“The gargantuan effort by policymakers to simultaneously the three major generational challenges: inequality, the green transformation and infrastructure, will come at a high price in the shape of inflation, a higher marginal cost of capital, and the realisation that they need to be prioritised separately.
“The days of believing that the economy can revive on credit creation through tinkering with the price of money, relying on the banking system and a focus on mere financial stability are over,” says Steen Jakobsen, Chief Economist and CIO at Saxo Bank.
“We are undergoing a violent switch in focus by policymakers away from financial stability and toward social stability. We can call it the Social Stability Paradigm. Simply put, the new mantra is to print and spend as much money as possible while rates and inflation are low. It seems so easy at first, but we need to reflect on the consequences of this new policy, like galloping inflationary risks.
“Asset inflation will no longer be the name of the game. Focus will now turn to increasing the income for relative to capital. This will mean higher wage inflation and lower equity returns over time.
“Tangible assets will outperform non-tangible ones, and assets with positive convexity will win. Rising supply constraints and excess demand from government into basic resources is the Kryptonite of this “free market”. Next comes marginally higher interest rates, higher volatility, but also the best macro environment in my lifetime.
“We are into the epilogue of this failed model of pretend and extend, and governments have fired up the engines of helicopter money while thinking there won’t be any unintended consequences.
“Our main message for investors: you are living in a different world now relative to anything you have known in your lifetime.”
Rising input costs to challenge equities
The online world has been able to expand on the foundation of the physical world that supports it, but now many of the tailwinds seem to be turning. Rising interest rates are likely to create a downward adjustment of equity valuations in the most speculative growth segments such as bubble stocks and inflation above 3.8% is bad news for real equity returns. Investors may wish to increase their exposure to the commodity sector and high-quality companies with low debt leverage. We can also expect more negative antitrust and regulation headlines to hit large technology companies in the US.
Peter Garnry, Head of Equity Strategy, said: “Overall, we are not worried about equities with the MSCI World Index currently valued at a forward free cash flow yield of 5.8% still offering an attractive equity risk premium.”
“What about leisure stocks as the economy re-opens? The leisure segment has been rising to record price levels, reflecting an over-optimistic rebound scenario. It simply represents a bad risk-reward ratio.
“Rising interest rates are likely to create a downward adjustment of equity valuations in the most speculative growth segments as we observed in late February and early March, and as vaccinations are rolled out and the US economy re-opens, it will be in a situation of very high stimulus and no output gap. This has the potential to unleash real inflation for an extended period.
“Months of rising inflation are associated with lower relative real equity returns and one needs to understand that inflation raises the cost of capital and introduces volatility, making decision making more difficult for companies.
“The green transformation and ESG trend will also add to inflationary pressures as it’s more costly to expand both non-renewable energy sources and mining capacity in the much-needed metals for the electrification of society.
“The EU has long been fighting the US technology giants, and China has stepped up its efforts to increase competition and reduce monopolistic behaviour. There is also a sign that Washington will increasingly regulate big companies.
“Higher inflation, higher cost of capital, more regulation and more antitrust cases will likely eat into profit margins and reverse the tailwind that companies have enjoyed for decades.”
What was deemed a safe investment last year is now too risky. Everything from sovereign bonds to investment-grade (IG) corporates are quickly losing value. Crucially, the correlation between Treasury yields and junk bond returns has now turned negative and duration will be a much bigger threat to the market in Q2 than credit risk. Yet, while the US can accommodate higher Treasury yields, Europe cannot.
“The key is to beware of convexity, eliminating those assets that provide near-zero yields while continuing to build a buffer against rising rates with higher-yielding credit,” says Althea Spinozzi, Fixed Income Strategist at Saxo Bank.
“This quarter, the bond market will find itself short of options, and only junk bonds may close Q1 in positive territory. However, their honeymoon will soon be over with growing pressure from the higher cost of capital.
“The higher cost of capital negatively affects risky assets and rates must rise fast and keep high to provoke a deep selloff. Such a selloff could materialise soon when 10-year Treasury yields break and sustain trading above 2%.
“Investors should also be aware that the correlation between Treasury yields and junk bond returns has turned negative, meaning if yields continue to rise, junk bonds will tumble, as seen during the 2013 taper tantrum.
“With the 10-year breakeven rate at 2.2%, the yield that IG bonds provide will be completely eroded by inflation. However, it is possible to limit duration considerably as one can secure a yield above 2.5% with an average duration of 4 years. This is why they still represent a vital part of a portfolio in managing and diversifying risk.
