Quarterly Outlook

Q4 2013

Insights

A race against time

STEEN JAKOBSEN, Chief Economist

We are running on empty and, going into 2014, I foresee a bigger discussion on what is the real exit strategy from this extend-and-pretend mentality.

Welcome to Saxo Bank and TradingFloor.coms Insights Q4 Outlook.

The sense of drift that epitomised the third quarter may just have turned on two key events in September: the surprise decision of the US Federal Reserve to delay tapering and German Chancellor Angela Merkels election victory. Merkels victory was expected. The US Fed decision, too, if you factor in weaker US data in September hardly out of character for a central bank to play it safe if in doubt. But what is indisputable is that while both events played out, markets were in stasis. That should now change. The German elections and its impact on the beleaguered Eurozone and the very future of the euro itself will now come to the fore. Indeed, it dominates the thoughts of Saxo Banks analysts in this edition of Insights Quarterly Outlook. The role of central banks as market changers, perhaps even just as market moderators, may also have reached a critical juncture. The Feds wavering, the Bank of Englands unraveling forward-guidance strategy and the Bank of Japans efforts to address the value of the yen have seen their credibility stretched to the limit. What is clear is that the fourth quarter will be pivotal. And it is likely to set the tone for much of 2014.

Kim Fournais Co-founder and CEO of Saxo Bank

Lars Seier Christensen Co-founder and CEO of Saxo Bank

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Contents
Q4 OUTLOOK, by STEEN JAKOBSEN, Chief Economist

Driven to distraction
EQUITY OUTLOOK, by PETER GARNRY, Head of Equity Strategy

Aiming for new highs

FX OUTLOOK, by JOHN J. HARDY, Head of FX Strategy

Hard landing
MACRO OUTLOOK, by MADS KOEFOED, Head of Macro Strategy

Debt-ceiling curveball
MACRO OUTLOOK, by TEIS KNUTHSEN, CIO Saxo Private Bank

Fazed and confused

MACRO OUTLOOK, by NICK BEECROFT, Chairman, Saxo Capital Markets UK Limited

Compromising factors
COMMODITY OUTLOOK, by OLE S. HANSEN, Head of Commodity Strategy

Holding fast

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Driven to distraction
As world growth looks set to slow again and fiscal spending cuts and emerging market woes move up the agenda, central banks are facing excruciating decisions and the clock is ticking.
by STEEN JAKOBSEN, Chief Economist

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The third quarter was rich in confusion with more of the usual glossing over from policymakers. While that was pretty much the cocktail expected, what is in store for the fourth quarter and the early part of 2014? Several trends are maturing simultaneously. There is the need to reset interest rate expectations after the US Federal Reserves non-tapering of its asset-buying programme, the current account trends, the tired emerging markets model and the end of extend-and-pretend as world growth looks destined to slow down once more.

Fed non-tapering
The Federal Open Market Committee (FOMC) issued a de facto Put option on the bond market by not proceeding with tapering in September. The committee also failed to get the desired effect from its forward guidance, in which it promised low rates for longer. Instead, the market took this, probably wrongly, as indicating a normalisation process. But there was never the substantial improvement in the economic data that Fed officials wanted as a pre-condition for starting the quantitative easing (QE) withdrawal in the first place. The Feds official excuse for not taking the patient off the QE drug was tighter monetary conditions another way of saying that its forward guidance failed to keep rate expectations from ramping higher for much of the year. The Fed has now drawn a line in the sand at 3 percent for 10-year US government bonds and 4.5 to 4.6 percent in 30-year mortgage rates. The fixed-income market can now compete fully with the embedded Fed Put on the equity market that

Alan Greenspan first put in place more than 25 years ago and was generously extended, to say the least, by Ben Bernanke. This makes for interesting analysis. One thing is the relative change in asset values. The relative equilibrium has shifted towards fixed income and away from equities. It will take the market several FOMC meetings to fully grasp this, but expect the 10-year US government bond rate to reach 2.25 percent by the end of Q4. Looking ahead to 2014, there is a fair chance of a retest of the old lows in yield based on a 2014 US growth forecast range of between minus 2 percent to plus 1 percent.

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 If a perfect storm is brewing on the economic horizon, it would be good news as the only way to stop the unprecedented monetary experiment is for it to fail

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Some of the slowdown in growth will be the legacy of the decline in job creation that has already been seen, as well as a lower labour market participation rate. In addition, the housing market is facing a huge headwind from a 120 basispoint increase in 30-year mortgage rates from less than 3.4 percent to more than 4.6 percent. This will change many US consumers minds on the status of home values and whether it is time to buy. Add to this the depressing budget talks in the US, which have started in earnest this is never a process that whips up the investment appetite of CEOs and CFOs. The reason for our relatively strong call on a slowdown from Q1 2014 and at least a few quarters forward is that a number of our independent models show the same trend: significantly lower readings mean a likely continuation of the disinflationary environment, fiscal spending cuts, emerging markets doubly hamstrung by lower demand from income-squeezed middle classes, as well as by less available liquidity to refuel from fixed income in Europe and the US. Our models are constructed to reflect both the cyclical nature of todays society, but also to pinpoint the leaders and laggards among the drivers for the economy. Hours worked, housing markets, inflation, yields, terms of trade and productivity are our primary indicators. Most people in the market seem to think that the equity market leads the economy, but in our models its the opposite we can actually show that the real economy leads the stock market by an average of three months. Hence, the relative slowdown we have seen in the past month will not really impact valuations before November or December.

Dont forget that stock markets, valuation and consumer demand are the first signposts of principal economic trends. Thats why we still see more upside in the S&P and risky assets precisely into November and December this year. If a perfect storm is brewing on the economic horizon, it would be good news as the only way to stop the unprecedented monetary experiment is for it to fail to show that it is generating what always must be the number one priority: more jobs and rising incomes. All major historic shifts in policy have only come as a result of massive stock market declines or unemployment rates becoming too high and too painful to ignore. We may reach this threshold for change in 2014, but for now we are only readjusting back to more QE rather than less, which will mean one or two more months of selling hope and rising market valuations.

Watch Steen talk about his Q4 forecast

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Emerging market trends

China is again fuelling credit growth after a too-steep slowdown in growth seems to have scared the political elite. But this will only make 2014 more difficult for the country as the shadow banking economy (accounting for 65 percent of GDP) cant keep leveraging up forever. China will need to not only deleverage, but also to substitute exports with domestic demand. It could and will happen but not overnight. The path to a better growth composition is via lower growth first, a redefinition of the economy and then on to a better place. China is a tired 34 year old (the present economic model was born in 1979) that needs to reassess its life and goals. But for now, Chinas creation of debt will make Q3 and early Q4 better for green shoots and commodities. The one dominant force that too many people ignore is the trend in current accounts. Before the crisis started, the much-discussed BRIC countries ran a surplus of 5 percent to 7 percent of GDP. Now, these are reduced to a zero balance with an outlook for them to go negative. This obviously alters dramatically the leverage of any society. If you always have more money than you spend, you can invest or over-consume. But when you have less money than you spend a current account deficit you become dependent on a bank credit line and you have to reduce your expenditure. Emerging markets need this slowdown as their models, largely built on exports only, became unsustainable. Remember that

all current accounts globally add up to zero as one nations surplus is anothers deficit. When someone makes money, someone else loses. We cant all live from exporting, although this does seem to be Germanys and the IMFs rescue blueprint.

 Prepare for a good start to Q4, but for building headwinds as we roll the calendar to 2014.

