Saxo releases Q1 2023 Quarterly Outlook: “The Models Are Broken”

Rick Steves

“2023 is likely to prove a rough ride for currencies if the USD bear market fails to continue in a straight line, but EUR and JPY may outperform.”

Saxo has published its Q1 2023 Quarterly Outlook, arguing that markets and the global economy are entering a new era and that pre-pandemic and pre-Ukraine invasion global economic standards and assumptions for how market cycles are supposed to work are simply broken.

The brokerage firm’s Chief Investment Officer, Steen Jakobsen, believes that it won’t be all pain for all assets, quite the contrary; it will bring a refreshing return of productive investment and a brighter future for everyone.

The Q1 2023 Quarterly Outlook includes trading ideas covering equities, FX, currencies, commodities and bonds, as well as a range of central macro themes impacting client portfolios.

Below, a summary of Saxo’s Q1 2023 Outlook: The models are broken

The economic models and assumptions for how market cycles are supposed to work had predicted a recession in the US towards the latter half of 2022. This failed to materialise, and the country will now likely see a ‘soft landing’ or shallow recession. Saxo’s Quarterly Outlook questions whether a return towards pre-pandemic and pre-Ukraine invasion global economic standards is feasible, or whether it is time to adapt to a new paradigm and leave behind these broken models.

Indeed, focus needs to shift away from the intangible digital economy and towards the real economy. Steen Jakobsen, Chief Investment Officer at Saxo, says: “In the S&P 500, 90 percent of market value is in intangibles. This means the real economy is too small for the ambitions of fiscal and monetary policy, the green transformation and global digitalisation.

“Going into Q1, we think there should be more focus on building infrastructure, generating cheaper and environmentally friendly energy and improving productivity.

“What will boost the real economy is President XI’s reversal on zero-Covid policies, tech companies and housing. Perhaps the biggest event in 2023, this policy change will mean renewed support for fiscal spending – with much of it in infrastructure – support for housing credit, expansion of state-owned banks’ balance sheets and a reopening of the economy.

“However, the coming months will still likely be dominated by the fight between a soft landing and recession. The models are broken, but before we change, we will likely see the market pricing a new round of extend and pretend in Q1.”

A painful phase transition for equities

In 2022, we saw the successful entities of globalisation stumble into an unknown phase transition. What lies on the other side of this is difficult to predict, but Saxo’s working idea is that what was successful during globalisation will be less so in a world driven by geopolitics and the move to a bipolar world driven by two different value systems. The broken models that have previously worked very well will struggle going forward.

Peter Garnry, Head of Equity Strategy at Saxo, said: “Digitalisation – a dominant force in the equity markets since the Great Financial Crisis – has faltered since the Covid-19 vaccines. The faster-than-expected reopening unleashed demand in the physical world. The tangible-driven industries are now in their third year of outperformance against the intangible world – a trend that has only just begun.

“US equities will also lose their dominance over their European counterparts. With deglobalisation kicking into gear, a war in Ukraine amplifying the energy crisis and a world in need of physical assets, Europe will stand to gain from this shift. European equity markets have many more of the companies that will thrive in this new environment across green energy technologies, mining, automation, robotics and advanced industrial components.

“Companies that are prepared for higher interest rates, a reset in wages and high inflation are those which will provide a high return on investment capital or a high operating margin combined with less excessive equity valuations.

“On a country-specific level, export-driven countries such as Germany, South Korea, and especially China, who have been successful in previous decades, will likely start losing out to countries like India, Vietnam and Indonesia as well as to regions such as Central Europe, Eastern Europe and Northern Africa as manufacturing finds new homes.

“Countries south of the Sahara will also become more successful as they experience an investment boom due to Europe’s hunger for energy and materials as Russia is cut out of the equation. Closer to the US, Mexico will benefit in manufacturing and countries in South America will benefit from the commodity super cycle.”

China’s reopening will drive another strong year for commodities

Cautious and defensive trading – with a few exceptions – best describes the early 2023 price action across the commodity sector, a year that hopefully will provide less drama and volatility than last year, which saw the Bloomberg Commodity Total Return index surge higher to record a first quarter gain of 38 percent before spending the rest of the year drifting lower before closing with a 16 percent gain. This was a very respectable return considering the stronger dollar and market participants spending the second half increasingly worrying about a recession.

“The key macroeconomic event that will drive developments in 2023 has already occurred. The abrupt change in direction from the Chinese government away from its failed zero-Covid tolerance towards reopening and kick-starting its economy will have a major impact on commodity demand at a time where supply of several key commodities from energy to metals and agriculture remains tight” says Ole Hansen, Head of Commodity Strategy at Saxo.

“In addition, risk sentiment will likely also be supported by a continued and broad drop in the dollar as US inflation continues to ease, thereby supporting a further downshift in the Fed’s rate hike trajectory.

“Furthermore, an increased likelihood of an incoming recession either not materialising or becoming weaker than anticipated may also trigger a response from financial and physical traders as positions and stock levels are being rebuilt in anticipation of stronger demand.

