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A Winter Of Discontent

Feature Stories | Oct 07 2022

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The December quarter should see ongoing market volatility in equities and bonds, Saxo Bank believes, while commodity prices should in general remain supported.

-Central bank aggression, a stronger US dollar and Fed QT to drive December quarter volatility
-European energy crisis could divide the world
-Winter is coming
-Commodity demand-supply balances should provide ongoing price support

By Greg Peel

In June this year, the US Federal Reserve delivered a super-sized rate hike of 75 basis points, following an initial 25 point hike in March from the 0-0.25% covid emergency rate, and 50 points in May.

That “shock and awe” rate hike had Wall Street hoping that “peak Fed” would arrive sooner rather than later due to the anticipated damage the aggressive Fed hiking cycle would do to the economy. A stock market rebound rally ensued.

That rally was not upset by a second hike of 75 points in July, as given the surge in US inflation data in the interim, Wall Street feared 100 points may be forthcoming. Moreover, Jerome Powell’s rhetoric at the July press conference suggested the Fed was ready now to pause and reflect, or at least to deliver smaller hikes from thereon.

An incensed Powell then shot down any notion of a pause at Jackson Hole in August. Fed rhetoric ever since has been uber-hawkish. Wall Street has since fallen to a new low.

Denmark’s Saxo Bank has argued since early 2020 that inflation would be deep rooted and persistent. This view still holds but Saxo believes we are fast approaching a breaking point for the global economy — one that we’ll arrive at due to the “peak hawkishness” from policymakers over the next quarter or so. Three factors will lead to this breaking point.

First, global central banks realise it’s better for them to err on the side of excess hawkishness than continuing to peddle the narrative that inflation is transitory and will remain anchored.

Second, the US dollar is incredibly strong and reduces global liquidity through the increased import prices of commodities and goods, reducing real growth. Third, the Fed is set to finally achieve the full run-rate of its quantitative tightening program, which will reduce its bloated balance sheet by up to -US$95bn per month.

This triple-whammy of headwinds should mean that in the December quarter we should see an increase in volatility at a minimum, Saxo warns, and potentially strong headwinds for bond and equity markets.

Saxo suggests this is the point at which the market truly begins to price the anticipation of recession rather than merely adjusting valuation multiples due to higher yields. That turning point to pricing an incoming recession, again, could come in December, when energy prices peak due to the same above reasons.

It's estimated the total share of energy in the global economy has risen from 6.5% to more than 13%. This means a net loss of -6.5% GDP. The loss needs to be paid for by an increase in productivity or lower real rates.

And lower real rates will need to be maintained to avoid the seizing up of our debt-saturated economies, Saxo warns. This means that there are really two ways this can play out: higher inflation persists well above the policy rate, or yields fall even faster than inflation on the back of recession expectations.

The odds right now favour further hikes in global interest rates, while inflation remains either stuck at high levels or only comes off gradually, meaning risk-off is the most likely outcome during this window of time.

Beyond Saxo’s anticipated peak hawkishness scenario, the market will be champing at the bit to go long risk assets on any sign that policymakers have surrendered in their fight against inflation as the costs of tighter policy become unacceptable relative to supporting the economy and labour markets, and the costs of servicing sovereign debt.

This is the scenario implicitly considered by the Reserve Bank of Australia in deciding to hike by only 25 points in October, following four consecutive monthly rate hikes of 50 points after an initial 25 points in May.

The Energy Crisis

The world is going through its biggest energy shock since the late 1970s with primary energy costs as a proportion of GDP rising 6.5% this year. It is impacting consumers hard and forcing them to cut down on consumption, but it is also forcing factories to curb production and EU politicians to draw up schemes to ration economic resources as the approaching winter puts more pressure on the already troubled energy sector, Saxo notes.

According to the International Energy Agency, the total primary energy supply to the global economy is 81% from coal, oil and natural gas with main source of growth coming from non-OECD countries.

The energy crisis will slowly ease, Saxo suggests, as the world economy naturally adjusts to the shock and higher prices, but the adjustment will likely take many years. The challenge facing the world’s largest economies is that the elasticity on supply of fossil fuels is low and the green transformation is accelerating electrification — this will put enormous pressure on non-fossil energy sources.