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 SMEs work longer, cheaper, with higher risk reward, and are less dependent on absolute interest rate levels. If there ever was a time for the politicians and policymakers to embrace the supply side of the economy, its right now.

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Energise the SMEs

But whats the alternative? Investment, consumption and activating the small and medium-sized enterprises (SMEs) sector. Dont forget that all monetary policy in the QE regime is directed at 20 percent of the economy that comprises listed companies and large banks under quasi-state sponsorship. This 20 percent gets 95 percent of all credit and political capital. This leaves the 80 percent of the job creation engine the SMEs starved of crucial oxygen, or access to credit. This is ironic as SMEs account for 67 percent of jobs globally and have created 85 percent of all jobs in Europe since 2000. SMEs work longer, cheaper, with higher risk reward, and are less dependent on absolute interest rate levels. If there ever was a time for the politicians and policymakers to embrace the supply side of the economy, its right now. We are running on empty and, going into 2014, I foresee a bigger discussion on what is the real exit strategy from this extend-and-pretend mentality. Right now, there are really only two paths: inflating the economy to reduce the burden of debt (which will not happen) or writing off the debt between Treasuries and central banks basically putting all the paper the central banks have bought into the shredder. But this makes the mistake of ignoring historical precedent. The last time the Fed engaged in a similar exercise of helping the market was during the 1940s, when it was ultimately rescued by deflation and a recession. That increased the demand for Treasuries on its balance sheet and when the bank and end-

investor started bidding up fixed income, the Fed could reduce its exposure. It did extend the recession, but it also saved the central banks bacon. This might be exactly what will happen in 2014. The wake up will be global growth going zero-bound again. This would ease the burden of reducing the bloated balance sheets, but would also rebalance the economy for a strong recovery in 2015. I know we are now looking way into the future, but the mandate for change is coming not because we want it or see it, but because we need it. Prepare for a good start to Q4, but for building headwinds as we roll the calendar to 2014. Use 2014 to clean up and prepare for a world that is increasingly more balanced, less leveraged and more proactively helping the one part of the economy we have kept outside the loop throughout this cycle: the SMEs.

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GRAPHIC 1

New home sales vs. ratio of houses for sale to houses sold (months supply)

-1.5 -4 40 -3 20 -2 -0.5 1Y actual change of sales of new one-family houses (moved forward 3 months) 1Y actual change of median price of new one-family houses sold during month (inverted) -1.0 Key

-1 0 0

1Y actual change of ration of houses for sale to houses sold (months supply) 0.5 Detrended US FRM 30-year contract (inverted, moved forward 4 months)

-20 1

-40

1.0

3 -60 02 04 06 08 10 12 14 1.5

Graphic 1 Source: Thomson Reuters Datastream

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Aiming for new highs

As the global economy continues to make a slow recovery, not even the joker of the US debt-ceiling bomb can stop equities soaring.
by PETER GARNRY, Head of Equity Strategy

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Equities remain the most attractive asset class in the coming years based on three main factors. Firstly, central banks around the world will continue to keep interest rates low to buy time for fiscal consolidation and allow for economic reforms to filter through to the economy. Secondly, leading global economic indicators continue to signal that the global economy is about to shift into a higher gear. And finally, equity-risk premiums will continue to decline due to the improving economy and contracting tail risks leading to higher equity valuations.

US joker
Equity markets may, however, lose their tranquility in the early part of the fourth quarter as the US debt-ceiling debate may yet again shake markets. This could cause volatility and downside risk to equities during October. My base scenario, however, is for the Republicans and Democrats to find a solution. Once we are on the other side of the US debt debacle, equity markets will again begin to discount the improving global economy and push towards new highs before the end of the year. Previously, we highlighted that global equities remain undervalued compared with their average valuation since 1996 and that still holds true. The current valuation is about a half standard deviation below average. This time, we also calculated the implied cost of equity for US stocks since 1990. Based on this indicator, they still remain cheap, albeit approaching fair value.

 The era of paradoxical financial markets will end and normal functioning markets will be restored. If not, all of our theories must be wrong.

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Some appreciation
Despite the concerns and challenges facing the economy, risk assets (such as equities) have always appreciated over the long term. If history is a guidance, then our best forecast would be to expect that trend to continue. Another supposed financial market law is that equities outperform fixed income over time. Since 1929, equities have outperformed long-term government bonds by 4.2 percent annually. This is also known as the equity-risk premium. If the historical equity-risk premium is projected since 1992 for US equities, while comparing it to the relative performance between the S&P 500 and US seven to 10-year Treasuries, then the case for investing in equities remains intact. Equities have underperformed fixed income since 1992, highlighting the perverse in mean-variance jargon the inverted relationship between return and risk, in which fixed income has provided higher returns with less risk compared to equities. This recent relationship highlights the unconventional period we have seen in the past two decades, with huge oscillations concerning the equity-risk premium trend. The era of paradoxical financial markets will end and normal functioning markets will be restored. If not, all our theories must be wrong. As the global economy continues to recover, the current highrisk premium on equities will drop and push equities higher both in absolute and relative terms compared to fixed income. My take is that equities will be the best asset class both in

absolute and relative terms over the next couple of years, so forget everything about Shillers price-to-earnings ratio or all-time highs and be overweight in equities. If equities do not outperform over the coming years, it means either the historical equity-risk premium theory should probably be revised, or the global economy would have fallen back into recession.

 If equities do not outperform over the coming years, it means either the historical equity-risk premium theory should probably be revised, or the global economy would have fallen back into recession.

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Mine the stock

In the past couple of months, our quantitative model has signalled that European mining companies are undervalued by a wide margin, based on analyst expectations for future return on invested capital. The lack of positive market signals, with relative momentum being quite weak, has kept us from taking a positive view on mining stocks. But entering the fourth quarter, the outlook has finally changed for these stocks. Rio Tinto leads the pack with a positive view in our model. Analyst expectations are high regarding Rio Tintos profitability over the next 24 months and, given the mining companys current valuation, there is plenty of upside. Our model indicates that the upside is about 35 percent. With perceptions finally changing due to the brightening outlook for the global economy, the stock is likely to experience some tailwind. The driving force behind this potential bull market is lower supply as mining companies in recent years have cut back on capacity. But demand is now increasing due to the Chinese-driven pickup in the global economy. The fourth quarter may mark the beginning of a renaissance for mining companies following more than two years of underperformance relative to global equities. If the global economy picks up, as currently signalled by leading economic indicators, mining companies could in the coming quarters represent the most exciting bull market within equities.

Watch Peter talk about his Q4 forecast

 The fourth quarter may mark the beginning of a renaissance for mining companies following more than two years of underperformance relative to global equities.

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Cornering the market

The third quarter marked the beginning of Quant Corner, a blog on TradingFloor.com that features Saxo Banks newly developed quantitative models and the light they shed on European equities. Quant Corner is published four times a week. The first weekly post focuses on banks, the second on non-financials, the third on its conviction within non-financials and the fourth looks at its views on insurance. The quantitative models behind the first three reports incorporate factors relevant to each market segment to best explain variations in price-to-book ratios. Based on the best fit and taking into account underlying factors and current valuations, a model-driven valuation for each stock is given. Currently, the top view for each model (based on data from September 23) is illustrated in the table below.

