Saxo Q1 Outlook: The Commodity Bull Market

USD bears celebrate Blue Wave Lite, but what about rates?

During the first half of 2021, USD bears will be hoping yield rises prove muted while EM and commodity currencies continue their stellar performance on normalisation, but a rising trade deficit could weigh on the USD as its position as the world’s reserve currency comes under pressure.

“The Democrats’ tenuous control of Congress, “Blue Wave Lite”, allows for large-scale fiscal stimulus but limited prospects for corporate tax reform - good news for USD bears”, says John Hardy, Head of FX Strategy at Saxo Bank.

“However, the effects of the Covid-19 policy response are clear. The US trade deficit number from November was reported at over $68 billion, the second largest on record. Further stimulus will only add to deficits because this largely ends up in purchased manufactured goods produced in China and elsewhere. CNY strength was one of the biggest FX stories in 2020 but we doubt it’s in for a repeat performance. Any further strength could bring with it a host of challenges for China.

“Unless the US can find a way to offset the outflows with incoming capital inflows, the worsening external balances will wear further on the US dollar. Despite the compelling fundamentals for the USD bearish, the spoilers are a steepening yield curve and a further rise in US long yields, which broke higher above key thresholds in the first week of 2021.

“The Goldilocks scenario for USD bears is that US yield rises will prove muted and EM and commodity currencies will continue to put in a stellar performance on normalisation. From a valuation and carry perspective, the Turkish lira is compelling and other winners in a reflationary recovery could include the South African rand and Russian ruble.

“Within the G-10, the commodity currencies are less compelling although they should do fine in a reflationary recovery. In G3, the euro benefits from global growth normalisation on the export side, but is dragged by less generous domestic stimulus and a negative policy rate, while the JPY hates higher yields and tends to track the US dollar in the crosses. For sterling, there are the same negatives as for the USD, but its valuation is in a completely different post code – so its ceiling may prove somewhat low in a recovering economy.

“The key challenge for the US dollar could become downright existential if the world begins to lose trust in the “faith and credit” of the US Treasury. This challenge could come from negative real interest rates, the rise in hard assets of any kind and an exodus from USD-linked former risk-free assets like T-bills and Treasuries.

“There is the challenge to the US dollar as the sole real global reserve currency as China looks to replace the US dollar in its trade relationships with the outside world through the Digital Currency Electronic Payment framework or “digital yuan”. A successful rollout of the DCEP could be the most momentous change to the global monetary system since the Bretton Woods system was created.”

Cryptocurrencies becoming more institutional, less obscure

Cryptocurrencies blasted through the last quarter of 2020 and the trend has continued into 2021, driven by increasing institutional interest and the growing enthusiasm about DeFi (‘decentralised finance’). Two things are driving this: the opportunity to stake 3 to 5 percent of your portfolio on something which could deliver a many-fold return, and the insane amount of fiat money in circulation.

This fear of a devaluation has made people look to inflation-protected assets and the decentralised nature of cryptocurrencies attracts investors. With significant upgrades to major players on the way, demand looks set to increase, despite notable challenges.

Anders Nysteen, Quantitative Analyst at Saxo Bank, commented: “With the limited supply of Bitcoin (BTC) and the large energy costs associated with verifying transactions through mining, it’s considered more a store of value than other cryptos such as Ethereum. Ethereum (ETH) has industrial applications but the broad spectrum of applications is currently strongly constrained, as the network only allows processing of a small amount of transactions per second.

“Apart from significantly boosting the bandwidth, the ETH 2.0 upgrade will move the verification process away from energy-intensive miners. The continuous flow of new issuances makes ETH inflationary by nature and a long-term holder who do not actively participate in staking will experience a leakage in value. However, the overall aim of ETH is  to keep inflation at a sufficiently low level to have enough validators and thus keep the network safe.

“Looking into 2021, the positive sentiment in the crypto space relies on increased mainstream adoption, as well as on successful developments of technological infrastructure to keep pace with the rising network demands. At the same time, the threats of regulatory challenges and hackers finding a backdoor are still lurking on the horizon.”

