Saxo Bank

Saxo Q2 Outlook: The End Game has Arrived

Saxo Bank’s Outlook for Q2 argues that we are witnessing nothing less than the arrival of the end game for the paradigm that has shaped markets since the advent of the Greenspan put in the wake of the LTCM crisis of 1998. The twin shocks of the pandemic and Russia’s invasion of Ukraine have shifted priorities on all policy fronts, including fiscal, monetary and geopolitical. In the US, the imperative for the Fed to grapple with spiraling inflation risks has disrupted the traditional rinse and repeat of bailing out financial markets and the economy at the first ripple of trouble. Shortly put, the strike price of the “Powell put” is far lower than it was a year agothe Fed must get ahead of the curve. In Europe, the Russian invasion of Ukraine has seen Germany tossing decades of fiscal and defence policy out the window, ushering in a new era of investment that should drive a strong rise in productivity. EU existential risks have disappeared as defence priorities soar above all other considerations.

Helmets on, as 2022 will prove a wild ride for global markets.

“This outlook addresses the tectonic shift already underway in global macro and politics. Gone are the days of ever-falling real interest rates and ever more financialisation, to be replaced by a new rise in productivity as we move the economic agenda to a better and more rational place, despite the gruesome humanitarian news we get day by day from the war in Ukraine,” says Steen Jakobsen, Chief Economist and CIO at Saxo Bank, in the introduction to the Quarterly Outlook and adds:

“The starting point for this paradigm shift is that the fiscal restraints that have been a central premise in global economic policies since the 1990s are now gone! The shift was already enormous during the pandemic, but was most stark in the case of the German response to the war in Ukraine,”

“Now, the supply-side shocks of Covid and the war in Ukraine have accelerated our path toward more productivity. Policy simply must take us toward more price discovery and positive real yields as market and government actors fight for investment in a world, we now understand is highly constrained by absolute energy, environmental and capital limits.

I am probably too early in prognosticating this necessary shift and I fear a runaway inflation end game before we get to the point described above; central banks are not only late to the party but may have entirely missed the opportunity to bring down inflation in the medium term. Into this reality, there is now a dire need for central banks to stop chasing inflation from behind and to get ahead of the curve. “

“In conclusion, we have three cycles simultaneously impacting the market:

  1. The ongoing supply crunch from Covid and the war in Ukraine, but also from the world’s physical limits
  2. The repricing of assets against a backdrop of rising inflation
  3. The new Fed tightening cycle lifting off in March and set to continue

These will eventually lead to two key outcomes. Firstly, on a strategic macro level, an increased spending on energy and defence priorities, but also supply chain diversification to remove single points of failure for strategic industries. Secondly, negative real rates turning more positive as an indication that the global economy is set for a major productivity boost, away from short-term financial gains and rent seeking and toward tangible assets, infrastructure and a reaffirmation of the social contract.,” says Steen Jakobsen.

Equities: Productivity, innovation and pricing power have never been more important

“Before Russia’s invasion of Ukraine equities were already under pressure from rising commodity prices and a worsening interest rate outlook. The war and subsequent severe sanctions against Russia have catapulted the world into an unpredictable and maximum uncertainty environment. When the future becomes more uncertain, the precautionary principle dictates that the equity risk premium should go up, with equity valuations going down as a consequence.” says  Peter Garnry, Head of Equity Strategy at Saxo Bank.

Equity valuations are primarily driven by four factors: revenue growth, EBITA margin, incremental investment needs, and the discount rate on future cash flows. While the ongoing inflationary pressures might push up nominal revenue growth, the three other factors are all moving in the wrong direction.”

“With a large-scale war back in Europe and commodity markets in upheaval, this has aggravated inflationary pressures and equities have entered an environment not seen since the 1970s. High inflation is essentially a tax on capital and raises the bar for return on capital, and thus inflation will filter out weaker and non-productive companies in a ruthless fashion. The days of low interest rates and excess capital keeping zombie companies alive longer than necessary are over.

Reading Warren Buffett’s shareholder letters from the 1970s the key to survival is productivity, innovation or pricing power. The latter is often a function of productivity and innovation, and coincides with high market share—or just size in general—providing economics of scale. Over the past year, we have frequently mentioned mega caps as a theme during inflation. The largest companies in the world are the last to get hit from tighter financial conditions, and they also have the pricing power to pass on inflation to their customers for a longer time than smaller companies,” says  Peter Garnry, Head of Equity Strategy at Saxo Bank.