Quant Corner: View on European equities

Market segment Banks Non-financial (liquid) Insurance
Source: Bloomberg, Saxo Bank * Based on data from September 23, 2013

Most positive Deutsche Bank (DBK:xetr) Fiat (F:xmil) ING(ING:xams)

Most negative Commerzbank (CBK:xetr) Repsol (REP:xmce) Baloise (BALN:xvtx)

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Among European banks, the model is most positive on Deutsche Bank despite ongoing uncertainty about its Basel III Common Equity Tier 1 capital and leverage ratios. Commerzbank is the models least favourite bank driven by a valuation that actually does not reflect the very low analyst expectations for return on equity in 24 months. Fiat is the models top pick among European non-financial stocks as the current valuation does not reflect the ongoing improvement in fundamentals among global carmakers. Repsol is the least favourite non-financial stock as expectations for return on invested capital remain significantly below the average cost of capital. The model for insurers is most bullish on ING, which is currently experiencing a tailwind from the planned separation of its insurance arm from its banking business, a step that will unlock shareholder value. Baloise is the models least favourite insurer as the Swiss-based firm is facing headwinds in its non-life insurance business.

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10 9

GRAPHIC 1

S&P500

1.4

GRAPHIC 2

Mining companies have been underperforming

1.2 8 7 6 5 4 3 2 1 0 90 92 94 96 98 00 02 04 06 08 10 12 14 Key 0.2 Implied cost of equity (%) +1.5 std. (cheap) -1.5 std. (expensive) 0 Bloomberg World Mining Index 0.6 1.0

0.8

0.4

Key Bloomberg World Index

JUL-11

OCT-11

JAN-12

APR-12

JUL-12

OCT-12

JAN-13

APR-13

JUL-13

3.0

GRAPHIC 3

The big repricing between equities and xed-income continues

2.5

2.0 Key S&P500 total return / US Treasuries 7-10 year total return Equity-risk premium (4.2% in the period 1928-2013)

1.5

1.0

0.5

0.0 92 94 96 98 00 02 04 06 08 10 12

Source: Bloomberg, Saxo Bank

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Hard landing
The US Feds failure to give tapering lift-off at the tail end of Q3 may have sounded the death knell for its credibility, but it has also left markets wondering if it was nothing more than a one-meeting delay.
by JOHN J. HARDY, Head of FX Strategy

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Underwhelmed. Its a pretty apt way of depicting how the third quarter played out among the major currencies as momentum ebbed and the quarter was rendered something of a damp squib. Sure, emerging markets saw considerable fireworks as the fear of the US Federal Reserves taper generated a liquidity pinch that exposed ugly current account imbalances in countries such as Turkey, India, Indonesia and Brazil. But elsewhere, there was a lack of conviction. The market clearly deleveraged on its former bets of AUD weakness and even JPY weakness, as well as USD strength. But it seemed unconvinced that the opposite side of those trades offered any future. Going into the fourth quarter, the market is wondering if the Federal Open Market Committees (FOMC) September 18 notaper bombshell was a one-meeting delay due to uncertainty over the improvement in US economic data, or more about FOMC concerns over the now yearly political wrangling over the US budget and the next raising of the debt ceiling. Elsewhere, the German election outcome saw a strong vote for Chancellor Angela Merkel, but a weak result for her coalition prospects. Weak German leadership in the Eurozone can only mean a Europe that careens from one crisis to the next as before with ad hoc decision-making. The market appears very complacent on Europe.

The theme of failed QE could emerge strongly in the coming quarter and we are probably on the way towards central banks losing more and more credibility.

US dollar pushback
Any breakout of this feeling of limbo early in Q4 depends on a generally mean-reverting stance in the markets, with the idea that the most recent moves will likely be retraced. This would mean the US dollar could push back after a weak Q3 performance, the euro upside would be shown to have been overdone and the commodity currency rally would also falter. Not particularly compelling stuff but this could be the quiet before the storm. Late in Q4 or early in Q1, the market will increasingly feel that the quantitative easing (QE) game is less able to move markets than it did in recent years. There have already been signs

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that forward guidance is failing as a policy tool and crisis-hit emerging markets will be picking up the pieces even if the rate of money printing stays high. Is it time for the realisation that QE is failing the major economies as well? The theme of failed QE could emerge strongly in the coming quarter and we are probably on the way towards central banks losing more and more credibility. Aside from the US economic trajectory and how that impinges on Fed tapering prospects and ongoing EU uncertainty postGermanys election, there are two further themes that could crop up in Q4: Risk appetite: it was telling that the initial reaction to the FOMCs shock decision failed to hold. Is QE merely a confidence game of hot potato bidding up asset prices in response to endless Fed liquidity because it seems the only alternative is the hope there will always be a greater fool on which to unload? It is clear that the Fed has backed itself into a corner when the mere mention of the idea of a slowdown in asset purchases over the summer triggered de facto massive tightening in markets via higher bond yields (especially at the belly of the yield curve) and sent emerging markets tumbling. Bank of Japan policy hints: in September, finance minister Taro Aso mentioned the idea of a new stimulus without the issuance of bonds. This failed to receive much notice, but is the evolutionary next step in policy, in which central banks recede into the background as money printing may eventually be superseded by governments outright printing of money to finance activities, an exercise known as overt monetary

financing. New policy extremes like this are more likely if Prime Minister Shinzo Abes moves thus far show signs of faltering and if the JPY begins to strengthen sharply again.

 The transition to a new Fed chairman as its credibility is in question could hardly be happening at a more interesting time.

USD QE delay or derail?

The USD remains about the when and whether of the taper as well as the factors that affect the Feds decision-making, including the political wrangling over the budget and debt ceiling. We may see a rough October for the USD on the political gridlock, but the base case is that the log jam is cleared by November without permanent damage. The transition to a new Fed chairman as its credibility is in question could hardly be happening at a more interesting time. Even a complete lack of Fed tapering might not prove so USD bearish in the medium term as the conditions that would accompany a delay to tapering would likely mean asset-market weakness, which could prove USD supportive from a safe-haven standpoint.

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EUR weak German government means trouble

European Central Bank (ECB) president Mario Draghi took the bank into the brave new world of forward guidance for the first time this year and the market shrugged its shoulders. Actions will speak louder than words for the ECB in Q4 and Draghi is likely to do what he can to prevent further euro strengthening more than just a possible 25 bp cut. Meanwhile, one wonders if German behaviour is set to change at all as the government will be weak despite Angela Merkels resounding personal victory. Europe has shown that it can stagger from one mini-crisis to the next for years, but the fundamental predicament remains the same: one central bank and currency with multiple sovereigns. The only thing that is certain is that the market is extremely complacent on political risks in the EU and is sceptical that the ECB can or will do much. The surprise side for EURUSD couldnt be clearer.

GBP UK lift-off or mean reversion?

The UK pulled off what no one expected in Q3 signs of a strong recovery just as the market was anticipating the arrival of a very dovish central bank governor who would test the outer edge of the dovish policy envelope. GBP ripped higher in response, testing new highs since early this year versus the euro and the USD. New Bank of England (BoE) governor Mark Carney promptly set about peddling forward guidance to convince the market that the central bank was happy with how things were going and had no intention of touching rates for a long time. The market is letting the data do the talking for now. But there is no escape velocity for an economy so burdened in the public and private sectors with high debt levels while the government maintains an austere stance.

JPY bearish with a sting

There is no turning back for the BoJ or Abe, but if the central banks policy is unchanged and we get a risk-off, such as a government bond yield down move in Q4 (odds increasing if faith in QE falters), this will likely send the JPY carry traders for the exits in a temporary challenge of one of the great consensus trades of the year. This, in turn, is what may provide the foundation for the next big JPY weakening move as we are sure to see a strong eventual BoJ/Abe response.

