Saxo Q3 Outlook: the runaway train

Saxo Bank, the online trading and investment specialist, has today published its Q3 2022 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 client portfolios.

“Inflation will prove a runaway train that central banks can only chase from behind until the inflationary dynamics result in a crash into a hard recession.

Steen Jakobsen, Chief Investment Officer at Saxo Bank, says: “Central bankers continue to peddle the idea that ‘normalisation’ to around the 2 percent inflation target is possible within an 18-month horizon. But why should we listen when these same people never conceived that inflation could reach above 8 percent in both Europe and the US?”

“The risk is that inflation expectations are rising fast and driving second-round inflationary effects that will require central banks to tighten even more than they or the market currently conceives until the runaway train is controlled, likely sending us into a deep recession.

This creates the next macro policy change and response we will need to look for in Q3 2022. Given a policy choice of either higher inflation or a deep recession, the political answer will likely be to instruct central banks, directly or indirectly, to move the inflation target up from 2 percent. The optics of this would hopefully mean requiring a bit less tightening, but also that negative real rates, or financial repression, are a real embedded policy objective now. It’s also a risky bet that there is some Goldilocks-level of demand destruction from a higher policy rate that will start to force inflation lower, all while demand is subsidised for the most vulnerable with support schemes for power, heating, petrol and food. The holes in this policy argument are that none of this addresses the imbalances in the economy. Whether the Fed has a 2 or 3 percent inflation target does not create more cheap energy.

“What is clear is that the political system will favor the ‘soft option’ for inflation in which the chief imperative is financial repression to keep the sovereign funded and a reduction of the real value of public debt via inflation. This is exactly why inflation will continue to rise structurally. Q3 and beyond will make it clearer that political dominance pulls far more rank in the new cycle than monetary tightening, which will forever chase from behind. The great moderation is dead - long live the great reset.”

Equities: Tangible assets and profitable growth are the winners

The V-shaped recovery is dead this time. The past six months have seen the biggest shift in market sentiment in a lifetime and in Q3, the outlook for global companies’ earnings is not good. The bottom of this bear market could arrive later this year or far away as the first half of 2023. In the meantime, commodities and defence stocks are the two themes which we expect to continue doing well until equities hit bottom in the current drawdown.

“Given the current outlook and interest rates level, the equity valuation on MSCI World should be below average. Earnings for global companies are already down 10 percent from their peak in Q2 2021 and the outlook is not looking rosy.”

Peter Garnry, Head of Equity Strategy at Saxo Bank, said: “A relentless bull market over 12 years, only punctuated occasionally by short-term V-shaped recoveries, has reinforced a buy-the-dip mentality and more risk taking. Investors are simply slow at updating their views, and we observe no material change in behaviour among retail investors, which is also why this equity market has more room to fall.

“US equities are officially in a bear market, but the big question is: Where and when is the bottom in the current drawdown?

“Our best guess is that the S&P 500 will correct around 35 percent from its peak, and it could take somewhere between 12 and 18 months to hit the trough, which means sometime later this year or in the first half of 2023. The bear market will likely not exhaust itself until the new generation of investors that went all-in on speculative growth stocks, Ark Invest funds, Tesla and cryptocurrencies have fully capitulated.

“Since the GFC, technology stocks have enjoyed ever-lower interest rates, inflows from ESG funds overweight technology stocks and expanding margins, while energy stocks suffered from low returns on invested capital.

“Now things are reversing as the world realises that it still runs on diesel and gasoline. For every percentage point that the energy sector is getting relative to the other sectors, ESG will be under more pressure on performance, and the resurgence of fossil fuels could cause a crisis for ESG funds suffering from outflows over poor performance and lack of exposure to natural resources amid the new age of inflation.

“Commodities and defence stocks are the only theme baskets that are up. We expect these themes to continue doing well until equities hit bottom in the current drawdown. The only exception to tangible assets winning is real estate. Low interest rates combined with tight supply in many urban areas in the US and Europe have pushed real estate into a position where it is quite vulnerable to rising interest rates in the short term.”

