Saxo Bank

Saxo Q3 Outlook: A European Revolution

“Liberté, égalité, fraternité was the most important slogan for the French revolutionists of the late 18th century. Now, once again there is a growing sense of a ‘Revolution in Europe’ as voters, especially the younger ones, are leaning hard against the status quo in many countries. All eyes are on the German election on 26 September, where a Black-Green alliance is a likely outcome, and there is a chance of the Greens getting the keys to the Chancellery.

Steen Jakobsen, Chief Economist and CIO at Saxo Bank, says: “This would be a revolution. The Green Party is pro-EU, anti-Russia and China, against the Nordstream2 project and, not least, very much in favour of removing the German Schuldenbremsen, or “debt brake”, that drives the policy of reflexive German fiscal austerity.”

“The German election will most likely also show how the young generation’s politicians need to be different. Ms Merkel, a child of East Germany and a Russian speaker, has been frugal and patient, and often used a scientific modus operandi of letting facts and time dictate the pace rather than allowing the social media rollercoaster to drive the political agenda.

“Ms Merkel was personally a big part of the German export miracle but she failed to invest in German infrastructure. This has resulted in Germany having one of the slowest internet speeds, lowest adoption of digital technology, and a policy that is usually about correcting previous years’ mistakes rather than creating vision and hope. She was the ultimate compromiser. But the young people of Europe want the opposite: a vision for a Europe, one that is greener and with the hope of a good job and access to the real estate ladder, not one that is about old politicians looking at yesterday’s priorities and defaulting always to a policy of not rocking the boat.

“This outlook has our team fully engaged on the impact of a potential Green win in Germany, the impact of too many EU bonds, changing demographics and the UK outside of the European Union.”

Decarbonisation is Europe’s last chance to prosper

European equities have underperformed versus US equities consistently since late 2007, when two major currents gained strength. The snowball effect of digitalisation was starting to make a difference and was driven by US companies, and Europe was hit the hardest by the Great Financial Crisis of 2008 leading to post-crisis years with fiscal austerity and a severe euro crisis. Fast forward 14 years and the world has reached an important juncture. The world has procrastinated on carbon emissions and climate change for decades due to economic incentives, forcing the entire world to start aggressively accelerating its decarbonisation. This is both an opportunity and a challenge, not only for societies, but also for equity investors.

“The publicly available opportunity set in green technology is still limited for investors, but many new companies are rushing to public equity markets in a bid to raise equity capital and build out these technologies,” says Peter Garnry, Head of Equity Strategy at Saxo Bank.

“We have managed to find 40 European companies within green technologies that in different ways provide exposure to the decarbonisation policies of the EU towards 2050. The companies span wind, solar, hydro, fuel cells, bioplastic, electric vehicle car-sharing services and recharging stations, as well as recycled materials, insulation materials for better energy efficiency in housing, uranium mining (a bet that EU will designate nuclear power as a green technology) and energy storage.

“We have no opinions and don’t provide any investment recommendations of the companies on our decarbonisation list. Instead, we show the distance in percentage terms to the current consensus price target; investors can then do their own due diligence. It is important to note that green transformation stocks have experienced a lot of volatility this year and so this is a long-term investment theme, where investors should be patient and prepared for volatility.”

Bonds the beating heart of the European revolution

The bond space will be the beating heart of the European revolution. Harmonisation of funding costs across the euro area and a common fiscal budget will be critical contributors to a much better monetary union, accelerated by a new German government and the issuance of communitarian liability bonds under the NextGenerationEU fund (NGEU).

“The revolution was set in motion already last year with member states’ agreement over the NGEU fund. Within this program, the bloc is issuing common liability bonds funded by taxes raised across the broad European region at a much larger scale than it has ever done before. The program will contribute to a better monetary union, levelling out financing conditions across the euro area,” says Althea Spinozzi, Fixed Income Strategist at Saxo Bank.

“The German election will accelerate the profound change that the NGEU fund will cause as the Green party’s campaign centres on the need for bigger fiscal spending and better European integration. These policies translate directly to higher Bund yields and spread compression across the whole euro area.

“A new paradigm in the European sovereign space will come with more significant issuance of joint liability green bonds, but until the German election, we can expect European sovereigns to continue to behave as they did since the beginning of the year, remaining sensitive to rising US Treasury yields and tapering talks on both sides of the Atlantic.

“Meanwhile, we expect the ECB to keep its dovish stance until autumn as demand for European sovereigns remains weak despite continuous support. The latest 15-year Bund issuance turned into a technical failure and the German finance agency allocated only €1.7 billion out of the targeted €2.5 billion. Putting money at work in near-zero yielding Bunds is dangerous in an inflationary environment. Also putting investors off is the fact that EUR-hedged 10-year US Treasuries with a 3-month forward offer higher yield than most of the European sovereigns.

