Winter is coming

I am sorry to disappoint our younger readers of this Q4 Outlook who think that its title is a play on Games of Thrones. Rather, it’s a reference to the 1970s movie Being There, in which Peter Sellers plays Chauncey Gardiner, a simple gardener who becomes a sensation on Wall Street and as a presidential adviser. Observers misinterpret his basic gardening and seasonal tips as oracular advice—for example, “In the garden, growth has its seasons. First comes spring and summer, but then we have fall and winter.”  

This year winter is coming once again for global markets. Winter came already for the crypto market last year and has lingered since the pivot by the Fed in November 2021. And more broadly speaking, the same has been the case for the equity market, save for a brief thaw in the spring of this year and then for a sunny couple of months after the 16th June FOMC meeting. That meeting’s super-size 0.75 percent rate hike had the market hoping that peak Fed would arrive sooner rather than later due to the anticipated damage that the aggressive Fed hiking cycle would do to the economy. 

We have argued since early 2020 that inflation would be deep rooted and persistent. This view still holds but 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 that 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 QT program, which will reduce its bloated balance sheet by up to $95bn per month. This triple whammy of headwinds should mean that in Q4 we should see an increase in volatility at a minimum, and potentially strong headwinds for bond and equity markets.  

The question facing investor is really this: If we are set for peak hawkishness in Q4, what then comes next? The answer is possibly that the market 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 the energy prices peak with the above trio. 

It's estimated the total share of energy in the global economy has risen from 6.5 percent to more than 13 percent. This means a net loss of 6.5 percent GDP, whether through an increase in prices relative to lower volumes or service output, or however one wants to define it. 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. 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. Which one will it be? That will be the critical question. 

The odds right now favour another 50-70 bps higher for US and 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. But beyond our 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. The battle is on, but to paraphrase Chauncey Gardiner, before we can have spring we must have fall and winter.  

Safe travels, 
Steen Jakobsen 

Chief Investment Officer, Saxo Bank Group 

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