Saxo Q4 Outlook: Bonds. Long Bonds.

As we enter the last phase of the year, Saxo believes that the overall outlook is that spending is likely to slow, and the US fiscal cycle is turning from tailwind to headwind. The world may indeed have reached ‘peak rates’, says Steen Jakobsen, Saxo’s Chief Investment Officer, providing a once-in-a-decade opportunity to go long bonds.

“We are either at a four-decade opportunity to lock in rates at cycle high or at an inflection point where we have a full paradigm shift to a Schumpeter moment of creative destruction in economic policy via government overreach.”

“In an economic environment where real rates are too positive, there will be a fallout from sectors and consumers with financing needs. This will particularly impact green transformation companies such as offshore wind developers, as their projects’ economic value goes deep into the red under current interest rates.”

Commodity sector supported by peak rates, tight supply focus

Strength in the commodities sector, forecast in Saxo’s Q3 Outlook, is set to extend into the final quarter of the year, according to Saxo’s Head of Commodity Strategy, Ole Hansen. The weakening economic outlook in Europe and the US, and to a lesser extent China, continues to be more than offset by supply concerns – not least in the energy sector.

“The OPEC+ group of producers’ active supply management has proven extraordinarily successful, thereby creating an elevated and price-supportive level of tightness across crude and fuel-based products.”

In precious metals, Hansen maintains a bullish view on gold, along with silver and platinum – with the yellow metal “eventually reaching a fresh record in the coming months”. The timing of this will remain very dependent on US economic data, however. “As we wait for the FOMC to turn its focus from rate hikes to cuts, […] we are likely to see continued choppy trade action.”

In industrial metals, “the lack of big mining projects to ensure a steady flow of future supply continues to receive attention from long-term focused investors.” In turn, this “supports our structural bullish outlook, driven by rising demand for green transformation metals, especially copper.”

Finally, focus in the agriculture sector over the coming months “will turn to weather developments across the southern hemisphere, not least in Australia where La Niña hot weather concerns are already on the rise, and South America, which increasingly has replaced the US as the main supplier of corn and soybeans to China, the world’s top importer.”        

Equities: Higher cost of capital is getting painful

The fight against inflation “has raised the cost of capital to levels that have triggered open cracks in the global economy,” says Saxo’s Head of Equity Strategy, Peter Garnry. This, in turn, shines a spotlight on the fragility of the green transformation – potentially one of the biggest catalysts for lower interest rates outside a weakening economy, “as fast decarbonisation will only happen under a lower interest rate environment.”

One sector that is particularly vulnerable is offshore wind, as many projects in the global pipeline “were negotiated on assumptions of permanently low-interest rates and cheap industrial metals.” Capital-intensive projects related to the green transformation have been the hardest hit by the changing interest rate landscape, and the three worst-performing theme baskets over the past year have been renewable energy, green transformation, and energy storage.

Elsewhere, Saxo’s artificial intelligence theme basket – consisting of 20 AI-related stocks – is valued at a forward equity valuation that is 33% above the Nasdaq 100 Index, and almost twice as expensive as the MSCI World Index.

“If bond yields decline from here due to a slowdown in economic growth, then it is not certain that this lower discount will help AI-related stocks, as their sensitivity is much larger to the growth outlook is much larger and thus AI-related stocks carry some of the highest risks in Q4.”

FX: King dollar and its far-reaching repercussions

As most central banks appear to be at the end of their tightening cycles, FX markets will be waiting to see which will be the first to switch over to an easing cycle, and how relative rate cut aggressiveness will play out.

Saxo Market Strategist Charu Chanana sees several risks to the consumer in the fourth quarter, “with the erosion of pandemic savings and the start of student loan repayments weighing on household budgets. This weakening of the US economy could bring rate cut expectations forward from mid-2024 for now, weighing on the USD.”

In the meantime, the USD continues to be strong, and “with the increased stagflation risks in Europe and the UK, combined with a structurally weak Chinese economy hit by balance sheet recession dynamics, the USD could extend its momentum, despite a pricing of ‘peak rates’ and rate cuts in 2024.”