Infrastructure investment gap and hidden inflation

The pandemic has been a trend accelerator. It has transformed consumer spending habits for good. Only digital companies or those able to levy digitalisation were able to protect or, in some cases, even increase their revenue stream. All of this is unlikely to change when stores open their doors again, exacerbating the infrastructure investment gap.

“If we accept that digitalisation will drive everything and online platforms will become dominant, we need to understand that we have reached the point where the lack of investment in infrastructure to source and build, and in logistics to deliver the products that these successful platforms sell, is becoming a serious constraint that is about to drive cost inflation higher,” says Christopher Dembik, Head of Macro Analysis for Saxo Bank.

“The shipping infrastructure does not have the capacity to handle such a sudden jump in demand. We are currently in the unique situation where we have the highest-ever freight cost rates between China and Europe, and between China and the United States.

“Physical constraints are likely to be a main driver behind higher inflation in the months and quarters to come, but this risk has not been captured by capital markets and traditional models. Capital markets have entered a system of administered prices, either due to government impact through regulation or due to direct impact from ultra-accommodative monetary policy.

“This period will create remarkable new opportunities, specifically in the logistics space that is traditionally characterised by very low margins. We already see opportunities in healthcare logistics with the arrival of the vaccines, where entrepreneurs and investors are focusing on more specialised delivery and much higher-margin areas, such as cold supply chain.”

Equity investors must embrace the commodity sector during reflation

The US is showing a degree of pricing pressure not seen since mid-2018 when inflation last peaked, while China is also showing an increasing rate. Classic hedges against higher inflation include gold, inflation-protected government bonds and energy. However, the equity market also offers some interesting alternatives as record-high valuations are challenged in 2021.

Peter Garnry, Head of Equity Strategy, said: “Our Saxo Commodity Sector basket, an inspirational list of 40 stocks with exposure to the commodity sector, has delivered a 171% total return since 1 January 2016. The basket is up 7.5% year-to-date, being one of the best performing segments of the equity market and underscoring that investors are positioning for reflation.”

“S&P 500 earnings have recovered most of the decline during the early months of the pandemic, down only 10% in Q3 2020 from the Q4 2019 level. Based on 12-month forward P/E, the S&P 500 is getting awfully close to its historic peak in December 1999 during the dot-com bubble.

“Assuming growth in free cash flows in 2021 and unchanged spread between government bond yields, corporate bond yields and free cash flow yields, then a 100-basis points upward move in the US 10-year yield could translate into a 15-20% decline in Nasdaq 100 stocks, the most rate-sensitive of all the major equity indices.

“Global green energy stocks rose 142% in 2020, outperforming all other major equity themes. The dark side of this strong trend are very high valuations with the largest holding in the iShares Global Clean Energy UCITS ETF, Meridian Energy, trading at a 12-month forward P/E ratio of 83. That’s quite an aggressive valuation for a state-owned utility with 90% of its revenue in New Zealand, a low-growth economy, and negative revenue expectations.

“Green companies will have to justify their valuations. Our view is that old energy sources will outperform clean energy, and that the green transformation trade will split into that of ‘quality green’ and ‘speculative green’, with the potential for the latter segment to experience a dramatic sell-off.”

 “Game Over” for Treasury Bonds

2021 will prove challenging for bondholders as the negative real policy rate adopted by central banks has reduced downside tail risk on one side but squashed risk premia on the other. However, high-yielding securities and green bonds present an opportunity for investors.

“The only way to hedge against a policy mistake and rising inflation will be to seek coupon income while reducing exposure to near-zero yielding debt. As real rates will continue to fall, duration and low nominal yields will prove toxic, while higher-yielding securities such as junk and emerging market bonds can provide an adequate buffer as the economy finds a new equilibrium,” says Althea Spinozzi, Fixed Income Strategist at Saxo Bank.

“Inflation-protected securities will provide an important hedge against rising inflation despite their negative yield.

“Unfortunately, Treasuries are still offering the lowest yield in history, providing no buffer against rising yields and exposing investors to considerable losses. In 2021, we could see them closing the year with a negative return for the fifth time in more than forty years, marking the end of an era for ETFs with high duration. Amid falling real rates, we continue to favour Treasury-Inflation Protected Securities (TIPS).

