Market Has Not Only Priced In QE4... It's Also Pricing In QE5

Consumer sentiment is tumbling, economic data continues to disappoint, and earnings (actual and expected) drift ever lower... but stocks refuse to be dragged lower by anything related to fun-durr-mentals.

Source: Bloomberg

As Nordea warns, once again, "no one fears a potential slowdown."

Well that's not exactly true, it seems some Americans "fear" it, but none of them are C-level execs telling their corporate finance departments to BTFD...

Source: Bloomberg

Nordea explains, if it walks like a duck and talks like a duck, then it probably is a duck (read QE)...

That’s at least how the market has chosen to interpret the balance sheet increase from the Federal Reserve. It doesn’t matter a whole lot that neither the Fed nor we see this as QE as long as the QE narrative is fully adopted by the market. The Fed had the chance to “correct” the 60B’s extrapolators this week but refrained from doing so (they will buy 60B’s the next 30 days as well).

The market is partying like it is a massive liquidity addition, but isn’t the party getting slightly out of hand even, considering that this is “just” a soft QE like liquidity addition? The S&P 500 would be up more than 30% y/y by Christmas (assuming unchanged S&P 500 levels from here). Such yearly increases have usually gone hand in hand with much bigger liquidity increases than we are seeing right now. There is clearly a FOMO in markets on the asset pricing positivity, stemming from the soft QE from the Fed. Admittedly, this QE and trade relief FOMO has caught us wrong-footed on the market narrative over the past 4-6 weeks.

Chart 1: Is the market party getting slightly out of hand due to a FOMO on the Fed liquidity addition?

When equities sold off in Q1 and Q4 of 2018, it was preceded by a material increase in long bond yields. 10yr real yields will soon be up roughly 30-35bp on last quarter. Such an increase corresponds to a 5-10% correction in S&P 500 over the next 30-40 trading days, if correlations from 2018 are to be trusted. Interest rates seem to have played an important role in defining trends in equities over the past 18 months, will this time be different?

Chart 2: Higher real rates preceded both of the 2018 sell-offs. Will Q4 2019 be any different?

Slowdown 2.0 – the labour market...

Admittedly our negative market narrative is under severe pressure at the moment, since the manufacturing weakness is now 100% old hat. We need another negative shock/surprise to the global economy before our central market scenario can unfold. So, what could that surprise be driven by? Currently our best guess is the service sector/labour market.

In a sense we are tempted to even increase our conviction of an adverse market scenario, since it is now suddenly already very “consensus’y” to conclude that this slowdown was just a manufacturing thing that has now already troughed. But no one is worried whether second-round effects on to the service sector and ultimately the labour market will be up next.

On our leading indicators, it is now essentially almost a G10-wide phenomenon that the risk of rising unemployment already in Q1-2020 is surging. That be in the Euro area, the US, the UK, Sweden (you basically name it!) ...

In the Euro area we are now facing a third consecutive quarter of negative earnings growth in MSCI Europe. That is the stuff labour market slowdowns is made of. People are costs and European corporates will soon have to cut costs to improve margins.

Chart 3: Investors are (still) negative/uncertain. Usually it spills over to higher unemployment after a while

We have some of the same type of early warning signals in the US as e.g. NFIB job openings have started to pre-warn of the risk of negative NFP readings already three months from now. This is one, out of several signs that small and medium-sized companies have started to react to the uncertainty.

Chart 4: NFIB job openings (small/medium sized companies) hint of future negative monthly NFP readings

The big question is whether uncertainty festers, even if a Phase 1 trade deal is signed?

Should our leading indicators be right on unemployment in G10 countries, then the next phase of this slowdown will hit the service sector and labour markets in Q1 2020 and that is much worse than a manufacturing slowdown.

We are not blind to the possibility of a continued market rally into a potential signing of a Phase 1 trade deal, but we still have the Phase 2 service sector slowdown on top of mind as well.

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The real message from all this is simple - while JPM's Kolanovic says market can easily absorb 150bps of 10Y yield increases, Nordea takes the other side and warns that just a 35bps rate rise may be enough to trigger a 10% correction.