One indication that peak rates have been achieved is the emerging market (EM) rate-cut cycle that kicked off in the third quarter of the year – namely in Brazil, Chile and Poland. The pace of these cuts has been “an aggressive surprise” and, while sharp rate moves could destabilise EM currencies, “one would expect the rate cuts from here to remain more modest if the Fed continues to preach higher-for-longer.”

“Market participants with a high exposure to USD assets, but with a bearish view on equities and looking to hedge their portfolios could consider being long US dollar as a safe haven.” However, “it is also worth noting that the wide interest-rate differentials between the dollar and other currencies make hedging costly for Asian and European investors today. The decision to invest internationally in a well-diversified portfolio could be more relevant for portfolios than the decision to hedge.”

The road to a bond bull market is paved, although challenges remain

According to Saxo’s Senior Fixed Income Strategist, Althea Spinozzi, the last quarter of the year will see stagflation deepening on both sides of the Atlantic, while elevated inflation throughout the rest of the year and into 2024 will require central banks to maintain a hawkish bias.

“Within this framework, it is safe to expect a steepening of yield curves through the last quarter of the year on both sides of the Atlantic, as markets consider how long rates can be kept at current levels before the cutting cycle begins.”

However, Spinozzi warns that while rate cuts are bullish for short- and long-term bonds, the period that precedes it, given the ongoing, and uncertain inflation outlook, may not be as positive for long-term bonds. Indeed, “longer-term sovereigns become appealing once inflation has no chance to rebound,” and “better opportunities to add duration to one's portfolio will emerge towards the end of the year when central banks might be forced to ease the economy.”

Inflation-linked bonds, meanwhile, offer “an excellent risk-reward ratio” in an environment characterised by rates that are either too high or projected inflation that is priced too low in the market.

“The beauty of inflation-linked bonds is that they have dual exposure to inflation and rates. That means that if inflation rises, their notional and coupon will increase. However, if inflation reverts to its mean, linkers will gain from a drop in interest rates, despite paying smaller coupons and par at maturity.”

No one's indestructible

On 12 March 2020, the world of US Treasury securities suddenly found itself grappling with turmoil. Primary dealers, the lynchpins of the US Treasury market, were inundated with a deluge of Treasury sales.

“The US Treasury, the deepest and most liquid pool of safe government securities, experienced a seismic shift, illuminating a potential underlying risk to the financial system.”

In response to this crisis, the Federal Reserve took extraordinary measures – extending massive financing to dealers and initiating a substantial purchase of Treasury securities. As time has passed, the US government has dramatically increased its issuance of government bonds to support the USD 1 trillion in additional fiscal spending by the Biden administration. At the same time, the Fed faces mounting unrealised losses.

“If long-term bond yields continue to surge due to Fed rate hikes or increased Treasury issuance, the Fed's unrealised mark-to-market loss could expand even further.”

Saxo Market Strategist Redmond Wong explains the capital constraints faced by primary dealers, the complexity of the US Treasury market and regulatory constraints could spark a liquidity event.

Time to (re)consider bonds

Following the longest drawdown in US 10-year Treasury bonds in half a century, Peter Siks, Investor Trainer at SaxoAcademy, highlights the benefits of integrating bonds into portfolios during an economic slowdown.

During the ultra-low interest rate period, bond yields were exceptionally low, and “were not the place to be as an investor”. However, the tide has changed dramatically in the last two years, and the interest rate landscape has transformed the outlook for bonds, “from a low-yielding asset class to an interesting opportunity given the current effective yields.”

With the majority of interest rate hikes likely over – especially in the US – there is “limited downside risk for the price of bonds, and this makes the current yield attractive. And, in the scenario where rising interest rates flip to declining interest rates, the bond holding will even appreciate in value.”

Siks notes that bonds can add critical diversification and lower volatility to portfolios, a stable income and principal protection, and can also balance out some of the risks associated with equities. In turn, “increased bond exposure in portfolios at this point adds an asset with a good risk-reward ratio and some hedging against a slowing economy.”

To access Saxo’s full Q4 2023 Outlook, with more in-depth pieces from its analysts and strategists, please go to: https://www.home.saxo/en-sg/insights/news-and-research/thought-leadership/quarterly-outlook