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Q3 2022 Outlook: The Runaway Train

Steen Jakobsen
Chief Investment Officer

Summary:  The market fails to understand that we have shifted into a new paradigm for the economy, inflation and the incoming policy response. Inflation will prove a runaway train that central banks can only chase from behind until the inflationary dynamics result in a crash into a hard recession.

An executive summary 

Our outlook for Q3 2022, and really for the balance of the year, argues that the market fails to understand that we have shifted into a new paradigm for the economy, inflation and the incoming policy response. Inflation will prove a runaway train that central banks can only chase from behind until the inflationary dynamics result in a crash into a hard recession. But that eventual recession won’t mean that we are set for mean reversion back to disinflation and calm conditions. That’s because inflation is here to stay, driven by deglobalisation and supply-side shortcomings from decades of underinvestment in the physical world, as policy was overgeared toward pumping up leverage and ever greater financialisation of the economy. Over 40 years of falling yields and ever greater policy stimulus after every recession since the early 1980s, the final period was characterised by zero- and negative-policy rates and, even more importantly, negative real rates that drove tremendous malinvestment. Now, we have entered a new super cycle of greater volatility and a higher background inflation level. With monetary policy sidelined, fiscal dominance will mean that inflation is as much a feature as a bug, because it is the only option policymakers can take for deleveraging our over-indebted economies. 

In equities, we argue that the market has undergone one of its largest sentiment shifts in the past 100 years in just six months. This was after it dawned on the market that the famed Fed put has been thrown out the window as the Fed finally realised it must focus single-mindedly on tightening conditions until inflation is reined in. Given our macro theme that the supply side of our economy has suffered underinvestment, the new landscape for equities should favour tangible assets such as logistics, commodities, renewable energy, infrastructure and defense. The energy sector is the only positive sector in US equities this year and, with its rising importance in equity indices, we foresee a potential crisis in environmental, social and governance (ESG) funds due to their significant underweight in oil and gas stocks. Elsewhere, we feature an equity focus piece on commodity-related stocks, naming names that offer exposure to a variety of commodities and noting the current risks to the green transformation theme. 

Given our focus on inflationary risks due to the physical world being unable to keep up, it is interesting that our commodities outlook notes that commodities are fretting risks to the downside in the short to medium term as the market predicts an incoming recession due to the policy tightening and a demand adjustment after severe price rises over the last year. But for the longer term, decades of underinvestment in capacity and the need for the metal-intensive push for a more carbon-neutral future leave us convinced that commodities remain in a rising super cycle. 

In currencies, we assess where we are in the strong USD cycle as the Fed is now forced into the position of continuing to tighten policy ‘until something breaks,’ with the USD possibly not peaking and turning over until we are clearly heading for a hard landing, even as other central banks are largely seen matching and even exceeding Fed policy tightening. The euro is in a tough spot as it tries to tighten while avoiding policy fragmentation due to the foundational challenges of the Economic and Monetary Union (EMU), as we discuss in a focus piece on Europe and the European Central Bank (ECB). We also feature a separate focus piece in currencies on the Japanese yen—the Bank of Japan has doubled down on its yield curve control policy that is seeing it lose control of its balance sheet as it intervenes to defend yield caps on Japanese government bonds. This could potentially mean that we are set for an explosion in JPY volatility if market forces and realised inflation in Japan become unbearable later this year. 

Our European focus in this outlook is squarely on the ECB and the euro. The ECB is set to announce a new tool in Q3 to keep sovereign spreads under control. It may manage to do so, but what about the euro itself? Shortly put, the eurozone could well end up in crisis territory once again if the ECB lags too much behind its global peers in tightening policy. But that does not have to be entirely negative. From 2012 onwards, crisis has at every turn prompted new institutional reforms which have strengthened the eurozone framework. The second half of this year will prove critical for the eurozone. 

The weakness in the Chinese economy due to the country’s zero-Covid policy has been an outlier this year. Our outlook focus piece on China judges the road ahead for the country to be likely bumpy through this winter and into early next year, as it appears intent on stopping any uncontrolled spread of the virus, with only hesitant offsetting stimulus measures. Still, long-term perspectives for China are in order as we look at the country’s huge initiative in transforming its economy away from the factory-of-the-world era to a new ‘dual-circulation’ paradigm led by high-tech prowess and increased self-reliance.  

In our crypto coverage, we note that the crypto market has come under heavy pressure this year with the vicious tightening on global liquidity that has devastated risky assets of nearly every stripe. All parts of the crypto market are under pressure, from crypto traders to crypto service providers. Some claim this can serve as a healthy clean-up of the industry by removing overleveraged speculators and exposing unreliable and untenable crypto services. Going into Q3, cryptocurrencies are in limbo, awaiting changes in the general macroeconomic sentiment, regulation and breakthroughs in institutional adoption of crypto technologies. 

Finally, this outlook also features a rundown of the longer-term technical outlook for critical assets, particularly the longer US treasury yield and Nasdaq-100 Index after US equity markets entered a bear market in Q2, as well as the USD Index and Brent crude oil.  

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