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CHF no visibility
The hope that the German election might provide some visibility on Europe did not materialise and CHF could drift stronger against the euro back closer to the 1.20 peg. Eventually, the Swiss National Bank will feel backed into a corner and will act, but it is holding its cards very close to its chest this year.

Europe has shown that it can stagger from one mini-crisis to the next for years, but the fundamental predicament remains the same: one central bank and currency with multiple sovereigns.

AUD, CAD and NZD the comeback wont last

AUD squeezed back higher on fresh hopes that China can restart its old style of growth and on unwinding of one of Q2s most popular trades. But Australian domestic fundamentals remain dismal and are on the downslope of a deleveraging cycle after a credit and mining bubble. Meanwhile, CAD was the recent weakling of the trio on drifting US economic hopes and the limp USD. The kiwi has been the market darling on the back of Reserve Bank of New Zealand policies and robust risk-appetite in developed markets. I would expect mean reversion in the relative performance of all three in Q4: NZD weakest, then AUD, then CAD.

SEK and NOK downside risk

NOK has been up to some serious mischief again as Norges Bank continues to confound the markets attempts to anticipate policy. An incredible ramp in Norways core CPI data saw Norges Bank barely bat an eye and downside risks dominate for the two Scandies more for SEK than NOK eventually as the market remains too complacent on the risks from Swedens overleveraged private sector.

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Watch John talk about his Q4 forecast

Trading themes in Q4
Short NZDCAD: relative valuation trade (mean reversion) NZ economic mean-reversion and an unwinding of almost 100 bps of anticipated RBNZ hikes could hit NZD hard in Q4. Short EURUSD and long USDSEK: market too complacent on EU risks and Swedens structural risks. Long JPY calls: perhaps against a basket of AUD, GBP and EUR. The JPY weakening will come, but not until 2014? Long GBP/NOK: upside potential if the market starts to fret liquidity and oil prices come off heavily.

Benchmark forecasts
Currency Pair EURUSD USDJPY EURJPY GBPUSD EURGBP EURCHF USDCHF AUDUSD USDCAD NZDUSD EURSEK EURNOK 3 months 1.26 98 123 1.52 0.83 1.23 0.97 0.88 1.06 0.76 8.80 8.15 6 months 1.19 105 125 1.48 0.80 1.25 1.05 0.82 1.10 0.72 9.20 8.30 12 months 1.16 112 130 1.46 0.80 1.30 1.12 0.76 1.15 0.66 9.00 8.00

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GRAPHIC 1
18

USDJPY overview

GRAPHIC 3 Table of benchmark forecasts

1.26 1.19 1.16 98 105 112 123 125 130 1.52 1.48 1.46 0.83 0.80 0.80 1.23 1.25 1.30

16

14

12

10

6
Q3-10 Q4-10 Q1-11 Q2-11 Q3-11 Q4-11 Q1-12 Q2-12 Q3-12 Q4-12 Q1-13 Q2-13 Q3-13 Q4-13

0.97 1.05 1.12 0.88 0.82 0.76 1.06 1.10 1.15 0.76 0.72 0.66 8.80 9.20 9.00 8.15 8.30 8.00

GRAPHIC 2
115 110 105

NZD vs rest of G10

Key 100 NZD 95 200-day SMA 90 85 80 75

JAN-05 JAN-06 JAN-07 JAN-08 JAN-09 JAN-10 JAN-11 JAN-12 JAN-13

Key 3 months 6 months 12 months

Source: Bloomberg, Saxo Bank

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Debt-ceiling curveball
The global economy looks set for some acceleration into the New Year, but the annual US political battle over the budget and the impact it has on the debt ceiling could throw a curveball into the economic picture.
by MADS KOEFOED, Head of Macro Strategy

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 The longer the uncertainty over the ceiling lingers, the more adverse the impact is on an economy that is otherwise showing resilience in the face of sequestration and rising interest rates.

The world economy is showing signs of strengthening following a subpar first half of the year, with leading indicators pointing towards a stronger pace of growth in the fourth quarter and into 2014. Developed economies have been signalling a stronger rate of expansion for some months now. After experiencing a weak first half, China has also joined the growth wave, which is particularly encouraging for global trade prospects. With that in mind, the global economy is set to accelerate at the end of this year and into 2014, when global growth could hit 2.7 percent, up from 2 percent this year.

The US shuts down

In August 2011, bickering over the US debt ceiling reached new heights when Standard & Poors downgraded the long-term rating of US government bonds for the first time in history, sending confidence among both consumers and businesses markedly lower. Notably, the crash in the Philadelphia Fed survey that month to minus 19 from 9.4 in July 2011 took it to the lowest reading of the recovery and spurred cries that it was about to embark on a new recession. A recession was, however, averted with the US economy accelerating into the fourth quarter when it posted the strongest quarterly growth rate of 4.9 percent (annualised) since the current expansion began in the third quarter of 2009. The first quarter of 2011 so far remains the only quarter with negative growth of 1.3 percent. The US recovered then, but a new round of bickering and resultant market tension may be upon us. The fiscal year began on October 1 and no budget was passed, leading to a

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government shutdown. If the shutdown is limited to a couple of weeks, it should not be too disruptive to the US economy as all necessary public workers are still required to report for duty. A breach of the debt ceiling and subsequent exhaustion of emergency funding, however, is a different matter altogether and the latter is currently projected to happen later this month or early next month. I expect Congress to find an agreement, which has been the case many times before, but the longer the uncertainty over the ceiling lingers, the more adverse the impact will be on an economy that is otherwise showing resilience in the face of sequestration and rising interest rates. The US labour market has lost momentum in recent months, but continues to add jobs at a reasonable pace. Private sector jobs have increased by 1.485 million year-to-date, while jobless claims are at a six-year low. Housing, too, has softened in the face of rising mortgage rates with building permits barely up over the six months through to August. Nevertheless, housing is expected to continue to contribute positively to the economy going forward a view that is supported by homebuilders. The positive impact on the economy is twofold; directly through housing-related investment and indirectly through higher purchasing power as higher house prices help to repair households balance sheets. The main risk to our US outlook is political as Congress has the power to once again disrupt the economy. I expect a solution to be found quickly and project growth to pick up pace in the final quarter of the year, which will allow the Fed to finally

begin the tapering of its quantitative easing programme although an October tapering is out of the question. I expect US GDP to climb 1.6 percent this year and 2.7 percent in 2014.

 In addition to stronger global trade, the drag from austerity measures, which have regrettably mostly centred on tax hikes, should fade a bit and lessen the pressure on households purchasing power.

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Eurozone recovery grabs

The euro area escaped the longest recession on record in its short history in the second quarter and available data suggests consolidation of the recovery in the second half of the year as the impact from austerity efforts fade and global trade picks up. Among the global economies expected to accelerate is the Chinese, which is on track for a moderately stronger finish to 2013. This is particularly important for Germany, which has seen China emerge as one of its biggest trading partners. Chinas progress should help keep a hand under German exports. Furthermore, the domestic German economy looks to be in good shape with consumer confidence climbing on close to record-low unemployment, real wage growth and sound household balance sheets. Private consumption should, therefore, continue to contribute to German growth in the coming quarters following the 0.7 percent increase in the first half of 2013. In addition to stronger global trade, the drag from austerity

measures, which have regrettably mostly centred on tax hikes, should fade and lessen the pressure on households purchasing power. Having said that, the turnaround will be slow due to the wealth of excess capacity in the economy both in terms of machinery and not least the more than 19 million unemployed.

