Nomura: Beware Halloween's Massive Fed Liquidity Withdrawal

Last Friday, when surveying the carnage in capital markets, Nomura's cross-asset chief Charlie McElligott observed that "Next Week Is Make Or Break For Stocks" and so far it's been so good, with European and US stocks defying yet another swoon in China, which was driven by the latest drop in Industrial Profits suggesting more "slowdown" pressure, as well as the PBoC skipping reverse repo operations Monday, draining 120B Yuan net—the largest liquidity withdrawal since August and reversing some of the large 460B Yuan injection last week, while the Onshore Yuan is heading towards its weakest level in more than a decade, while offshore too sees speculative flows again pressing near 6.97.

Meanwhile, as noted earlier, European stocks lept higher on 1) news that Merkel looks to remain “on” as German Chancellor despite stepping-down as CDU leadership after disastrous election result, while specifically within the Cyclical / High Beta Equities universe, 2) tax-cut headlines from Chinese regulators (this time a 50% cut on new car purchase tax) shows they are continuing to tinker with stimulus, driving the massively China-levered and very-cyclical European Autos sector +5.0% at peak delirium/illiquidity.

However, as McElligott notes, the most relevant drivers for this week's performance will be in the liquidity space, where "bullish flows" will need to override the risk-negative “QT” liquidity impulse of this week’s largest Fed SOMA run-off YTD (with another coming Nov 21st).

On the bullish flow side, over the weekend we noted that the much-anticipated surge in buybacks is finally coming, as companies with $50bn of quarterly buybacks were off their blackout periods, and the number jumps to $110bn by the end of next week and to $145bn the following.

Offsetting the favorable flows from corporate buybacks will be the Fed itself, even as rates move back to the cross-asset forefront into a critical week of month-end Macro, which includes the largest Fed balance-sheet reduction-to-date ($-33.2B) on Helloween, as well as the payrolls report this Friday.

As McElligott reminds readers, the “Quantitative Tightening” via the Fed’s SOMA unwind going "max" in the month of October— along with ECB’s ‘halving’ of bond purchases and the BoJ’s ongoing “stealth taper” escalation — were the key inputs when he made his original call to expect a “financial conditions tightening tantrum” towards the end of October… "and here we are."

As such, the Nomura strategist notes, Bloomberg’s major global financial conditions indices (U.S. + EU + AeJ) show that global FC’s are “tightest” since June of 2016, as higher Equity Volatility, higher U.S. Dollar and higher Money Market / front-end Rates now begin to drag Credit spreads modestly wider as well in a collective lunge "tighter."

So what the market does will be determined by this liquidity tug of war between buybacks and central banks soaking up liquidity. Meanwhile, as McElligott notes, the month of October saw four major market reassessments:

  • The re-pricing LOWER of U.S. growth-expectations (“the best is behind us,” with late-cycle bellwether Equities industries seeing capitulatory sell-flows)
  • The re-pricing LOWER of Fed expectations (this current “policy error” tantrum instead forcing the Fed to “pause” or outright “cease” normalization)
  • The pulling-forward of the “end-of-cycle” timing (2019) and thus…
  • The commencement of the next EASING-cycle timing (Eurodollar calendar spreads for both 2020 and 2021 are implying RATE CUTS)

That said, just like JPM and Goldman, McElligott is in no rush to throw in the "tactical towel", and continues to believe there remains short-term upside-trade in U.S. stocks (1 to 3 month window) for the following reasons:

  • Earnings-season progression means > 50% of Corporate repurchases are back “online” through this week = bullish / price-insensitive flows
  • +++ Mid-term elections analogs, with data back to 1936 showing “bullish” outcomes on ALL “ownership” scenarios
  • Contra- “Bullish” signal generated by current leadership from the uber-Defensive “Dividend Yield” Factor, with the 2w 97th %ile positive move showing as a forward-looking SPX tactical positive, with SPX 1m median return at +2.0% with a 67% “hit rate” / 3m median return +4.1% with a 71% “hit rate”
  • Nomura “Fear and Greed” indicator at just 10th %ile, generating a contrarian “BUY” signal for SPX, with median 1m SPX forward returns +3.1% @ 59% hit-rate
  • “Volatility / De-Leveraging” signal in SPX, where three unique 1.5 standard deviation + AND - moves in SPX within a two week period and within 10% of a 52 week high shows SPX median return of +2.9% out 21d with an 85% “hit rate”
  • Powerful month-end Pension Fund rebalancing flows also likely, due to the scale of the performance differential this month between Equities (Russell 1k -9.0% MTD) and Bonds (AGG -0.6% MTD), with some Street estimates of ~$50B notional in U.S. Stocks to BUY on weakness
  • U.S. growth “macro wise” should see positive catalysts resume as well, with our expectations for U.S. data set to resume “better” into the “bearish rates” dynamic of HEAVY UST supply in Nov and Dec driving +++ Equities / --- USTs performance drivers for consensual Macro positioning

To be sure, any tactical bounce will need to overcome what has been a painful gravitational pull on hedge fund performance, which has been skewered by the "QE to QT" transition, as the macro regime shift has been a "bust" for leveraged fund performance. As McElligott shows in the chart below, the year-to-date underperformance of hedge funds has been exclusively tied to "tighter", more restrictive financial conditions:


Finally, what happens if this time buy the dip fails again, and if buybacks prove less powerful than the upcoming Fed liquidity drain?

According to McElligott, "if U.S. stocks cannot “get legs” in these next two weeks, it is likely indicative that investor psyche has pulled-forward the “end-of-cycle” trade in self-fulfilling fashion, with prior “buy the dip” conditioning now being reset to “sell bounces,especially as portfolio de-risking occurs via either:

  • 1) MECHANICAL “gross-down” VaR-model driven flows (reduce $ exposure) OR
  • 2) more bearish “net-down” flows (sell longs, press shorts) occur, following the realized volatility spike created Fed Chair Powell’s infamous “far-from-neutral” comments on running outright “restrictive policy”

And the above summarized: how the market closes the year will likely depend on what happens this week - if stocks can stage a rebound from last week's beat down, there is still hope for a year-end rally. If not, don't be the last one heading for the exits.