Commodities: Understanding the lack of investment appetite among oil majors

The Bloomberg Commodity Spot Index reached a fresh record high during Q2 before entering a phase of consolidation, as global growth concerns received an increasing amount of attention. In Q3, Russia’s willingness to stop the war in Ukraine, China’s slowing economic growth, the strength and speed of US rate hikes, as well as the potential for demand destruction from rising prices, will help set the tone during the second half of 2022.

“With millions of tons of grains still stuck in silos just weeks before the next harvest will require the storage space, the outlook for food prices will depend on the level of crop-friendly weather around the world and whether a corridor allowing exports of Ukraine crops will be established,” says Ole Hansen, Head of Commodity Strategy at Saxo Bank.

“We maintain a bullish outlook for gold, considering the risk of continued turmoil in global financial markets as the transition towards a higher interest rate environment takes its toll on companies and individuals. We stick to our forecast in Q2 that gold—and silver—following a period of consolidation in the second quarter, will move higher during the second half of the year, with gold eventually reaching a fresh record high.

“Industrial metals suffered a major correction during the second quarter, mostly due to China’s increasingly fraught zero-Covid tolerance policy. While the energy transformation towards a less carbon-intensive future is expected to generate strong and rising demand for many key metals, the outlook for China is currently the major unknown.

“Copper, rangebound for more than a year, risks breaking lower before eventually reasserting its long-term bullish credentials. With this in mind, we are neutral heading into the third quarter, meaning that existing exposure to the sector should be maintained but not added to until the price action either signals renewed upside, potentially on a break back above $4.65 or alternatively around $3.5 on additional weakness.

“Oil majors swamped with cash, and investors in general, showing little appetite for investing in new discoveries is the long-term reason for the cost of energy likely remaining elevated for years to come. In addition to the challenges of high volatility and historically bad returns on investments, the immediate challenge relates to future expectations for demand.

“We suspect corrections in the energy market during the second quarter may end up being short-lived, with the risk of a prolonged period of high prices the most likely outcome. A brief return to the 2008 record high cannot be ruled out, but in general we believe that some emerging demand weakness on the other side of the peak summer demand season should keep prices capped within a wide $100-to-$125 range.”

FX: Why can the Fed never catch up and what turns the US dollar lower?

The US dollar has surged in correlation with the steady repricing of ever more Fed tightening. It will likely only find its peak and begin a notable retreat once either the economy lurches into a disinflationary demand-induced recession or the market realises that the Fed can never catch up with the curve, because if it did, it would threaten the stability of the US treasury market.

“Clearly, the Fed retains the fervent hope that the current high inflation levels will still eventually prove transitory. The June FOMC meeting refresh still put the 2024 expected personal consumption expenditures (PCE) core inflation at 2.3 percent. The risk here is that inflation is a runaway train and the Fed is still chasing from behind the curve, never able to catch up,” says John Hardy, Head of FX Strategy at Saxo Bank.

“One argument for how the US dollar might peak and begin its turn lower despite the Fed’s tightening regime is that many other central banks are set to eventually outpace the Fed in hiking rates. Take AUDUSD, where Reserve Bank of Australia (RBA) hiking expectations have now caught up and surpassed Fed expectations for the coming nine months.

“This leads us to believe that the dominant strong US dollar driver in this cycle is the US dollar’s global reserve status and the simple directional fact of US inflationary pressure requiring the Fed to continue to tighten. This wears on sentiment and global financial conditions. If that is the case, then the USD will only begin turning once economic reality finally flounders, sufficiently reversing inflation via a demand-induced recession. Only then will the US dollar finally roll over after its remarkable ascent to its highest level in more than 20 years.

“The euro will have a hard time rebounding if Chinese demand for its exports remains sidelined, the war in Ukraine grinds on and the US tightening on global liquidity continues. Sterling is in the same boat, and it remains difficult to conjure an upside scenario for that currency, given the country’s extreme supply side limitations and the enormous external deficits aggravated by high import prices for energy. At least the Bank of England continues to talk tough and can hike rates more easily than the ECB. In GBPUSD, watch the enormous 1.2000 chart level after it was challenged in June.

“CNH could prove the most important currency to watch as a significant potential new source of market volatility if China makes a move to weaken it this quarter or the next - possibly also helping set up the end of a stronger US dollar.”