“The commodity sector remains on a journey towards higher prices and, while the speed of the ascent will slow, we project several years ahead where supply of key commodities may struggle to meet demand. With that in mind, we forecast another positive year for commodities resulting in a more than 10 percent rise in the Bloomberg Total Return Index.”

The euro and Japanese yen may prove safest harbours in the first half of the year

Q4 saw a massive retreat in the USD as the market ignored the Fed’s attempt to keep the policy rate ‘higher for longer’, profoundly inverting the US yield curve. Meanwhile, the ECB played catch-up with its tightening cycle, and the JPY bounced back with a vengeance as the Bank of Japan arrived to the tightening party just as central banks elsewhere are trying to shut it down. The Chinese renminbi also came back from the brink following a disorienting policy about-face.

John Hardy, Head of FX Strategy at Saxo, said: “2023 is likely to prove a rough ride for currencies if the USD bear market fails to continue in a straight line, but EUR and JPY may outperform.

“As 2023 gets under way, we see the market expressing increasing confidence in a disinflationary outcome for the US. Despite the Fed’s persistent ‘higher for longer’ narrative and the FOMC having placed the median dot plot Fed Funds rate forecast above 5 percent for this year at its December 2022 meeting, the market is happy to continue to mark Fed expectations lower by the end of this year.

“However, Saxo find it highly unlikely that the disinflationary backdrop can persist for long in an under-invested world that is scrambling to transform itself away from fragile, globalised supply chains, to upgrade and green its energy system, and to arm itself for new national security imperatives.

“Thus, any nominal growth slowdown will prove shallow and growth will re-accelerate on the bounce-back in demand for commodities as China comes back online. In the meantime, the USD may occasionally rally hard if the market must second guess its expected path for the Fed next year, and if that adjustment sees new bear market lows in risky assets, particularly US stocks.

“The ingredients for a sustained USD sell-off would include the Fed providing liquidity and a global rebound in risk sentiment, with the latter as important as the former. In the past two cycles, the big USD sell-offs have come only on the Fed providing massive liquidity after some sort of global crunch. However, the Fed is still tightening.

“A slowdown in corporate profits and recession fears could bring a comeback in the USD as a safe haven at times in the first half of this year, even if it falls short of the cycle peak. Further out the curve, far beyond the purview of Q1, when inflation reaccelerates beyond a possible short-term growth scare and the current misleading comedown in inflation, the USD may finally turn significantly lower on the Fed having to provide liquidity to ensure an orderly treasury market, even without significantly cutting rates or cutting them at all. Think QE with no ZIRP – a new paradigm that breaks the old model.”

The energy crisis and poorer workers still spell a broken Europe

Softer energy prices, the lack of black-out (resulting both from energy supply diversification and better weather conditions) and resilient hard data (notably in Germany) are pushing forecasters to review their 2023 recession calls. The eurozone 2023 consensus GDP is up from minus 0.1 percent to 0.0 percent – a small but significant move. “We were too pessimistic about the euro area,” says Christopher Dembik, Head of Macro Analysis at Saxo.

“At Saxo, we are not as bullish as some. However, we confidently believe that the eurozone could avoid a recession this year with a GDP growth target close to 0.3 to 0.4 percent.

“Overall, we believe the consensus was and is still too pessimistic about the eurozone 2023 GDP growth. However, Europe is still broken.

“The energy crisis remains a major risk for the next winter – with the EU being still reluctant to embrace nuclear energy and being unable to move fast on the project of a reform of the electricity market.

“While the ECB expects wages to increase substantially, we see that workers are in fact becoming poorer in most countries. Several companies which have benefited from the abnormal negative interest rate periods will now face a moment of truth – many of them will probably go bankrupt.”

China’s reopening could be favourable to Australian assets

With China aiming for 5 percent GDP growth as it reopens after three years, Chinese infrastructure spending will likely get a boost in 2023, along with the coal-hungry power sector to drive it.

Jessica Amir, Market Strategist at Saxo, said: “Investors have begun increasing exposure to the coal and metal sectors, as they will likely benefit from China, the world’s biggest consumer of commodities, ramping up buying in the first half of 2023. Metal prices have already rallied 20-50 percent and the supply outlook remains constrained.

“To avoid a power crunch, China has cranked up thermal coal production, aiming to produce a record 4.6 billion tons this year, while it also started buying Australian coal for the first time in two years, a sign that domestic supplies are tight.

“Reopening the safety valve of imported coal supplies could cool what has been a hot market in late 2022, with a coal company like Whitehaven Coal seeing the most earnings growth and share price that rose over 300 percent in 2022. This also could mean investors may potentially be taking out excess capital and profits from energy markets, and moving them into metals markets, given the ingredients are there for a strong surge in metals.”

Deglobalisation creates opportunities in Asia

In Asia, dependence on China is loosening as new supply chain linkages and more regional co-operation are likely to see the region outperforming in 2023.

Charu Chanana, Market Strategist at Saxo, said: “Asian stocks have started 2023 with a bang, with the MSCI Asia Pacific Index and the MSCI Emerging Markets Index entering a bull market in January, outpacing the US S&P 500. A lot of this has been driven by China’s policy shifts and a weaker US dollar.