“Duration will be a much bigger threat to the market in Q2 than credit risk. Lower yields globally mean investors have been forced to take more risk or more duration to secure extra returns. Those who chose risk might weather a rise in yields, as coupon income serves as a buffer, however, those that picked high convexity will find themselves with a portfolio that is overly sensitive to yield fluctuations.
“While the US’ economic outlook can accommodate higher Treasury yields, Europe lacks unified fiscal stimulus. A rise in yields in the euro area could provoke a faster tightening of financial conditions, hindering a possible recovery.
“As yields rise, they will provide a better alternative to European sovereigns. Normally considered riskier, these are still offering historically low yields, well below US Treasuries once hedged against the EUR.
“Such rotation has the potential to spark a selloff across sovereigns in the periphery causing a market event that will see government bond yields rising fast. We would probably see yields going from zero to 100 basis points quickly, tightening financial conditions dramatically in weaker EU countries.
“Within this context, the ECB’s monetary stimulus will prove inadequate and it will need to tweak purchases under the PEPP in favour of the most volatile countries; while at the same time, the EU will be forced to take further steps towards fiscal unity.”
Supply deficits to propel commodities higher still
The commodities rally has become noticeably more synchronised across all the three sectors: energy, metals and agriculture, and the prospect for a new super cycle remains. However, the short-term outlook may become more challenging as “paper” investments have been exposed to the reduced risk appetite spreading from the recent rise in bond yields.
Crude oil is expected to rise further over the coming months but there’s the risk that a tight supply-led rally as opposed to a demand-driven one may slow the return. Meanwhile, the prospects for rising inflation look to support both gold and silver in the coming months. Demand for copper is also likely to remain strong on an accelerating decarbonisation drive. The one area where the rally may cool is agriculture as we enter the planting and growing season across the northern hemisphere.
“Following the spike in US bond yields since early January, the sectors’ recent success in attracting record amounts of speculative buying may, in the short term and despite strong fundamentals, force a correction or at best a period of consolidation,” says Ole Hansen, Head of Commodity Strategy at Saxo Bank.
“Crude oil is expected to rise further over the coming months as rising fuel demand will allow OPEC+ to further reign back the dramatic production cuts. The strategy will succeed as long as global fuel demand recovers by the 5.4 million barrels/day and non-OPEC supply growth remains muted at less than one million barrels/day.
“Looking ahead to Q2, a recovery for gold and silver is based on the prospects for inflation starting to rise by more than the market has priced in. Gold can reach $2000/oz this year while silver may do even better to reach $33/oz based on the additional tailwind from an in-demand industrial sector.
“The green transformation has gone global which will require enormous amounts of copper at a time where the future supply funnel looks relatively weak. We see HG copper trade in a wide range with the uptrend from the 2020 lows capping the downside while the upside focus will initially be the $4.65/lb record high from 2011.
“The strong rally in agriculture and record investor involvement look set to cool as the focus during the coming months will be planting and growing conditions. A strong beginning could leave the most elevated positions in corn and soybeans exposed to a correction while demand from China will also be watched closely with renewed outbreaks of African swine fever.”
FX Outlook: Weaker USD a must for deleveraging global economy
Q2 will likely see the USD pivot back lower even if volatility remains, while sterling could continue the surge of strength it enjoyed in Q1. However, the tailwind from its early vaccination success will slow in relative terms and post-Brexit issues remain. If the global economy emerges post-vaccine in Q2, as hoped, then we look for a buy-the-dip mentality for oil-linked currencies like NOK, and CAD. In Asia, real returns are likely to prove superior as the Chinese centre of gravity for the region keeps its currency strong and stable relative to the US, but for JPY (and EUR) if global yields and commodities do continue rising apace, and they don’t allow their yields to follow suit, it could prove a powerfully negative signal for these currencies.
“The US dollar must eventually turn lower again to keep the global economy on the reflationary track. A strong US dollar is simply too toxic. Q2 is likely to pivot the USD back lower, even if the issues above generate further two-way volatility on the same basis as we saw in Q1,” says John Hardy, Head of FX Strategy at Saxo Bank.
“The most rapid route to the resumption of a US dollar sell-off would be if longer US yields don’t rise much above the cycle highs established in Q1. Alternatively, the stimulus roll-out could mean US longer yields quickly pick up higher together with a stronger US dollar. At some level of rising longer yields and even a rising USD, the Fed and Treasury will have to push back.
“While yield curve control may be the next logical step, this is a drastic move and Q2 is far too early for such a development.
“We are long-term bulls on commodities thanks to the drastic underinvestment in the space, made worse by the pandemic. The Australian dollar should continue to outperform in coming quarters. In Asia, the Chinese centre of gravity for the region keeps its currency strong and stable relative to the volatility risks to the USD from the radical policy shift unfolding in the US.