The oil and gas industry is needed to bridge the gap and prevent energy costs exploding. In order to keep energy costs down we need to see investments, but unfortunately, notes Saxo, real capital expenditures are not really increasing at a sufficient enough speed, and this is prolonging the adjustment and higher energy prices.

Saxo sees the future bringing a wave of investment in securing energy supplies, deploying energy infrastructure, adopting new energy sources to meet power demand, and ensuring energy security and a broad-based fuel reliance. But this won’t come without some short-term pain, including blackouts, caps on industrial use and rising subsidy bills, as well as a possibility of social and political unrest in some of the weaker Asian markets.

We got a flavour of the crisis in Sri Lanka earlier this year, and Pakistan and Bangladesh also remain exposed to such risks.

LNG has been popular in Asia as a bridging solution between the jump from coal and other fossil fuels to renewable sources of energy, Saxo notes. However, Europe is now competing directly with Asia to secure LNG supplies as its gas supply from Russia dries up.

As such, LNG cargoes have started to be diverted away from Japan and Asia in general in a hunt for better price points in Europe. This means parts of Asia will lose their LNG supplies not just for this year, but for years to come as Europe builds its other sources of energy. Those that can afford it will have to pay a much larger fee to maintain a steady supply of LNG.

More alternate energy sources are also being explored. Singapore, for instance, has exerted efforts to unearth its geothermal potential to diversify its energy sources. Indonesia, the Philippines and New Zealand also have significant untapped geothermal potential which could be explored further as the energy crisis reigns.

Hydrogen and hydropower also remain a key focus in the region, with South Korea being the world leader in the hydrogen economy and others like China, Japan and Malaysia also adopting hydrogen-push policies.

In Australia, governments state and federal and the private sector are pushing forward with hydrogen investment, including “green steel”.

Asia’s nuclear adoption is also expected to take a step up in the current crisis, Saxo notes.

In addition to Japan, countries like India and China have also shown increasing acceptance of nuclear technology to meet the growing energy demand.

India plans to triple its number of nuclear power plants to 72 in total, while China has proposed the construction of 168 new reactors in addition to 18 being built and 37 being planned, which would amount to an increase of 337%. Overall, 35 reactors around Asia are already in construction, with Europe coming in second with 15 plants, according to data from World Nuclear Association.

Dividing World

India’s heavy reliance on oil, with about 80% of its demand being met by imports, made it vulnerable to the energy crisis early on, Saxo notes. What saved India from a balance of payments crisis was its continued oil imports from Russia, at an undisclosed discounted price paid in Russian roubles.

This is just a reflection of the course that other emerging markets could take as well, as they get immersed in energy scarcity issues and are unable to find any reliable short-term solutions to sustain their economies.

The Sri Lanka crisis has already raised alarm bells for many frontier economies. There have been reports recently that Myanmar has also started buying Russian oil products and is ready to pay for deliveries in roubles. Similarly, Moscow may continue to find buyers in smaller nations that have been hard hit by inflation and are running out of fuel supplies.

If more and more countries shift to similar trade arrangements with Russia for their energy imports, warns Saxo, and/or food and fertiliser, that could mean a significant shift away from dollar-based trade finance in the region.

This will have consequences beyond the global energy markets, with some countries potentially faced with the tough choice of taking sides as deglobalisation forces become stronger.

In recent years, Europe has invested massively into the green transition but there is a missing piece, notes Saxo. Namely, Europe's lack of industrial infrastructure and inability to control the supply chain required for this transition.

European Union member countries have agreed that new passenger cars and vans will only be sold if they don’t emit any CO2 from 2035 onwards. In theory, this should have boosted the adoption of EVs. But who is controlling the mining and processing of critical minerals needed for EV batteries and the green transition?


Saxo points out China represents 50% of the global manufacturing capacity for wind turbines, 66% for solar modules and 90% for storage batteries. Some 59% of rare earth elements are mined In China and 88% processed. The share is almost as important for other minerals such as lithium and cobalt.