“Within this context, it’s unviable for the ECB to pull support as it could lead to severe hiccups within countries’ regular debt refinancing operations. Therefore, the central bank will most likely wait for the German election before tweaking monetary policy.

“Yet, the long-term trend for Bund yields is to continue to rise together with the strengthening economic outlook and inflationary pressures. Therefore, although the ECB will remain dovish, it is unlikely that yields will remain negative in the long term.”

Nervous summer ahead of German election

The focus as Q3 unfolds will likely shift increasingly to the risk of a post-US stimulus hangover, even if some consumer dissaving could help to drive reasonable, if decelerating, growth in the quarter. And so, as we await what we believe will be the macro event of the year, the German general election on 26 September, we wonder if the US dollar “see-saw” will see the USD tilting back to the upside and remaining stubbornly strong after a weak Q2. In short, USD bears could suffer a walk in the desert until Q4 if things play out as anticipated. In the meantime, as Q4 approaches, anticipation of new stimulus will build in the US and even more so in Europe.

“In Q3, Europe will nervously watch the state of German polling as a pivotal general election approaches on 26 September. The election will mark the end of the Merkel era and the beginning of one that either sees Europe lurching slowly toward a new crisis, or one that sees Germany moving all-in on the EU project with a mutualised, climate-driven agenda and massive fiscal stimulus.

“The stakes for Europe could not be larger, as the “original sin” of the EU remains firmly in place, namely the challenge of multiple sovereigns with only one currency and one central bank,” says John Hardy, Head of FX Strategy at Saxo Bank.

“Looking back at the last few months, its actually remarkable that the US dollar didn’t fall even more than it did. We had unprecedented USD liquidity from stimulus checks and the US Treasury rapidly drawing down its account at the Fed, suppressing US Treasury yields as the liquidity seeks out a parking spot when banks don’t want it to inflate their balance sheets.

“Q3 will likely see no new stimulus checks nor stimulus outlays of note, and infrastructure spending packages seem to get smaller with every round of bipartisan negotiations after Biden tried to impress with the multitrillion-dollar American Families Plan and American Jobs Plan.”

Commodity rally not yet out of fuel; special focus on carbon

Despite five consecutive quarterly gains, the commodity sector looks set to continue higher during Q3, albeit at a slower pace. At the same time, an aggressive drive for carbon reduction will push the cost of emissions higher, accompanied by increased volatility and periods of corrections.

“The Bloomberg Commodity Spot index has surged by 75% since March 2019 to reach a ten-year high. Super-cycles are characterised by prolonged periods of mismatch between surging demand and inelastic supply, and we believe individual developments across the three sectors will continue to add support. The oil market will be supported by a period of synchronised global demand growth where OPEC+ can increasingly control the price, while in metals, the combination of increased government spending on infrastructure and decarbonisation will continue to drive strong demand, particularly for copper and iron.

Ole Hansen, Head of Commodity Strategy at Saxo Bank, said: “It’s our view that rising inflation is likely to be longer-lasting than transitory, thereby creating continued demand from investors looking to hedge their portfolios. Combined with our overall negative dollar view, precious metals should continue to attract demand, especially if an expected rise in Treasury yields prevent real yields from rising too far.

While rising physical demand is seen as the main reason behind the continued run up in commodity prices, investment flows from asset managers and hedge funds, are adding a layer of support.

“The European Emissions Trading Systems (ETS) covers roughly 40% of the greenhouse gas emissions (GHG) in Europe through sectors like utilities and industrials. During the past year, and especially since November, the ICE EUA futures contract which represents one tonne of carbon emissions, has rallied strongly to trade €40 or 300% above the average price from the previous five years on the back of the first vaccine announcement and the election of President Joe Biden. Politicians have finally understood that more aggressive action is needed in order to achieve a 55% emissions reduction below 1990 levels by 2030.

“With these developments in mind, the cost of emissions is likely to continue higher. Given the strong momentum seen in the past year, it will also attract an increased number of speculators, which will almost guarantee increased volatility and periods of corrections. Overall, however, the price is forecast to continue to move higher and could reach €100 per ton before 2030.”

Europe – a new hub for digital assets?

Major steps have been taken in Europe over the past year to be part of the digital transformation of assets and payment services, as well as being at the forefront of “green” crypto mining. The European Union (EU) has a vision to be a leader in digital assets, both in terms of innovation and adoption, but sees a growing threat to the autonomy of central banks caused by the growing cryptocurrency industry.

Anders Nysteen, Senior Quantitative Analyst at Saxo Bank, said: “The dream scenario for the EU is to create unified regulation across all EU countries which could spur technological innovation in the digital transformation, as well as protecting citizens using and investing in digital assets.

“A clear message was sent by the European Central Bank (ECB) in the beginning of June 2021, identifying a significant stability risk if a central bank chooses not to offer a digital currency. Multiple countries have pilot projects, such as the Swedish Riksbank with the e-krona, and Deutsche Bundesbank issuing a ten-year Federal bond, with settlements being carried out with the new technology.