Commodities: War and sanctions turbocharging already tight commodity markets

 “The prospect for a long-lasting cycle of rising commodity prices that we first wrote about at the start of 2021 continues to unfold. During the past quarter, the war in Ukraine and sanctions against Russia helped turbocharge a sector that was already witnessing a tightening supply outlook. Before government handouts and central banks dumping rates to zero helped drive a post-pandemic overstimulation of the global economy, years of ample supply with steady prices had reduced investments towards new production, thereby leaving producers ill-prepared for the demand surge that followed,” says Ole S. Hansen, Head of Commodity Strategy at Saxo Bank.

“With normal commodity supply channels from Russia broken, an end to the war in Ukraine is unlikely to trigger a swift return to normality. The breakdown in relations and trust between Putin’s Russia and the West is likely to take a long time to mend.

Multiple uncertainties will trigger another wide trading range during the second quarter—potentially between $90 and $120 per barrel. Ultimately the market should stabilise with an upside price risk from reduced spare capacity among key producers and continued supply disruptions related to Russia being partly offset by slowing demand as the global economy becomes increasingly challenged by inflation and rising interest rates. Add to this a temporary Covid-related drop in demand from China and the outlook for a revisit to the March high looks unlikely,” says Ole S. Hansen and continues:

“Key events that could trigger additional uncertainty remain the prospect for an Iran nuclear deal, Venezuela being allowed to increase production and, not least, an increase US shale oil production, should producers manage to overcome current challenges related to lack of labour, fracking teams, rigs and sand.“

Industrial metals: “Aluminium, one of the most energy-intensive metals to produce, raced to a record high during March along with nickel, while copper reluctantly also briefly touched the highest level ever. Current supply disruptions from Russia will continue to support the sector throughout 2022, not least considering the ongoing push towards a decarbonised future. At the same time increased defence budgets in response to the Russian threat will keep demand robust despite the current risk of an economic slowdown. In addition, and supportive for the sector, is the outlook for slowing capacity growth in China as the government steps up its efforts to combat pollution, and ex-China producers for the same reasons being very reluctant to invest in new capacity.

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, especially for copper where a sizable portion of Chinese demand relates to the property sector. But considering a weak pipeline of new mining supply we believe the current macro headwinds from China’s property slowdown will moderate throughout 2022”

Precious metals: “During the first weeks of 2022 thestrength of gold surprised the market, not least because the January rally unfolded while US real yields moved sharply higher. The outbreak of hostilities in Ukraine then added a short-lived geopolitical risk premium which saw gold charge higher, only to miss the 2020 record high by a few dollars.

Heading into the second quarter we see gold eventually adjust to the US rate hike cycle and move higher. Our bullish outlook is based on the belief that inflation will remain elevated, with components such as rising input costs from commodities, wages and rentals not being lowered by rising interest rates. We believe gold is also increasingly being viewed as a hedge against the markets’ currently optimistic view that central banks will be successful in bringing down inflation before slowing growth forces a rethink of the pace of rate hikes and the resulting terminal rate.

Having reached our $2000 per ounce target ahead of time we see the market consolidate its first quarter gains before eventually hitting a fresh record high during the second half as growth slows and inflation remains elevated.”

Macro: The Great Erosion

“In our view, comparing today’s inflation with the 1970s or the 1973 oil crisis does not make sense. There are at least two main differences: the Covid-19 policy mix in the developed world was out of all proportion to what we have known in the past, and there’s no price-wage loop in most euro area countries. In the 1970s, wages were automatically indexed to inflation. This is not the case anymore, with a few exceptions (in Cyprus, Malta, Luxemburg and Belgium, indexation is based on core CPI).

So far, wage negotiations in euro area countries have led to an average increase below inflation; this is not the stagflation we experienced in the 1970s. Some economists call this new period the Lowflation. We call it the Great Erosion: erosion of purchasing power, corporate margins and growth due to the explosion of supply costs at the global level,” says Christopher Dembik, Head of Macroeconomic Research at Saxo Bank, and continues:

“After the Global Financial Crisis of 2007-08, many countries tried the conventional way to reduce debt—meaning austerity and structural reform. It has failed and now it’s time to adopt a more unconventional approach: inflation, repression and, in a few cases, default. This will have major implications in terms of investment (outweigh commodities and real estate amongst other options) but also fiscal policy with increased income redistribution for the lowest quintile of households. Not everyone is prepared for what is coming: a prolonged period of high inflation before it drops.”