Diversification from China’s supply won’t be easy, and it won’t happen overnight. But there are other countries that can at least partly serve as supply hubs: Chile for lithium, South Africa for platinum and Congo for cobalt [not to mention Australia for lithium and rare earths].

What Europe has done wrong until now, says Saxo, has been to focus on the final product (EVs, for instance) without securing the supply chain. Europe is repeating the exact same mistake made with Russia (for fossil energy) and China (for masks and vital drugs during the covid pandemic).

On the other hand, notes Saxo, while China has abundant coal reserves and is close to being self-sufficient in coal, this is not the case for oil and natural gas. As the economy grows, China has become increasingly reliant on importing oil and LNG. China is importing over 70% of its oil consumption and more than 40% of its natural gas.

Winter is Coming

Much has been made of the EU’s efforts to build natural gas storage ahead of the heating season beginning in the northern autumn, but this will not cover the additional supply needed unless Russian gas flows resume over the winter, Saxo notes, unless EU demand drops further.

If Russian leader Putin, or anyone of his ilk, remains in power in Russia, the longer-term energy supply picture for Europe will remain difficult as the EU will have to continue bidding up for shipments of LNG in a tight global market.

New sources of gas could be in the wings, possibly in the long run from Algeria and already in coming months from the newly-arrived-on-the-scene LNG from Mozambique. But the EU energy outlook will likely never again prove as bad as it does for the coming winter of discontent, so some major low in the euro may emerge in the coming quarter or early next year.

The EU plans to cap prices may help nominal EU inflation readings to begin rolling over in coming months, but this won’t kill demand, says Saxo.

Physical limits to natural gas supply, possibly aggravated by risks that French nuclear power is not fully back on line until late in the winter, might force power rationing and real GDP output drops. Europe will be hoping that a mild winter lies ahead, and daily and weekly weather forecasts will receive more attention than perhaps at any time in the continent’s history.

It is the same for the UK except the UK lacks strategic gas storage facilities, Saxo notes, even if it is scrambling on that front. Winter is coming and will continue to come every year, but the EU will move with existential haste to address its vulnerabilities.

Commodity Strength

Multiple uncertainties will continue to create a volatile environment for most commodities ahead of year-end.

But while the recession drums will continue to bang ever louder, Saxo believes the sector is unlikely to suffer a major setback before picking up speed again during 2023.

This forecast for stable to potentially even higher prices will be driven by pockets of strength in key commodities across all three sectors of energy, metals and agriculture. Saxo suggests the Bloomberg Commodity Index, which tracks a basket of 24 major commodities, should hold onto its 20%-plus year-to-date gain for the remainder of the year.

While we are seeing concerns about growth and demand, the supply of several major commodities remains equally challenged, Saxo notes. An explosive rally during the first quarter was led by war, sanctions and the backend of a post-pandemic surge in demand for consumer goods and the energy to produce them.

The market then retraced sharply lower during June when the US Federal Reserve turbocharged its rate hikes to combat runaway inflation, while China’s zero-Covid policy and property sector woes drove a sharp correction.

During the third quarter however, the sector has reasserted itself and while pockets of demand weakness will be seen, Saxo sees the supply side as equally challenged — developments that should support a long-lasting cycle of rising commodity prices.

Multiple uncertainties will first of all mean a focus on the demand side, Saxo notes.

Increased efforts from central banks around the world, led by the Fed, to combat inflation by aggressively hiking rates will lead to some weakness in demand. In addition, China’s month-long and so far unsuccessful battle with covid and harsh restrictions have, together with its property sector crisis, driven a slowdown from the world’s biggest consumer of raw materials.

However, Saxo views the current weakness in China as temporary, and with domestic inflationary pressures easing, expects the government and the People’s Bank of China to step up their efforts to support an economic turnaround.

Global demand for food is relatively constant, hence the agriculture supply side will continue to dictate the overall direction of prices. Saxo sees multiple challenges that could see prices move higher into the northern winter and next spring.

The main culprits are the cost of fertiliser due to high gas prices, climate change, and La Nina during the 2022-23 northern winter — a weather phenomenon that has driven a change in temperatures around the world and led to several climate emergencies during the past couple of years [not just in Australia].

