monetary policy expansion but fiscal policy restraint.” says Kay Van-Petersen, Global Macro Strategist at Saxo Bank.
“In the US, inflation has more than doubled from +2.3% in December 2019 to +5.3% in August 2021. During the same period the Fed rate went from 1.50% down to 0.00%, alongside the biggest ever expansion of monetary and fiscal policy that has ever been seen.
Meanwhile in China, Indonesia and India, inflation has actually been falling from pre-Covid levels to the present. And in the case of China’s PBOC, they never cut rates during the Covid crisis.”
“EM Asia is host to some of the biggest real rates yielding bond markets in the world. These include Indonesia (+4.5%), China (+2.1%), and Malaysia (+1.1%); contrast this with the negative rates to be found in the USA (-4.0%) and the Eurozone (-3.7%). “