Fixed Income: A painful path to normalisation

“The most significant difference between the first and second quarters of 2022 is that while bond yields surged on monetary policy expectations at the beginning of the year, now markets need to consider what central banks will actually do. Policy decisions will not be confined only to interest rate hikes. They will touch upon other tools such as the runoff of their balance sheet, forward interest rate guidance and their economic outlook. If central banks disappoint market expectations, the risk of entrenched sustained inflation becomes higher; if central banks overtighten the economy, the risk of a recession increases.

Whether you want to admit it or not, we have entered a bond bear market, where yields are destined to increase substantially. In this environment, traditional safe havens like US Treasuries will not protect investors looking to diversify portfolios. Duration will be even more toxic than at other times in history because we are starting off from record low interest rate levels and there is no higher income to fall back on. This is a result of years of accommodative monetary policies, which distorted risk perception and forced investors to take on more risk either through credit or duration,” says Althea Spinozzi, Senior Fixed Income Strategist at Saxo Bank.

“Since the beginning of the year, US Treasuries have suffered from the most significant losses compared to any year since 1974. Their weak performance is attributable to bets on interest rate hikes for 2022. However, the situation has recently become more complex. With the rise of geopolitical tensions, investors have been divided between high inflation and a slowdown in growth.

That is a massive headache for the Federal Reserve, which originally envisioned tightening the economy in an expansion as inflation was peaking. Right now, it is difficult to say when inflation will be peaking, while it is inevitable that the economy will slow down. The Federal Reserve needs to redirect its efforts to fix one of these two problems. We believe that it will work towards containing inflation at the cost of growth this time around. Indeed, inflation expectations in the US have recently soared to record new levels across the curve, showing that high inflation is becoming more entrenched than initially thought.”

Foreign exchange: The great EUR recovery and the difficulty of trading it

“The Russian invasion of Ukraine took the euro down just after the currency had begun mounting a significant recovery attempt in anticipation of a shift toward tightening from the ECB at its March 10 meeting. The ECB did make a reasonably hawkish shift given the uncertain backdrop, but more important still has been Germany—within days of the Ukraine invasion—promising massive fiscal outlays to address its energy and defence vulnerabilities. The EU has joined the call and will fund large new fiscal initiatives with joint debt issuance. All of these fiscal moves will profoundly deepen EU capital markets and could provide a long-term boost for the euro. If the terrible fog of war hopefully lifts soon, the conditions are promising for the euro to reprice significantly higher,“ says John J. Hardy, Head of FX Strategy at Saxo Bank.

USD: Oh, just the end of reserve status and all that.

“Many suggest that the coordinated sanctions against Russia’s central bank assets in the wake of its invasion of Ukraine are a once-in-a-generation historic development, perhaps on a par with Nixon’s closing of the “gold window” that effectively ended the Bretton Woods system in 1971. Certainly, any nation that accumulates significant reserves and thinks that it could risk falling foul of Western alliances will find it unacceptable that its financial system and economy could prove as vulnerable as Russia’s.

China in particular, as the world’s largest holder of foreign reserves and in increasing rivalry with the US, will likely see the actions against Russia’s central bank as a massive wake-up call that will make it want to move as quickly as possible away from reliance on the US dollar. On top of that, with the explosion of commodity prices and the lack of US fiscal discipline, any major holders of USD and other fiat FX reserves may want to diversify out of holding negative-yielding fiat assets and invest in commodities and other hard assets and productive capacity instead, even if there is no immediate sanctions threat.

These processes take time, and the US dollar will retain a premium as the world’s most liquid currency as we navigate the rocky road ahead. Markets will need to get accustomed to higher inflation and far tighter monetary policy, but the US dollar is set for a major reset lower in the years ahead as major exporting countries will not find it a store of value. They will look to recycle their surpluses elsewhere, making it increasingly difficult for the US to fund its yawning twin deficits,” adds John J. Hardy, Head of FX Strategy at Saxo Bank.

For the full EUR, USD, GBP, JPY, CHF, CNH and EM currencies see the full Quarterly Outlook.

To access Saxo Bank’s full Q2 2022 Outlook with more in-depth pieces from our analysts and strategists, please go to: