Saxo Q2 Outlook: A World Out of Balance

“The virus outbreak has set three major macro impulses in motion: a global demand shock, a global supply shock and an oil war that has forced prices to multi-year lows. This final development will result in an enormous destruction of capital and, soon, structural unemployment.” says Steen Jakobsen, Chief Economist and CIO at Saxo Bank.

“The triple hit to the global economy almost guarantees 2020 will be a lost economic year, with policymakers needing to pull out all the stops to address a real, global recession.

“This current disruption has already eclipsed the 2008 chaos in some markets, as we suddenly find ourselves in a period in which some markets can move up and down more in one day than in an entire year and reflects how illiquid markets are.

“In an environment of panic deleveraging, the ‘cash is king’ mantra arises. Funds, banks, investors and even companies suddenly see not only a dramatic mark-down of asset prices, but wild swings in correlations across portfolios and swings in P&L.

“Central banks, meanwhile, try to move in quickly with ‘support’ in the form of rate cuts and liquidity provision. For a company or fund relying on credit for some portion of its operations, this may help in terms of the future cost of financing liabilities. But it does not help the price of the equity or credit on the asset side, causing significant numbers selling assets that are often highly illiquid to deleverage across the board.

“This cycle is even worse than ones we’ve seen before because of current low and negative yields have triggered a ‘reach for yield’ that forces market players further out on the risk curve and into super-illiquid financial assets such as private equity and high-risk corporate credit.

“We are therefore now in an environment of more price discovery, which will mean significantly higher volatility and a cleaning out of models for the valuation of private equity and other high-risk assets that are predicated on low interest rates, central bank intervention and a somewhat naïve assumption of multiples that can go up forever.

“The shakeup we are seeing here in Q1 will change the landscape of investment and risk tolerance going into 2021. It will also change the long-term allocation model away from a 60/40 bond/equity allocation to proper hedging through commodity exposure and long volatility.”

Against the backdrop of the growing COVID-19 crisis, Saxo’s main trading ideas and themes for Q2 include:

Equities facing worst outlook since 2008

The current crisis comes just after the US-China trade war disrupted supply and slowed growth last year. We are now experiencing a supply and demand shock alongside an oil price war between Russia and Saudi Arabia which threatens to significantly impact global investments. Equities are likely to suffer and, in a worst-case scenario, we think the S&P 500 could decline to 1,600.

Peter Garnry, Head of Equity Strategy, said “As equity prices reflect the future and growth prospects, they are the most sensitive to current crisis. Investors are desperate to get out and cash in on years of fat profits.

“As global pandemics of this type are very rare, all GDP forecasting models can be tossed out the window and with dramatic lockdowns in Europe and the potential for COVID-19 to become seasonal, the impact could become deeper and longer than anticipated.

“We are in the phase where policymakers will throw a lot of stimulus against the economy, including various lending programmes from governments and the extension of tax payments. With the Fed’s two panic cuts taking the rate to 0.25% all major central banks are also now effectively zero bound.

“Our view is that sentiment and asset prices could be lifted here due to all the stimulus. But then, as economic activity numbers are published, investors will realise more is needed and equity markets will take another leg down. Eventually, however, enough stimulus will be added to the economy that equilibrium is reached but at that time, equities will have bottomed.”

The great reset is upon us and ends when the USD tops

The COVID-19 crisis is very different to the 2008 global financial crisis. Rather than occurring against a backdrop of a relatively weak USD and supercharged FX liquidity, this time we enter the crisis on a strong USD and lower liquidity levels. Our view is that we likely need the USD lower to call an end to the equity and risk bear market.

John Hardy, Head of FX Strategy, said: “The trigger of this credit crunch is of course the coronavirus outbreak, but the severity of the fallout is a product of a financialised global system made so incredibly fragile by leverage and the QE medicine used to alleviate the last crisis.

“From here, it may take at least a couple more quarters to establish a cycle low in the market and a high in the USD — even as authorities swing more determinedly into action than we have ever seen. Relative to the global financial crisis, the medicine this time around will include far more helicopter money and far less QE. Real GDP may be slow to recover — but helicopter money is going to help nominal GDP come roaring back at some point first.

“A note of encouragement is that long-time investors know that crisis points are also the points of maximum opportunity for those with cash in reserve and the coming six to twelve months will bring extreme value to various oversold assets, regions and their currencies.

“Currency markets are likely to transition through to what may prove a U-shaped recovery with a bumpy bottom into 2021. The pressures and drivers we’re experiencing now are very different from those of the recent and pre-2008 past, when carry and investment flows in a globalised financial system were the chief focus.”

China will be first out of the global storm

We are in the midst of a bear market in equities, with price moves across asset classes showing clear signs of distress and as participants fight for liquidity. However, the situation will eventually pass and we expect that as the rest of the world catches up with what Asia went through in January and February, fears will generally lessen.

Kay Van-Petersen, Global Macro Strategist, said: “We need to reset expectations around fundamentals and earnings as policymakers deal with the challenge of the triple threats: a demand shock, a supply shock and the destruction of capital in the energy market.

“While China has led the world with regard to the economic slowdown we’re experiencing – talks suggest Q1 China GDP could be in the -10% to -20% range – we are also likely going to be entering a quarter or two where that slowdown ripples across the eurozone and the US. Therefore, the paradox here is that from Q2 China’s growth is likely to accelerate as the rest of the world decelerates.

“Most of Asia will benefit from rising growth in China as China does about 50% of its trade with the region. With an eventual return to the service economy – restaurant chains are once again opening across the country – some provinces are claiming to be almost back to 100% normal.

“When looking at the economic impact of the current crisis, we have to take a step back and remember that this is what happens after the longest bull market run in history. However, with the Northern Hemisphere summer coming and with the prospect of a potential breakthrough toward a vaccine there are potential advantages that Asia did not initially have.”

Commodities look to fiscal bazooka for support

The second quarter is likely to begin focussed squarely on the price-damaging impact of the dramatic drop in demand for many key commodities: from crude oil and industrial metals to some agriculture commodities. As coronavirus continues to spread it is very possible that the supply outlook will become challenging as well.

Ole Hansen, Head of Commodity Strategy, commented: “Miners and producers may begin to feel the impact of staff shortages and breakdown in supply chains. The impact of lower fuel prices is being felt from agriculture to mining as it drives down input costs. However, the potential risks to supply could see some markets find support sooner than the demand outlook suggests.

• Oil: "The biggest effect has so far been seen across the energy sector. A combination of strong non-OPEC supply growth and a weakening outlook for global demand led to the inevitable breakdown of OPEC+ co-operation on March 6 and since then under additional COVID-19 pressure Brent crude oil has dropped to an 18-year low.
  
  “Despite the market turmoil, given the fact that most oil producers are currently selling at a price well below their budget break-evens, we will eventually see the market recover as long as the virus shows signs of retreating or we see a meaningful reduction among high-cost production companies in places like the US and Brazil.”
  
  
• Gold: “Gold’s failure to rally as COVID-19 spread and economic uncertainty rose has brought back memories of 2008. During the early part of the GFC, all assets were sold as investors deleveraged to realise cash or pay for losses elsewhere. In the early weeks of the crisis, gold suffered a 27% sell-off to $725/oz before beginning an ascent which eventually took it to $1920/oz.
  
  “We believe the long-term reasons for holding gold have, if anything, been strengthened by current developments. While official interest rates have been slashed, corporate bond yields have been rising and US 10-year real yields have risen sharply in response to much lower inflation expectations.”
  
  
• Copper: “HG copper, which started the year with a forecast of a small supply deficit, finally broke key support at $2.50/lb. However, with the outlook for aggressive fiscal measures and the potential risk to supply from virus-related disruptions, we see risk being skewed to the upside in Q2.”

Demographics: the missing piece

The current crisis comes just before a significant demographic shift as baby boomers retire against a backdrop of structural issues in the global financial system. This could mean the economic impacts of COVID-19 could be felt for longer than widely anticipated and contribute to the end of the secular bull market.  

Christopher Dembik, Head of Macroeconomic Analysis, said: “In the coronavirus era, Governments are ready to do ‘whatever it takes’ to mitigate the crisis. We are moving from ‘bailout the banks’ in 2008 to ‘bailout SMEs and anything else’ in 2020.

“The huge fiscal stimulus that is coming is likely to increase inflationary pressures in months to come. Contrary to consensus, we doubt that the coronavirus is a temporary market shock. We think that the COVID-19, along with demographic factors will precipitate the end of the secular bull market.

“In our view, demographics are the ultimate indicator of how the economy and the market will evolve decades in advance. Retirement of the baby boomers will happen at the worst time ever for the stock market, when other structural factors are already affecting the macroeconomic outlook. Loose monetary policy, for example, has dramatically increased debt-to-GDP ratios — which are now at unsustainable levels — and diverted capital from productive investment. The amount of debt in the system, especially in the private sector, is dragging down productivity and the economy overall.

“The system that prevails, which is centred on central banks providing unconditional liquidity, is inefficient and has not been able to foster the emergence of decisive disruptive innovations. We are reaching the limits of this system, with spreads on high yields reaching crisis-levels on the back of the COVID-19 outbreak.”

A new investment paradigm

We are in unchartered waters with respect to both the global public health crisis and financial market conditions: hence the heightened cross-asset volatility. To have real confidence in a relief rally, volatility must reset meaningfully lower and investors must think about how portfolios are diversified.

Eleanor Creagh, Market Strategist, commented: “The virus outbreak has sent tremors through highly levered financial markets, revealing multiple fault lines that we previously caught glimpses of in Q4 2018 and September 2019. These fault lines were patched over, fuelling the complacency and yield reaching which have lulled markets and volatility over the past decade of central bank intervention. In the wake of the global pandemic, the fault lines are now fissures.

“What is currently a liquidity crisis could fast become a solvency crisis as the simultaneous shocks to demand and supply weigh on the balance sheets of otherwise solvent SMEs. This crisis is about too many to fail, as opposed to too big to fail. Distressed entities desperately need a lifeline to maintain wages, rents and other payments that do not stop as economic activity grinds to a halt.

“Although stimulus packages may ease downside risks to the economy, for markets to really recover the onus will be on reduced COVID-19 transmission rates, increased immunity and a clear containment of the outbreak. As yet, relative to previous crises, valuations have not become outright cheap. Nevertheless, hope springs eternal both in financial markets and humanity, so there will come a time for bargain hunting. At that juncture, we likely enter a different investment paradigm. The extraordinary fiscal stimulus, a de-globalisation tailwind and recovery in economic activity will bring at the very least higher inflation expectations, and long-term bond yields may eventually rise. Perhaps we’ll see an opportunity to rethink diversification beyond the traditional 60/40 and a comeback for value, cyclicals and commodities.”

To access Saxo Bank’s full Q2 2020 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