Macro: Towards a eurozone crisis redux?

The slow response in acknowledging that inflation is not as transitory as initially thought has left the eurozone in a worse position than the US or China. In Q3, expect many emergency measures to address inflation to become permanent and bond market volatility to continue as the economic situation deteriorates.

Christopher Dembik, Head of Macro Analysis at Saxo Bank, said: “We are going to be in much lower growth, especially in 2023, than many had expected, whether there’s technically a recession or not, and the eurozone is certainly in a worse position than the United States or China.

“There is an entire infrastructure built to refine Russian oil in Europe, but we cannot use it anymore. We need to replace it, but it will take years to build. Second, green transition regulation has diverted needed investment in fossil fuel infrastructures to renewable energy, without making sure that green energy can provide a constant supply of energy to Europeans. At the end of the day, this means higher energy costs for years to come. Inflation is structural.

“European governments have unveiled emergency measures to address inflation - for instance, value-added tax (VAT) reduction on energy. With the fiscal potential in Europe far greater than many other places, expect these one-shot measures to become more permanent and for other subsidies to come soon.

“The ECB will hike interest rates at the July meeting by 25 basis points (a ‘gradual’ tightening) - the first since 2011. However, there is another issue to tackle that’s as important as high inflation - financial fragmentation.

“Bond market volatility is picking up everywhere, but the deterioration is faster in the eurozone. Since the end of QE, Italy’s borrowing costs have jumped higher. The 10-year bond yield is now nearly three times as high as in early February. Volatility is picking up too quickly and liquidity conditions are deteriorating fast at the same time.

“There is no doubt the ECB will announce a new tool to manage sovereign spreads soon, perhaps as early as the July meeting. We can assume it will be some kind of Outright Monetary Transactions (OMT) programme with light conditionality,

“It should be enough to avoid a repeat of the 2012 crisis, but this is far from certain. The ECB cannot refrain from raising interest rates. The more they do, the more that breaks, and the more they will have to buy eurozone government bonds. From an optimistic viewpoint, a eurozone crisis redux is not all negative. The previous crisis helped to bring about crucial institutional reforms that strengthened the eurozone framework. The same could happen again in case of a new crisis. Can this go on forever? At some point, the southern eurozone countries should be able to face the markets without the ECB stretching its mandate to rescue them. Otherwise, the ECB could end up owing the entire Italian debt.”

Cryptocurrencies: the pressure is on as the wind is knocked out of the market’s sails

As we head into Q3, cryptocurrencies are currently in limbo, awaiting changes in the general macroeconomic sentiment, regulation and institutional adoption, as well as research into CBDCs as a potential competitor. Is this the beginning of a crypto winter or is the bear market an opportunity to prepare for the next bull run after a healthy clean-up of the crypto space?

“Bitcoin has been proposed to be the ‘gold of the 21st century.’ The market events in 2022 have, however, wiped out this narrative.

“Looking at the correlation between the Nasdaq-100 Index and Bitcoin, the correlation in 2022 is at record high. Thus, crypto investments are behaving more as regular high-risk assets with similarity especially to tech stocks. During these times of high correlations, cryptos are less likely to add any diversification to a portfolio to spread out risk,” says Anders Nysteen, Senior Quantitative Analyst at Saxo Bank.

“Further into 2022, the engagement in applications of crypto technology seems to have calmed down and stakeholders are divided in their outlook for cryptocurrencies over the next couple of months.

“The cryptocurrency space is screaming for a proper regulatory framework and the clean-up of the industry may just have started as the US and EU are expected to announce a regulatory framework around digital assets, which turn out to be stricter than originally expected.

“Pessimists see 2022 as the beginning of a crypto winter, where lower crypto prices and reduced engagement in crypto applications will decrease hand in hand in a negative feedback loop. On the other hand, optimists hope for a positive spiral if the investment appetite in cryptos increases, driving up the price and eagerness to engage in crypto technologies. They see the bear market as an opportunity to prepare for the next bull run and as a healthy clean-up of the crypto space, which can bring back some of the stability and reliability that were lost during the first half of 2022.”

To access Saxo Bank’s full Q3 2022 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