Adding to this is Putin’s war, which has led to a sharp drop in exports from a major supplier of grains and edible oils to the global market. With global stocks of key food items from wheat and rice to soybeans and corn already under pressure from weather and export restrictions, Saxo warns the risk of further spikes remains a clear and critical danger.

Saxo maintains a long-term positive outlook on the industrial metal sector given the expected ramp-up in demand towards the electrification of the world. But with regards to copper, Saxo expects the prospect for a temporary increase in production capacity next year by miners around the world, most notably from Central and South America as well as Africa, will likely dampen the short-term prospect for a renewed surge to a fresh record high.

The copper-intensive electrification of the world will continue to gather momentum following a year of intense weather stress around the world and the need to reduce dependency on Russian-produced energy, from gas to oil and coal. But for power grids to be able to cope with the extra baseload, a massive amount of new copper-intensive investments will be required over the coming years.

In addition, Saxo notes we are already seeing producers like Chile, the world’s biggest supplier of copper, struggling to meet production targets amid declining ore-grade quality and water shortages. China’s slowdown is viewed as temporary and the economic boost through stimulus measures is likely to focus on infrastructure and electrification — both areas that will require industrial metals.

With regard to oil, there is no doubt demand has softened in recent months, especially following the end of northern summer driving season, and prices have fallen back to pre-invasion levels, but this is also due, Saxo notes, to ongoing but temporary lockdowns in China that are hurting mobility and growth.

In Europe, punitively high prices for gas and power have also helped drive a slowdown in fuel demand but the region is still importing around three million barrels per day from Russia.

The introduction of an import embargo on December 5 will likely tighten the overall market, with Russia struggling to find other buyers.

Saxo views the current weakness in oil fundamentals as temporary, and agrees with the major oil forecasters of the US Energy Information Administration, OPEC and the International Energy Agency who, despite current growth concerns, have all maintained their demand growth forecasts for 2023. But during the December quarter prices are likely to remain challenged at times.

The demand-supply balance will be determined, Saxo suggests, by China’s lockdowns versus stimulus measures, the EU embargo on Russian oil, the direction of the US dollar, which is dependent on inflation, and US production growth, which is showing signs of stalling, thereby supporting prices.

Other determinants include an OPEC production cut and a need to refill the US strategic oil reserve. Since the publication of Saxo’s report, OPEC-Plus has cut production by -2 million barrels per day and Joe Biden plans to increase selling from the US strategic reserve as a counter, but will indeed one day need to refill.

Oil majors are swamped with cash, Saxo notes, and investors in general are showing little appetite for investing in new discoveries, hence the cost of energy is likely to remain elevated for years to come.

This is driven by the green transformation which is receiving increased and urgent attention, and which will eventually begin to lower global demand for fossil fuels. It’s the timing of this transition that keeps the investment appetite low.

Unlike new drilling methods such as fracking where a well can be productive within months, traditional oil production projects often take years and billion-dollar investments before production can begin.

With that in mind, oil companies looking to invest in new production will not be focused on spot prices around US$90/bbl Brent, but instead at -US$30/bbl or more lower prices currently traded in the futures market for delivery in five years' time.

We note this is not the case for LNG production, which needs to ramp up to meet urgent short term global need as fossil fuel bridging source towards longer term alternative energy.

From Australia’s point of view, gas giant Woodside Energy ((WDS)) handed out a lot of the cash it was swamped with as dividends in FY22, but now plans to divert earnings towards new offshore production.

Peer Santos ((STO)) on the other hand held back on cash handouts due to near term uncertainty, but has also sold down existing projects to fund new opportunities in its Alaskan assets.

Pre-war, investors were shying away from fossil fuel producers on an ESG basis, investing in green technologies instead. This was making it difficult for gas companies to secure funding for new projects.

But since the war, surging LNG prices have meant funding can be internal, and the need to service new-found gas demand in Europe, and ongoing demand in Asia, has become critical on a humanitarian basis (and rather supportive of gas producer profits), leading to wider acceptance of LNG as a bridging source of energy.

Somewhat controversially, the EU’s recent (and pre-war) “green taxonomy”, which is still in the consultation phase, included both LNG and nuclear power as bridging sources towards an alternative future.

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