Capped consumption growth

Wage growth will therefore be muted and keep a lid on consumption growth. Hence, I expect only a modest expansion of 0.8 percent in the Eurozone economy in 2014, below the current consensus estimate of 1 percent. However, 2013 euro area growth has been lifted to minus 0.3 percent following the strong second-quarter print. Even in the struggling southern countries, namely Spain and Italy, the end of recession is in sight.

 Evidence that the Chinese consumer can pick up the tab is not convincing as it would require consistently high growth in private consumption over many years.

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China picks up moderately

The Chinese economy struggled to overcome a downshift in economic growth in the first half of the year, with Chinas new leadership not keen to provide more stimuli. The result was GDP growth of just 7.5 percent year-on-year in the second quarter and mounting concerns about the likelihood of hitting that growth target. Since then, economic activity has improved, external demand, in particular, has been strong and recent trade data from South Korea suggests that this will continue. Furthermore, the largest importer of Chinese goods the euro area has finally escaped recession, which should also help Chinese exporters. However, inventory restocking has also been key to increased activity and it is unlikely to continue at the current rate. Hence, the prospects for the Chinese economy are for a moderate pickup in the final quarter of 2013 and into 2014, but the shelf life for such growth will be limited. Chinas leadership remains focused on keeping credit growth in check and new yuan loans are up just shy of 3 percent year-on-year through to August. Steering the Chinese economy towards a more sustainable growth path is a long-term project, but tentative signs indicate that the process has begun through efforts like restraining credit growth. However, fixed-asset investment continues to grow at an unsustainable rate of 20 percent a year and when readjustment begins in earnest, such investments should markedly drop. This leaves private consumption to compensate for the resultant negative impact on growth. Evidence that the Chinese consumer can pick up the tab is not convincing as it would require consistently high growth in private consumption over many years. Therefore, I see much lower Chinese growth in the medium to long term, likely even going below 5 percent. In the short term, however, the picture is brighter and I expect growth of about 7.5 percent both this year and in 2014.

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GRAPHIC 1
Change YoY % 15

Global PMI manufacturing vs global industrial production

Index 65 25

GRAPHIC 2
Change YoY %

China picks up moderately

Change YoY % Key Industrial production (left axis) 10 8 6 4

10

60

20 Leading indicators (right axis)

55 15

2 0 -2

0 Key -5 Global PMI manufacturing Global industrial production OECD global leading indicator

50 10 45 40 35 05 06 07 08 09 10 11 12 13 5

-4 -6

-10 -15

0 07 08 09 10 11 12 13

-8

GRAPHIC 3
Change, thousand 350 300 250 200 150 100 50 0 JAN-11 APR-11 Key JUL-11 OCT-11

US labour market
Thousand 450 430 410 390 370 350 330 310 290 270 250 JAN-12 APR-12 JUL-12 OCT-12 JAN-13 APR-13 JUL-13 90 110 120 140 150

GRAPHIC 4
Index, Dec 05 = 100

German exports
% 7 6 5 4 3 2 1 0

130

100

05

06

07 Key

08

09

10

11

12

Nonfarm payrolls

Private payrolls

Initial jobless claims (right axis)

Total (12-month MA)

Chinas share of total exports

Source: Bloomberg, Saxo Bank

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Table 1

Growth of GDP in % for 2012, 2013* and 2014*

-0.5 -0.3 0.8 Strong German households will aid consumption, while Italy and Spain are slowly seeing the results of reforms. The worst in terms of austerity is behind us. The failure to move decisively on reforms will result in subpar growth in France in the coming years. Italy is still too uncompetitive. Urban redevelopment and new, similar programmes will help stimulate the economy. Uptick in global trade growth also positive for China. Tighter monetary and fiscal policies and a heightened focus on rebalancing the economy by the new administration will result in weaker growth going forward. Investment still accounts for too large a share of economic growth.

7.8 7.5 7.5 1.3

2.0 1.8

Premier Shinzo Abes mandate to spend will see public consumption underpin economic growth. A corporate tax cut is also a possibility, but more likely in 2014. An increase in the consumption tax will likely be implemented in 2014, which will curtail domestic consumption.

0.3 1.2 1.7 Government and central bank policies remain supportive, including support for housing. 1.6

2.1

2.1 2.0 2.7 2.7 Fiscal consolidation in lower gear, which will aid growth in developed economies. Exports from developing economies to gain from fading austerity in euro area and stronger US consumers. The upheaval in emerging market economies caused (in part) by QE tapering speculation could send inflation north and lead to premature tightening of central bank rates India is a case in point.

The labour and housing sectors continue to recover, which stimulates private consumption and housing investment and repairs household balance sheets. The fiscal drag is expected to continue throughout the year before fading in 2014. A government shutdown will not have much of an economic impact, but a failure to raise the debt ceiling will.

Further cuts to the public budget as targets are missed.

Key GDP growth 2012 GDP growth 2013 GDP growth 2014 Upside Downside

*Note: GDP is real, inflation-adjusted, year-on-year changes in percent. 2012 is actual, while 2013 and 2014 are forecasts.

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Fazed and confused

An unprecedented experiment and crossed wires has led to confusion by the truckload in an era where real decision-making is an increasing rarity.
by TEIS KNUTSHSEN, CIO Saxo Private Bank

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Modern monetary policy appears strangely similar to the 1970s sitcom Soap. Bereft of the classical policy framework, we are watching an infinity loop of central bankers spinning the printing presses over and over, trying to provide an escape velocity from a financial crisis by pumping up asset values, strangely believing that deleveraging fatigue is best cured by encouraging, yes, more borrowing. At all costs, a mark to market of the financial sector is to be avoided. Confused? Yes, you will be, also after the next press conference. Or take it from the Sage of Omaha, legendary investor Warren Buffet: We are in an experiment which hasnt really been tried before.

gradually over the coming years. Unemployment rates will fall and inflation will rise, but only modestly so. The framework for forward guidance targets an inflation rate of 2 percent, with a threshold of 2.5 percent. A downside threshold, say at 1.5 percent, is being considered. As for the unemployment rate, the framework is to link tapering to a 7 percent level and to link any rate hike to a 6.5 percent jobless level, but these are not targets that tie the Fed to any mast. The result could be that the 6.5 percent target for unemployment will be joined to an expectation of a nearterm inflation rate of 2 percent. Ben Bernanke is likely to leave that decision to the next Fed chair(wo)man. This is all a bit fuzzy these days, partly because the Feds forward guidance is clashing with a market that is pricing a recovery that ultimately the Fed also believes in. Nonetheless, my view is that tapering will commence around the turn of the year and that the third phase of the quantitative easing (QE3) programme will be terminated in a years time. The first interest rate hike will probably be delayed to late 2015 or early 2016. Fed funds futures for August 2016 delivery dropped 40 basis points after the Federal Open Market Committee meeting and now imply a 1.69 percent rate. This seems adequate for now. At the long end of the curve, bond yields are unlikely to rise further in the coming months and may well correct lower, reflecting a lower expected trajectory for Fed funds.