“The indisputable trend that we will witness in the sterling bond space will be a steady fall of real yields. In this context, it is crucial to reduce weight on nominals and enter inflation-linked bonds, or ETFs which track inflation.

“Another way to reduce the risk of falling real yields is to buy higher-yielding securities. However, sterling spreads have tightened below pre-pandemic levels, meaning that credit is more expensive than a year ago despite carrying higher default risk.

“Green bonds represent the perfect opportunity for investors to diversify their investments and this is particularly true for euro-denominated green bonds, as interest rates will remain low for longer. However, we will still need to rely on the traditional energy sector and companies with a contained net debt to EBITDA will be able to weather depressed energy demand spurring from low economic activity, while state-owned companies will be better positioned to take advantage of stimulus packages.”

Game of Thrones – Reflation and inequality, 2021’s macro drivers

Inflation may not be visible in central banks’ hedonic price indices but inflation exists in the real economy and has been exacerbated by expansionary, unconventional monetary policy measures in recent years. Investors should look to adapt their portfolios to the fundamental shift in the market as we enter 2021.

Eleanor Creagh, Australian Market Strategist for Saxo Bank, said: “As the new year begins the average US worker must now work 141 hours to buy one share of the S&P 500, a fresh record. In the 1980s it took less than 20 hours to purchase that same share. A loss of purchasing power is, by default, inflation.”

“This dynamic is perpetuating the systemic wealth concentration and intergenerational inequities that are fraying our social fabric. It’s also a key driver of the increasing societal polarisation and populist tide that has grown in recent years. Moderating income inequality is not just beneficial for long-run potential growth, but also for financial stability.

“The incumbent big fiscal MMT-lite regime will be key, with a Yellen Treasury embodying the shift toward the abandonment of fiscal orthodoxy, debt monetisation and the evolution of central banking. A profound regime shift in western economies’ fiscal policies, combined with supply side pressures, is a perfect storm for higher inflation.

“We sit on the cusp of a fundamental regime shift that will promote a change in market leadership and portfolios must also transition.

“We see a shift in market leadership toward more cyclically orientated stocks, sectors (such as energy and financials), and geographies. 2020’s highflyers, where gains have been frontloaded, will be hampered by rising long-end yields.  

“As the world recovers from the depths of this crisis, growth will accelerate alongside inflation, while the financial system remains awash with new money; the asset allocation to commodities must be higher.

“Huge supply deficits with structural underinvestment, green transformation tailwinds, and the engines of a weaker dollar plus higher inflation will coincide with a historic underweighting and a multiyear bear market to bring a commodity renaissance in 2021.”

China is the North Star of Asia, and North Asia is a proven winner

China has dragged up the rest of North Asia and given the rest of the world a floor. With China being the North Star of the region, North Asia is the proven winner in a world consumed with Covid, while the US faces up to significant challenges in 2021.

“China will likely need to ramp up its activity and roll out stimulus going into Q2 of this year to get year-on-year comparisons at the preferred levels in time for the 100^th anniversary of the founding of the Chinese Communist Party on July 1^st,” says Kay Van Petersen, Global Macro Strategist at Saxo Bank.

“From summer, the world is likely to embark on the biggest tourism and travel binge ever experienced. Those that used to travel have saved up and those that generally don’t are tired of being cooped up at home.

“We expect asset class inflation across the board and structural trends continue to push the US Dollar lower. Eventually, we expect higher long yields. as the US cannot spend to infinity and have the market freely price their yields, while expecting to not to go bankrupt.

“Inflation and loss of faith in fiat money could make Bitcoin and crypto currencies winners in Q1. We entered a new bull market when Bitcoin punched through the $20,000 high seen in 2017, sending a signal that institutional investors and big hedge funds are willing to wager that crypto is a real asset. It’s still early days for crypto, with the only certainty being volatility and plenty of divergent views on the space, as well as the overhang of regulatory risk.”

To access Saxo Bank’s full Q1 2021 Outlook, with more in-depth pieces from our analysts and strategists, please go to: https://www.home.saxo/insights/news-and-research/thought-leadership/quarterly-outlook