“The euro was quite weak in Q1 and the JPY was abjectly weak in Q1. If global yields and commodities continue rising apace, it could prove a powerfully negative signal for these currencies. The only thing that offsets that risk is the traditional large current account surpluses these blocs normally maintain, although these will be eroded if commodity prices go into overdrive.
“Sterling could continue the surge of strength it enjoyed in Q1, the tailwind from its early vaccination success will fade and the UK looks isolated on trade relationships alongside post-Brexit birthing pains with Europe. Offsetting that will be considerable capital flows returning to the UK.”
In a globe drowning in capital, speculation is eating the world
The level of money that has been pumped into the global economy since the pandemic is over 20% of the 2019 pre-Covid world GDP of $88tn.
The fact that more than 80% of this has likely been from ‘developed markets’ also skews the distribution of that stimulus. Furthermore, speculation is eating up the world, through monetary and fiscal measures that circumvent the need for structural change for an equitable society that is sustainable and addresses the climate crisis. In a world where scarcity is becoming increasingly apparent, deflationary assets – be they traditional financial securities, crypto, or land – stand to benefit.
Kay Van Petersen, Global Macro Strategist at Saxo Bank, said: “What we learned from the financial crisis of 2008 is that the “temporary” measures central bankers put into place have been anything but temporary.”
“We are seeing a shift in policy regimes, from one that has been a multi-decade monetary dominance regime, to one that is going to be a potentially a multi-year fiscal dominance regime.
“Speculation is rampant, and it doesn’t stop with the hedge funds and proprietary traders, but also includes politicians, policymakers, and taxpayers. The social zeitgeist exploding in the West is one of MMT: a nanny state, colossal levels of debt and financial repression, all which will continue to drive up asset class inflation. Money is a commodity that is losing value with every new accommodative measure.
“The allocation of that capital to talent and compelling investment opportunities is the true value creation. The paradox is that it seems like the world is running out of commodities which, by definition, should not be rare. Before we have even fully opened, let alone the potential trillions in infrastructure spending on the Biden/Harris agenda. Oil is well over 30% YTD, on structural supply shortfalls and a levered play on the reopening of the world.
“The asset classes that I am fascinated about are those that are deflationary, whether by construction like Bitcoin; mismanagement such as the Amazon forest; or by thematically such as in the alternative protein sector. By having a finite supply and inflationary demand, their price has a structurally positive convexity.
“The fund managers, long-term investors and family offices that bring a ‘scarcity framework’ to assets and business models on their wealth allocation process and overall strategy will be the ones most likely to be outperforming in the future of this regime.
From transitory crisis to lasting change
Crises have become defining moments in sowing the seeds of innovation and defining consumer behaviour. Covid-19 has accelerated the pivot to deglobalisation and reduced reliance on China, meanwhile, monetary policy has been shown its limits in dealing with these challenges, and the efficacy of trickle-down economics has been debunked. Policymakers are now forced to redefine the social contract with a focus on the redistribution of wealth. In that pursuit, inflationary pressure is coming, and it is important to be on the right side of these three trends in Q2: inflation, commodities and higher rates.
“For investors, the macro paradigm shift toward fiscal primacy requires a more inflation-resilient portfolio,” says Eleanor Creagh, Australian Market Strategist for Saxo Bank.
“Moving forward, companies and nations will focus on reshoring critical areas and adding resilience and self-sufficiency to supply chains, as well as bidding to secure supply, restore jobs and manage production tail risks. This is another reason to be long inflation, real assets, cyclicals and small caps.
“The race for technological supremacy is also spurred by the pandemic’s acceleration of digital adoption. From semiconductor chips to copper, demand is on the rise while capacity remains constrained. The climate and real supply limitations are adding to “cost-push” inflationary pressures. Add to that the great fiscal shift taking care of “demand-pull” inflation and compounding supply constraints, and it is a cocktail for higher inflation.
“The new social contract is in many ways a poisoned chalice for markets as we know them: slow-flation, TINA, treasurised mega-caps and long duration. A strengthening growth outlook and rising inflationary pressures are supportive of commodity-heavy indices, small caps, cyclicals, and real economy stocks, but are difficult for multiple highflyers and speculative bubble stocks to navigate. The capacity to shift market leadership has moved toward real economy stocks, non-US markets and commodities.
“Expect higher volatility in this transitory environment. The allocation to commodities and commodity producers must be higher. A hedge against inflation but also positioning for tailwinds of supply constraints and price-inelastic demand, and green transformation.”
To access Saxo Bank’s full Q2 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