Below capacity
Ultimately, the Federal Reserves decision to postpone the tapering of asset purchases acknowledged that the US economy was still growing well below its capacity, that unemployment was high, inflation low, and that the budget dispute and the fiscal drag continued to weigh on the prospects of a sustainable recovery. With no smoking gun, the Fed could hold off on the decision to withdraw stimulus and monitor, among other things, how rising mortgage rates are impacting the economy. The fact that real rates fell and break-even inflation rates rose immediately after the announcement suggests that the Fed got it right this time. Nothing was lost. Well, apart perhaps from its communication policy. The Feds view is that the US economy will strengthen

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 We are watching an infinity loop of central bankers spinning the printing presses over and over, trying to provide escape velocity from a financial crisis by pumping up asset values.

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Articial sweeteners
At a deeper level, the Feds non-decision is symptomatic of an era where real decisions are hard to come by and where policymakers at many levels seem to fear the harshness of life without artificial sweeteners. A full life, however, cannot be lived on a sugar high and although financial markets the world over welcomed the move, perhaps one ought to reflect on the price that must ultimately be paid. I remember only too well the fear that the LTCM bailout and the Greenspan Put in 1998 would lead to a housing bubble. Well, it did. Back on this side of the Atlantic, the European Central Bank (ECB) introduced forward guidance at its July meeting, pledging to keep rates at current or lower levels for an extended period of time. As in the US, the purpose is to prevent interest rates rising in anticipation of further economic recovery. In August, the ECB talked of unwarranted market pricing, a comment that went missing again at its latest meeting in September. Overall, the ECB strikes a dovish tone, with president Mario Draghi straining to talk down economic recovery expectations. The euro area exited recession in Q2 and a range of indicators point to further improvement in the months ahead. However, the ECB must take into account that conditions vary dramatically across the monetary union, with the weaker parts of the area still in need of as much support as can be found. With core inflation low, unemployment high and spare capacity massive, there is little risk of the central bank being behind the curve for now.

 At a deeper level, the Feds nondecision is symptomatic of an era where real decisions are hard to come by and where policymakers at many levels seem to fear the harshness of life without artificial sweeteners.

Although a rate cut at this point looks unlikely, the ECB can add stimulus either through its outright monetary transaction (OMT) bond purchase programme or, perhaps more likely, through a round of VLTRO (very long-term refinancing operations). Either way, the front end of the curve will remain anchored at extremely low levels in the coming months. This also suggests that long-term bond yields will find little support to rise further from monetary policy and that German 10-year yields may pause below the 2 percent mark. Despite the differences in monetary policy communication between the US and the euro area this year, relative rates have moved very little and the two-year swap spread has mostly stayed within a tight +/- 10 basis-point range. For EURUSD, monetary policy has therefore yet to emerge as a key driver.

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 My view is that tapering will commence around the turn of the year.

Watch Teis talk about his Q4 forecast

Emerging market fallout

If Bernanke threw a spanner in the works on May 22, the fallout was felt the most in many emerging market countries. Over the summer, for instance, the Indian rupee and the Turkish lira fell to their lowest levels ever, while both the South African rand and Brazilian real fell to their weakest points since 2008. Many commentators tied this development to the perceived change in the global liquidity cycle, and a reversal in the search for yield among investors that had benefitted emerging market (EM) debt and equities. If fear of US policy tightening is being rolled back, one could also expect EM losses to be reversed as investors once again board the carry train. In truth, however, EM weakness has also reflected a less than impressive macro development, with countries like India falling short of expectations on reforms and economic benchmarks. Steps to lift policy credibility remain crucial. With that in mind, the change of guard at the Reserve Bank of India, where the respected economist Raghuram Rajan has stepped in as governor, should not be ignored. On balance, after three years of widespread EM underperformance, the rest of the year may provide a milder climate and we are generally looking for EM as a whole to claw back some of what was lost.

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GRAPHIC 1
%

US 10-year government bond yield

GRAPHIC 2

US spot and forward rates

% 3 2.5 2.0 1.5 1.0 0.5 0 -0.5 -1.0 J M M J S 2010 N J M M J S 2011 N J M M J S 2012 N J M M J 2012 S Key Break-even inflation rate Real yield 10 9 8 7 6 5 4 3 2 1 0 90 95 00 10 15 Forward rates Key Fed funds 5 year

GRAPHIC 3
Index 2000 1800 1600 1400 1200 1000 800 600 400 200 0 J M M J S 2009 N J M M J 2010 S N

S&P500

GRAPHIC 4
Currency units, trillion 4.0

US money base

QE-1

QE-2

TWIST

QE-3

3.5 3.0 2.5 2.0 1.5 1.0 0.5 0

QE-1

QE-2

TWIST

QE-3

J M M J S 2011

J M M J S 2012

J M M J 2013

M M J S 2009

J M M J 2010

S N

J M M J S 2011

J M M J S 2012

J M M J 2013

Source: Macrobond, Saxo PrivatBank

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Compromising factors
The year of sticking to the well-trodden path was perhaps best epitomised by the US Feds last-minute loss of faith on tapering, an about-face decision that has damaged its credibility.
by NICK BEECROFT, Chairman, Saxo Capital Markets UK Limited

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No fewer than six ministers in the present UK governments cabinet, including the prime minister, are Oxford University Politics, Philosophy and Economics (PPE) graduates. Twentysix of Britains 54 Prime Ministers went to Oxford and since its invention at Balliol College in the 1920s, PPE has become the degree course of choice for budding UK politicians. There is some justification for this; the deft combination of all three disciplines could be said to encompass the prerequisites for the successful management of any country and this year, certainly, a philosophical outlook on life seems to have become de rigueur for politicians globally. 2013 is looking increasingly like a year one can split into three very distinct thirds. The first third took us up to May, encompassing the Cypriot crisis and the inconclusive Italian election, sending risk markets into tailspins and yields lower, and finishing when outgoing US Federal Reserve chairman Ben Bernanke first mentioned the possibility that the Fed may taper, or reduce, its bond-buying quantitative easing programme. After Bernankes comments, the second third was characterised by a sharp increase in US Treasury and mortgage-backed security yields, with the 10-year Treasury note yield rising from 1.63 percent in May to a peak of 3 percent in early September, just before the release of slightly tepid data on US unemployment. Finally, we have entered the last third of the year, which began with a bang when the Fed confounded every single

expert, including this one, by failing to taper at its September Federal Open Market Committee (FOMC) meeting.

 Summers is such a divisive figure, provoking such entrenched support or opprobrium, that it became expedient for President Barack Obama to compromise...

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 Given how far down the euro path Merkel has cautiously and judiciously led the German people, it hardly seems beyond the realms of plausibility that she will eventually compromise and agree to eurobonds.

of denuding rich Russians of their deposits (the unspoken justification being the suspect origins of their money), while the confused political landscape in Italy didnt descend into anarchy and it was in none of the parties interests to provoke a snap repeat of Februarys general election. It even became convenient realpolitik for the US to find a compromise with Russia over Syria, with war crimes effectively brushed under the carpet. This final third of the year also seems destined to be all about give and take especially following the German federal election result. But as we go to press, diplomacy and compromise are facing their greatest and perhaps most important challenge of the year: the increasingly rancorous US Continuing Resolution and debt-ceiling debates. The likelihood of a US default seems minimal, but this is a problem to which everyone thinks a solution will be found, but actually has no idea how. So there is a distinct chance that before this is over, the markets will suddenly wake up to the gravity of the risks involved and suffer a very significant pullback, if not crash.

