As economic growth remains strong, led by sectors such as defence, artificial intelligence and the production of anti-obesity drugs, Saxo’s strategy team warns of the fragility of this ‘sandcastle economy’ quarterly outlook for the third quarter.
While their short-term outlook is neutral, this outlook explores the underlying threats of unsustainable US fiscal spending, geopolitical risks, and demographic trends that could destabilize current economic dynamics over the long term.
In his macroeconomic note, ‘Sandcastle Economics’, Peter Garnry, Saxo’s chief investment strategist, highlights the precarious nature of our current economic growth. He states, “Economic growth will remain steady, but along the way, several factors can destroy the sandcastle economy.”
Garnry explores the concept of a “two-lane economy,” where thriving sectors contrast with struggling sectors. This disparity complicates monetary policy, as bolstering weaker sectors could prolong inflation, raising economic costs. Inflation remains stubbornly high, prompting caution from the Fed and delaying rate cuts until a significant economic slowdown is seen.
- Fixed income: What to do until inflation stabilizes
With US and European government bond yields expected to remain pegged in the third quarter, the uncertain outlook for inflation remains despite less aggressive monetary policies. This is emphasized by Saxo’s chief fixed income strategist, Althea Spinozzi, who states in her outlook that “US bond yields are expected to remain high until inflation trends return decisively towards the 2% target. In contrast, Europe’s inflation rate has fallen below that of the US, allowing the ECB to potentially adopt less restrictive monetary policies.
Spinozzi also notes that the divergence between US and European interest rates “will keep bond volatility high, pushing us to weigh on high-quality credit and short-duration.”
Investment-grade corporate bonds “are likely to remain in good supply as the direction of inflation remains uncertain.” High-yield bonds, which act as a hedge against inflation, are also expected to remain supported despite tight spreads.
In this environment, it makes sense to maintain a cautious attitude and limit the duration of exposure. It is recommended to focus on quality and maturations up to five years, while being cautious with longer durations. Long-term interest rates remain vulnerable to inflationary trends and possible term premium recoveries.
- Commodities: Energy and grains take center stage as metals stall
Strong demand and production challenges are expected to continue to support commodities. While the metals sector, including gold and copper, is taking a breather after hitting record highs, energy and grains are poised for growth. Additionally, Ole Hansen, head of commodity strategy at Saxo, states that crude oil is “supported by the OPEC price ‘line in the sand’ and strong summer demand for mobility and cooling.”
Despite the energy pullback in the second quarter due to a deflated geopolitical risk premium, metals remain strong. However, Ole Hansen notes that “industrial metals require a recovery in Chinese demand to justify higher prices at this stage.”
The energy sector expects strong demand in the third quarter due to increased mobility and cooling needs amid seasonal heat waves. Speaking of heatwaves, the grains sector, which has been reeling from nearly two years of losses due to factors such as adverse weather, is showing signs of recovery in part due to short-covering by speculators. However, harsher weather from southern Brazil to Europe and Russia has raised concerns about rebuilding stocks.
In summary, while metals are consolidating, the energy and agriculture sectors are expected to be the key drivers of growth next quarter, supported by OPEC production curbs and weather-related grain supply concerns.
- Stocks: Are we blowing bubbles again?
As the third quarter of 2024 begins, the current market rally is showing signs reminiscent of 2021, driven by speculative growth in tech, crypto stocks, memes and high valuations in US stocks, “which is higher than what we saw during the dot-com bubble’. notes Peter Garnry, chief investment strategist. The index’s extreme concentration is evident, with the 10 largest stocks making up 35% of the S&P 500.
Despite the bullishness in US markets, we remain overweight European equities as “we believe European equities will appreciate higher relative to other markets due to the ECB rate cut in June and a pick-up in growth in the third quarter.”
Sectorally, we are positive on energy, healthcare, financials and information technology. Electrification is transforming the economy, creating opportunities in electricity grid infrastructure. Garnry reflects that the foundations laid to create an already interconnected European electricity market gives Europe the opportunity to gain the most, as it allows for “a higher degree of stability and diversification”.
In summary, while the US market may look stretched, European stocks and sectors linked to electrification are interesting sectors to watch.
- FX: High risk currencies to rise against havens
A bearish USD trend could extend into the third quarter if US economic weakness widens, although valuation and appeal to safe havens limit downside. High beta currencies such as the AUD and NZD are well positioned to outperform due to delayed central bank easing cycles and a stabilizing Chinese economy.
However, Charu Chanana, head of FX strategy, reports that “low-yielding currencies like the JPY and CHF are likely to underperform in a bearish dollar world due to negative carry.” Looking at the Japanese yen alone, it may face risks of easing carry trades as the Fed’s rate cut approaches, although the Bank of Japan’s hawkish stance is expected to fall short.
Emerging market (EM) carry trades could remain popular, but tighter risk management is required as yield gaps narrow. For example, “with the Mexican, South African and Indian elections out of the way, MXN, ZAR and INR could remain favored target currencies.” However, post-election uncertainty remains.
In summary, while the USD may face downside risks, select high-beta currencies and regular EM carry trades present potential opportunities in the evolving forex landscape.