A Winter Of Discontent

Feature Stories | Oct 07 2022

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.

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