Pragmatic Obama
The no-taper decision was closely preceded by the withdrawal of Larry Summers from the shortlist to become the next chairman of the Fed when Bernanke retires next year. Summers is such a divisive figure, provoking such entrenched support or opprobrium, that it became expedient for President Barack Obama to compromise by ditching his preferred candidate. This is perhaps the latest in a string of compromise solutions that have become the leitmotif for 2013. The Cypriot crisis was solved through the politically acceptable compromise

Euro bolstered
Chancellor Angela Merkels conservative CDU/CSU secured 41.5 percent of the vote, more than 40 percent for the first time since 1994, a landslide victory and a ringing endorsement of

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her skillful guidance during the recent euro crisis years. But her current coalition partners, the FDP, failed to reach the 5 percent threshold for parliamentary representation, as did the anti-euro AfD party. This all implies that the CDU/CSU will have to try to repeat its not altogether happy experience of an alliance with the centre-left SPD. Where does this leave the euro? Even more secure. Economic theory would suggest that to survive, a monetary union must also be a fiscal union. Merkel and other mainstream German politicians all realise this and also know they probably have five years, at most, to make it happen, or at least to set the euro on a certain path towards it. A precursor to the full fiscal union would be the issuance of joint and several eurobonds, which would immediately remove the threat of further marketinduced trauma in peripheral bond markets. Sigmar Gabriel, the chairman of the SPD, recently told Berliner Zeitung that his party was prepared to accept collective debt liability, the quid pro quo demanded of the peripheral states of stricter oversight of their budgets, from Brussels. He acknowledged that this would require a change in the German constitution and probably a referendum. Crucially, a Grand Coalition would have the requisite majority in the Bundesrat to achieve this. Thus far, the chancellor has refused to countenance eurobonds. Given how far down the euro path Merkel has cautiously and judiciously led the German people,

it hardly seems beyond the realms of plausibility that she will eventually compromise and agree to eurobonds. Softly, softly she will win the voters over to this view. In return for her agreement on this, the SPD will mollify some of its more left-wing domestic agenda on taxation and the

 This will be a brief victory for the Fed and maybe ultimately a pyrrhic one, endangering its credibility.

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minimum wage. She may bend somewhat more on demands for austerity in the periphery. Compromise will abound.

Feds credibility
The Feds recent decision to surprise the market by not tapering was clearly intended as a protest at the markets interest rate expectations. It may also have told us that now Summers has been forced out of the contest, the front-runner to replace Bernanke, San Francisco Fed President Janet Yellen, is already easing herself quietly into the chairmans seat. It was also yet another example of compromise. The hawks fear the systemic consequences of yet another bursting bubble, inflated this time by quantitative easing consequences. They saw what happened to Alan Greenspans reputation post the Great Financial Crisis. The doves fear the economy has suffered lasting structural damage and needs more nurturing. The hawks are in the ascendancy as their numbers will swell in January with the next FOMC voter rotation. But an arch dove, Janet Yellen, will probably be in charge. The FOMCs shock tactic certainly had the desired effect, forcing estimates for the timing of the first Fed funds hike further into the distance. However, this may be a brief victory for the Fed and maybe ultimately a pyrrhic one, endangering its credibility, the reason being that the Feds actions and statements are littered with inconsistencies.

The Feds own prognoses for the economy, the Summary of Economic Projections (SEP) would have us believe that by the end of 2016, the US will be enjoying an employment rate of 5.4 percent to 5.9 percent. This is very close to the FOMCs own estimate for the long-run full employment rate that the economy can support without inflation getting out of hand, of 5.2 percent to 5.8 percent. However, extraordinarily, the SEP also tells us that inflation will be at or near the 2 percent target, but that the nominal Fed funds rate will still only be at 2 percent (meaning the real rate will be near zero). This set of outcomes would represent an unheard of state of affairs; the standard piece of economic theory used to predict the appropriate level for interest rates, the so-called Taylor rule, would suggest a Fed Funds rate by then close to the long-run neutral level, which the FOMC itself estimates as 4 percent! My feeling is that the Fed will have to raise rates far earlier and faster than it would have us expect. What does all of this mean for risk markets, such as equities? All good news, with the probability that the inevitable normalisation of yields doesnt spoil the party because developed market growth will be enough to provide comfort. Emerging markets could pose a threat as hot money rushes home to the US, but Chinas robust recovery from this summers little dip will probably win the day.

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GRAPHIC 1
% 0.6 0.5 0.4 0.3

US government bond yields

% 3.5 3.0 2.5 2.0 Key 1.5

GRAPHIC 2
Billion 4000 3500 3000 2500 2000 1500 Key Total assets MBS held outright Treasuries held outright

US Federal Reserve

0.2 2-year (left axis) 0.1 0 JAN-13 FEB-13 MAR-13 APR-13 MAY-13 JUN-13 JUL-13 AUG-13 SEP-13 10-year (right axis)

1.0 0.5 0

1000 500 0 08 09 10 11 12 13

GRAPHIC 3
Index 65 60 55 50

Euro area Purchasing Managers Index

GRAPHIC 4
% 12

US unemployment and ination

Change YoY % 3.0

10

2.5

2.0

6 45 40 35 30 05 06 07 Key 08 09 10 11 12 13 4

1.5

1.0

0.5

0 04 05 06 Key 07 08 09 10 11 12

Composite

Private payrolls

Services

Unemployment rate (left axis)

PCE core price index (right axis)

Source: Bloomberg, Saxo Bank

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Holding fast
The no-taper decision may have been a boon for equities, but commodity markets are driven by demand and prices. With the US economy spluttering and Chinas growth subdued, the fourth quarter will be stable for oil.
by OLE S. HANSEN, Head of Commodity Strategy

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The decision by the US Federal Reserve to postpone starting the scale back to its asset-purchase programme has created a great deal of uncertainty in financial and commodity markets, which will carry into the final quarter. Equity markets love the boost that this wall of money has provided, while commodity markets are more concerned about growth to drive demand and thereby prices.

lowest annual average price since 2010. Now that the supply disruptions that occurred earlier this year, most notably in Libya, have begun to fade, global inventories should begin to rebuild as we head into the fourth quarter. Indeed, seasonal trends should add weight to that. As a result, the global oil market should remain well balanced, with expected demand growth for 2014 easily being met by increased supplies, not least helped by the continued ramping up of non-conventional production in the US. But, as usual, another geopolitical event cannot be ruled out and outbreaks such as these normally have a temporary explosive impact on prices as the market tends to very quickly price in a risk premium. We view the slow return of Libyan oil and the outside chance of sanctions against Iran being lifted as two of the main drivers in the final quarter, both of which have the potential to assert some downside pressure on prices into the New Year.

Spluttering
And thats been the problem. The US economy was spluttering in September, Chinese growth expectations remain subdued and emerging economies have been forced on the defensive following the flight of capital many witnessed during the third quarter. As a result, we see no major pickup in commodity prices in the near term, perhaps with the exception of some agriculture products where other fundamentals are at play.

 We see no major pickup in commodity prices in the near term, perhaps with the exception of some agriculture products where other fundamentals are at play.

Following a summer that saw several supply disruptions and the brief return of geopolitical tensions in Syria, global oil fundamentals look likely to keep prices stable over the coming months with the main risk pointing towards weaker prices. So far this year, Brent crude has been confined to a USD 22 range and despite two upside attempts in February and August, the price action during the first nine months points towards the

Speculative investors will maintain their bullish bets into the fourth quarter on both WTI and Brent crude. This situation, seen on a number of occasions in recent years, provides an additional downside risk once the supply disruptions begin to fade as it could lead to bouts of long liquidation and, ultimately, result in lower prices.