“The EU is steadily proceeding with developing a harmonised regulation of digital assets and cryptocurrencies are broadly considered legal throughout the EU, although there is still a clear gap when it comes to protecting investors and avoiding fraud. The Digital Finance Package seeks to add more digital resilience in the financial sector by boosting Europe’s innovation and competitiveness, as well as reducing the market fragmentation and letting authorised crypto companies carry out their services across the whole union.

Iceland has been one of the crypto mining hotspots in Europe due to its hydroelectric and geothermic energy sources, and the first Bitcoin mining facility opened there in 2014. Norway has since taken over in terms of mining power, and Sweden has similar potential. However, crypto mining is competing for the excess renewable energy with other industries such as “green steel” and the Nordic countries combined only account for a couple of percent of the global mining power (hash rate).

The European Commission wants the EU to be a leader in blockchain technology, both as an innovator and as a facilitator for blockchain companies and applications. If the crypto industry continues its rapid developments, the regulatory initiatives within the EU have a much shorter timeframe and will, if implemented, be a quantum leap for crypto regulation, and can pave the way for Europe to become a global standard-setter.”

Asia investors looking to Europe should focus on the UK, while China’s lagging tech names climb

Approaching the European Union (EU) as a large conglomerate, the UK represents the spin-off which gives a company the ability to be laser focused on their own objectives and on fulfilling the needs of their stakeholders. As a result, there is reason for Asian investors to be bullish about both UK assets and the economy as a whole.

“Asia investors looking to Europe should keep it simple and focus on the ‘spin-off’ that is the UK,” says Kay Van-Petersen, Global Macro Strategist at Saxo Bank.

“The case for being structurally bullish about UK assets comes with several running risks, including new Covid strains, the border situation in Northern Ireland and a stronger GBP challenging exports. However, there are a number of potential tailwinds for a long-term bullish stance on UK assets.

“For example, with Brexit turbulence behind it, the UK market is one of the most underweighted on a global landscape. The FTSE 100 is one of the few major equity indices that never got back to their pre-Covid levels of 7,500 and has heavy exposure towards cyclicals like financials and commodities should do well in an inflation and rates-rising regime. While we’ve seen much clearer evidence of asset class inflation in places like the US and Canada.

“Furthermore, sterling is still at multi-decade lows and the BoE has moved to discussions around tapering and a more hawkish policy. The UK has also been one of the leading countries globally on the vaccine roll-out and it will emerge to some serious spending both by consumers and companies. Finally, the UK will always be a destination for the global elite and if they need to be the offshore private banking centre of Europe, they will.

“At the same time, whilst the US tech giants such as Facebook and Google are pretty close to their ATHs, their Chinese counterparts are anything but. This is despite earnings being relatively strong across the Chinese tech space, lower valuations, the scarcity value of listed tech champions in Asia, the underlying domestic economic currents being sound, and a world that is slowly emerging from Covid fatigue. It’s worth noting that China’s monetary policy has been tighter than in the rest of the world and is likely to stay put in 2H21.”

The Greens Come of Age

On a federal level, the German election campaign is heating up and change is afoot. In September, a potential Green party victory or strong governing share brings with it the capacity to radically mold both German and European policy agendas in the years ahead along environmental and economic lines. It points to the rise of a new generation intent on mitigating climate change and reducing emissions through a lens of equality and social justice.

“A strong governing share with our baseline call of a black-green government, or potential victory with Annalena Baerbock becoming the first Green chancellor, would be a historic shift for Germany,” says Eleanor Creagh, Market Strategist for Saxo Bank.

“Why should markets care? The Greens’ growing electoral clout provides an opportunity to pioneer a number of structural changes. Core policy includes pledges to achieve a 70% reduction in greenhouse gases from their 1990 level by 2030 achieved through phasing out coal power, accelerating Germany’s renewable energy transition, investment spending on green infrastructure and only allowing zero-emission cars from 2030 onward.

“The Greens are also unequivocally globalist and pro-EU, aiming to expand the bloc’s influence as a “global player”, favouring deeper EU integration and a strong state with increased spending challenging German orthodoxy. They are in favour of revising Germany’s constitutional “debt brake”, which limits structural federal deficits to 0.35% of GDP, and stepping up investment to the tune of €50bn per year.

“The Greens support centralised EU power and the federalisation of Europe – a shift that should accelerate the recent post-pandemic policy pivot towards fiscal dominance and, in the case of Europe, joint fiscal policy. Over time this has the potential to catalyse a future fiscal union sprouting from the seeds of the EU’s pandemic recovery fund, underscoring the push to prioritise broader social goals and income and wealth distribution with fiscal policy, alongside the green transition. This is a far cry from the austerity of recent years that was instrumental in perpetuating slower, lower growth, and potentially marks a new era for Europe.”

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