“However, risks of a slowdown in the global economy as well as inflation remaining higher-for-longer cannot be discounted. The outlook for domestic demand in Asia is also challenged by the rise in interest rates seen in 2022. Meanwhile, geopolitical risks remain in play, clouding the outlook.

“The other key thing to consider will be that Asia’s dependence on China is waning, as is evident from the region’s outperformance in 2022 despite China’s slowdown. As China reopens, we are likely to see new supply chain models and more regional co-operation that will push Asia’s relevance higher in the global economy.

“The escalating US-China trade and tech wars have prompted many companies to diversify their supply chains to reduce risks from sanctions. The pandemic had already highlighted the need to address concentration risks as supply chains for everything from basic industrial components to medical supplies and even toilet paper was over-reliant on China.

“Finally, the invasion of Ukraine and the resulting impact on Europe’s gas supplies has set a clear agenda for many countries traditionally aligned with US foreign policy to think about supply chain resilience and avoid relying too heavily on Russia or China, and instead sourcing from friendly countries.”

Refitting China’s broken growth engine

China’s attempts to shore up its economy through the removal of its covid restrictions, support to the real estate sector, ending of its crackdown on internet platform companies and attempts to thaw relations with key trading partners are in a positive confluence of an upturn in the credit impulse cycle. “The combined impacts tend to support further rallies in Chinese equities in Q1 and lend support to global commodities and growth,” says Redmond Wong, Market Strategist at Saxo.

“As discussed in our Q3 and Q4 outlooks last year, China has been moving towards a new economic development paradigm, walking away from its labour-intensive, energy-intensive and export-oriented model that had been the backbone of the development of the Chinese economy in the prior decades to focus on high value-added industries, self-reliance and comprehensive national power.

“With economic growth grinding to a halt, refitting and reviving the economic engine brought a quick about-face in policies. In November 2022, the Chinese health authorities relaxed guidelines for the country’s pandemic containment measures, with a series of further relaxations and the subsequent abandonment of the dynamic zero-Covid policy in December 2022.

“Investors are rightly looking through the initial shockwave of Covid-19 infection across the country in December and into the start of this year to the subsequent reacceleration of economic activities and credit expansion. The investment case for Chinese stocks in Q1 is strong.”

Institutions could save crypto before retail vanishes

Over the past few years, crypto market advocates have touted the impending arrival of serious institutional participation. The ‘don’t-touch’ attitude towards crypto held by many until 2020 has given way, as respected institutions have dipped their toes into the space, trading the market themselves, offering it to clients, and in some cases executing various transactions directly on-chain.

“While this is a step in the right direction, the institutional interest in crypto has been relatively modest, as it is still dominated by relatively few institutions. As a consequence, institutions are not likely set to arrive in sufficient force in the near-term to offset retail’s crypto exit, particularly for the smaller and less liquid cryptocurrencies,” says Mads Eberhardt, Crypto Analyst at Saxo.

“Nonetheless, less retail activity may lead the market to a less speculative but more robust and sustainable model long-term, although most cryptocurrencies may not survive the wash-out of speculative activity. To bring about a sustainable model for the market to thrive in the future, crypto must return to its roots by offering unique decentralised use cases and mature into more economically sustainable assets.

“On the latter, last year was encouraging in demonstrating that cryptocurrencies can be economically sustainable assets by generating dividend-like returns, following Ethereum’s transition from proof-of-work to proof-of-stake last year.

“Hopefully, other cryptocurrencies and tokens follow in Ethereum’s footsteps in turning into more economically sustainable assets, altogether leading the space to become less speculative.”

The ‘balanced’ 60/40 portfolio is here to stay, for now

The 2022 investment year was an extraordinary one as both stocks and bonds went down hard – an unusual combination for the modern investor. In fact, the traditional ‘balanced’ portfolio of 60 percent stocks and 40 percent bonds saw the worst nominal performance since 1871.

Peter Siks, Investor Trainer at SaxoAcademy, says: “The idea of the 60/40 portfolio is based on the assumption that growth rewards the stocks in the portfolio, while the bond portion performs a kind of income-generating buffer function and diversifier in downturns, due to recent years in which bonds were most often negatively correlated with stocks.

“The return over the last 40 years for the 60/40 portfolio has been about 7.5 percent per year with a volatility of 8.9 percent. But with the disastrous investment year 2022, can we argue that the 60/40 portfolio should be a thing of the past?

“Despite a disastrous year, the 60/40 portfolio is not dead, and the expected returns for both stocks and bonds have improved substantially. Stocks are less expensive than they were about two years ago, and bonds are returning to positive nominal returns at worst (and even positive real returns if inflation continues to drop this year).

“Of course, the determining factors remain corporate earnings growth and central bank interest rate policy. We assume that the reopening of China will contribute to the profitability of companies worldwide. It is also Saxo’s view that the US will experience no – or a very shallow – recession. In addition, inflation will stabilise at slightly higher levels than the current consensus, yet this will have a limited upward effect on interest rates.”

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