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rate of demand. Such a situation could force the price of WTI down to attract demand at the expense of imported crude oil such as Brent. Turning to the international stage, the outlook for supply and demand looks the healthiest its been in years. Demand growth will be manageable on the back of a trend towards retrenchment in emerging markets, while supply from countries such as the US, Canada and Brazil will continue to grow.

Middle ground
This leaves Opec in the middle and as a result, Saudi Arabia should eventually be able to turn down the tap from current record production levels, thereby increasing its available amount of spare capacity. Indeed, the reduction of that capacity has been one of the reasons behind elevated oil prices over the summer. Spare capacity has been defined by the Energy Information Agency as the volume of production that can be brought on within 30 days and sustained for at least 90 days. Such an increase in spare capacity provides the global oil market with the ability to respond to potential supply disruptions and it should help to limit the upside potential for crude oil over the coming quarters. Brent should remain rangebound at USD 100-115/barrel, with the risk of a revisit to the USD 100/barrel level increasing as we move deeper into the final quarter and beyond.

US bottleneck eases
The US oil market has finally managed to solve its infrastructure problems, which resulted from an increase in the production of shale oil and oil sand over the past few years. The bottleneck of oil inventories at the delivery point for WTI crude, in Cushing, Oklahoma, is now contracting fast as increased pipeline and rail capacity have caused inventories to drop to their lowest levels since January 2012. Going forward, we see limited possibility for WTI to regain its historical premium to Brent and see the latter maintaining a premium in the USD 2 to USD 5 range, reflecting the cost of transportation. However, continued strong flows of oil only carry the risk of moving the bottleneck from inland to the US coast as refineries will struggle to keep up the current high

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Precious metals retrenching

Gold and silver continue to be driven by expectations about when the US Federal Reserve will begin reining back its massive stimulus programme. The surprise change of heart at the September FOMC meeting gave both metals a much needed boost, but whether a delayed tapering is enough to support a continued rally remains doubtful. The selling pressure on precious metals, especially from an institutional investor exodus out of exchange-traded products, eased during the third quarter. So far, a change of heart that could see these investors begin to return to gold seems unlikely as increased growth prospects and thereby higher real yields make other asset classes more interesting. Lower gold prices in 2013 have been driven by a turn in the US interest rate cycle, which has seen rising real yields due to falling bond prices at a time of a subdued inflation outlook. Investors have sought and found better opportunities elsewhere, especially in developed market stocks. Going forward, several obstacles still exist as a favourable growth outlook, especially in developed economies, and will continue to attract investors into equities. But gold should be underpinned by the fact that most of the selling has probably already been seen. This leaves the price in a better position to react to market-friendly news. After the postponement of tapering by the Fed, the focus may switch to the upcoming debt ceiling and budget negotiations in the US together with continued attention on economic data,

 Continued strong flows of oil only carry the risk of moving the bottleneck from inland to the US coast as refineries will struggle to keep up the current high rate of demand.

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 So far, a change of heart that could see these investors begin to return to gold seems unlikely as increased growth prospects and thereby higher real yields makes other asset classes more interesting.

which began to slow towards the end of Q3 and hit lending support. We see the upside potential for gold limited to a maximum of 1,488 USD/oz and probably even lower for the remainder of the year. This level represents a 50 percent retracement of the sell-off from October 2012 to June. Technically, a bull market is called when a price corrects higher by more than 20 percent from the previous low. Although this level in gold has already been reached, any talk of a renewed bull market cannot be called unless prices manage to climb back above 1,525 USD/oz. Physical demand, especially from Asia, and central bank demand from emerging economies remains robust, but also very price sensitive. This means that higher prices tend to slow demand. The reduction in holdings of gold in exchangetraded products has slowed dramatically compared with Q2, but we still need to see a pickup in demand from the institutional investor and hedge funds before a meaningful rally can commence.

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Taper worry
We see the price of gold rangebound for the remainder of the year, but due to the postponement of Fed tapering, were lowering the end of year price from 1,375 USD/oz to 1,325 USD/oz as another round of taper worry into Q4 will put off many potential investors from re-entering gold. Any renewed weakness carries the risk of a move to 1,090 USD/oz, which would represent a 50 percent retracement of the rally seen over the past 12 years. We see copper mostly rangebound and with a negative bias for the remainder of the year, with the boost given by the decision to delay tapering unlikely to carry prices much further. The fundamental outlook for copper points towards a market moving into surplus. With accelerating Chinese growth in 2014 looking less likely, a sustained price recovery from an improving demand situation seems limited. As a result, the dramatic outperformance of silver against gold in the third quarter is not expected to be repeated in Q4.
Commodities Upside risks Geopolitical events/worries Weaker dollar Production cuts as cost oors are broken Strikes/labour disputes in key production areas Downside risks Chinas growth fails to pick up speed Major stock market correction Excessive speculative positioning Production catches up with demand, resulting in inventory builds

Energy Upside risks Oil producers need high prices to nance rising government spending Re-emergence of geopolitical tensions New production techniques require higher prices to the maintained Stronger-than-expected pickup in global growth Downside risks Impact of US government shutdown and debt-ceiling negotiations Non-Opec supply growth bucks trend Surging US shale production reduces crude imports The capital ight from EM countries triggers an economic slowdown

Cards to chest
So were really not expecting fireworks in Q4 and consolidation might be the best we can hope for. For some sectors, perhaps ending the quarter no worse than the start represents the best outcome. Until the tapering uncertainty ends and there are clear growth signals for the global economy, a cards-close-to-your-chest approach and hope for uplifting developments are needed as we move into 2014.
Upside risks

Precious Metals Downside risks Rising bond yields Subdued ination outlook Rising growth expectations Continued long liquidation from exchange-traded products

US growth slows delayed tapering Strong physical demand from central banks and retail Rising ination expectations Cost pressures on miners requires higher prices

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GRAPHIC 1
% 5 0

2013 sector performances

Key

GRAPHIC 2

Brent Crude Oil Seasonality

USD/barrel
DJ UBS SP GSCI 15

10 -5 5 -10 0 -15 -5 -20 -10 -25 -15 JAN FEB MAR APR MAY JUN JUL AUG Key SEP OCT NOV DEC

us

ria

de

tu

in

fts

gy

er

In

Pr ec

ul

So

ra

st

En

du

es

to

io

ck

re

In

GRAPHIC 3

Ag

Liv

2011

2012

2013

ric

Saudi Arabia oil production

(million barrels per day)

GRAPHIC 4

Gold and 10-year US real rates

GRAPHIC 5

HG copper and silver

13 12 11 10 9 8 7 6 02 03 04 05 06 07 08 09 10 11 12 13

7 6 5 4 3 2 1 0

1800 1700 1600 1500

-1.0

390 380

36 34 32 30 28 26 24 22 20 18 SEP-12 NOV-12 JAN-13 MAR-13 MAY-13 JUL-13 SEP-13

-0.5

370 360 350

0 1400 1300 1200 1100 MAY-12 AUG-12 NOV-12 FEB-13 MAY-13 AUG-13 1.0 340 330 0.5 320 310 300

Key
Est Spare Capacity, RHS Est. Production Capacity Actual Production

Key
Gold, USD/oz US 10-year real rates (rhs, inv)

Key
Spot Silver, USD/oz (right axis) HG Copper, Cents/lb

Source: Bloomberg, Saxo Bank

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Will the tapering debate continue into 2014 or will it be a return to QE infinity? Stay tuned for our Q1 Insights Quarterly Outlook, out in January.