22 March 2019

Week ahead: Marketof Hope and Glory

Mikael Sarwe | Andreas Steno Larsen | Martin Enlund

• Has Federal Reserve’s reaction function changed?• The case for a revisit of the equity market lows from last December.• Looser financial conditions to temporarily lift IFO?

Read the report as pdf here.

Read our financial forecast here.

What happened this week?

The week started with continued risk on, had some second thoughts around the Fed decision but then tried toget back on the risk on hope train – Fed will save the day, or?

There was a fair share of corporate profit warnings for 2019, perhaps most notably BMW and FedExheadwinds giving more tailwind to our earnings recession outlook. FedEx pointed to “slowing internationalmacroeconomic conditions and weaker global trade growth” and the stock price development certainlymake us wonder why analysts still are so upbeat about the US macro outlook.

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Chart 1: FedEx leads the way lower?

In Scandis, SEK continued to strengthen on the back of Riksbank comments from Skingsley and Ohlssontoning down the importance of the recent lower than expected inflation print. Norges Bank was themain focus and as expected delivered a rate hike. The overall message was more hawkish than marketexpectations and fairly in line with Nordea’s view. The rate path was lifted by about one rate hike bymid-2020, while the end-2021 point was lowered equally much. It also revealed a possibility for an earliernext hike, possibly in June.

Global data were mixed with US core capital goods orders pointing to a non-residential investment slowdown.Sentiment indicators such as ZEW and headline Philly Fed rebounded. We have in previous editions of WeekAhead pointed to a rising likelihood of looser financial conditions helping foremost European business surveysto improve somewhat in the short-term (read more in FX Weekly: The Devil’s Advocate). That said, EuroArea PMI disappointed massively to the downside and continues to follow the negative Swedishroadmap we have talked about. Also, the leading versus lagging parts of Philly Fed dropped like astone and indicate weakness ahead. We saw a slight improvement in macro surprise indices in both Europeand USA, but at the same time note that they still are in negative territory which has been our call since early2018.

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Chart 2: Data surprises have firmly stayed in negative territory

On the everlasting US/China trade negotiations there was the usual rollercoaster of Trump statingall is well, some media sources pointing to worries that China is about to walk back on trade oers and yetanother media source indicating that a deal is very close. Anyway, the late March deadline seems to havegotten postponed until a rather fuzzy later one, like June. The equity market might thus get a continued “buythe rumor” period, or maybe the market will finally get tired of this postponement game and stop waiting to“sell the fact”?

Oh, we almost forgot. The Brexit farce of course continued. Theresa May asked for an extension until June30 and the pound got whacked for a while. In their wisdom however, the EU27 agreed to a two-weekrespite until April 12 – should we venture to guess that it will drag on even longer? Even though all of thatwas interesting, Fed was clearly the main act – Jay Powell, the new Wizard of Oz?

Has Federal Reserve’s reaction function changed?

For a full-blown Fed comment, read Fed Watch: Dovish. In short, the signal is a dovish long on hold. A dotplot that was clearly lower than expected. An end of balance sheet run-o by October, as has been expectedby many Fed analysts but might have surprised some portfolio managers. A balance sheet as share ofGDP that will continue to fall, i.e. policy is in some sense still tightening but much less than before.

For a while we thought Federal Reserve chairman Jay Powell seemed to change monetary policyviews almost as often as a normal person changed underwear and, thus, stopped putting any greateremphasis on his statements. It however now seems as he has stabilized around a monetary policy pausemessage. It is a tricky economic puzzle to solve right now so that makes sense. A twist of the pause is

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though that the market participants seem to have interpreted the pause as a high likelihood of a “risk on”full monetary policy reversal, no matter what. In our view, however, such a restart of stimulus should beharder than envisaged.

Chart 3: Fed’s reaction function seems quite intact

First, the overall state of the usual Fed drivers doesn’t motivate a policy reversal. We have modelledthe Fed reaction function from 1986 to 2008 by looking at the output gap, core inflation, the labour marketand S&P 500. Such a model has also worked well from 2012 and shows a recent sideways move witha slight upward bias from today’s Fed funds target (given Fed’s economic forecasts), much in line withthe new dot plot. The model acknowledges that the equity market is important for Fed, but not asimportant as the economic factors. The model roughly indicates that 50% of Fed decisions are explainedby inflation, 30% by output gap/labour market and 20% the equity market. There is so far little in the Fedstatement and Powell’s words to indicate that this model has gone bust and that the equity market suddenlyis the only thing that matters.

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Chart 4: Higher wage growth should make it hard to cut the Fed funds rate

Second, wage growth has historically been another extremely important Fed indicator and a risingtrend in wage increases has basically always meant Fed hikes. Wage growth is currently slightly above3%, but our broad model continues to indicate even higher numbers later in 2019. Wages are undoubtedlythe most important underlying inflation indicator and we believe wage growth trending towards 4% willmake it hard for Fed to go further than a pause. With history as a guide, Fed would probably hike againin such a scenario but that should be weighed against our leading US GDP indicator pointing to a morepronounced slowdown than Fed’s scenario. Also, even though Powell hasn’t mentioned it, a couple ofFed governors have indicated a tolerance for an inflation overshoot since it has been below target forso long.

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Chart 5: Wage growth should continue to rise in the USA

The knee-jerk reaction of 10-year bonds falling to 2.50% was reasonable, and as an aside a large partof the yield curve is now inverted, but what does this mean going forward? Should yields rise on higherwage inflation or fall on slower growth? Nordea has a forecast of a quite substantial slowdown in nominalGDP in 2019/2020. Historically such slowdowns have always gone hand in hand with falling or sidewaysmoving long-term interest rates. The rising wage trend, however, makes the case for a large drop in yields lessprobable.

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Chart 6: Nominal GDP slowdowns usually means lower long-term interest rates

What did other market reactions tell us? A higher probability of a 2020 rate cut rhymes well with whatthe Fed model would say if we enter the predictions of our macro models instead of Fed’s forecasts.The USD broke out of recent trading ranges and in relative terms had the biggest move. As we have pointedto before, that is reasonable given the balance sheet decision. The bounce in EURUSD was short-lived,however, because of an awfully weak EUR PMI. The terrible trend in the EUR PMI figure needs to stabilize,before we can call an end to the EUR rates receiver-palooza (Bund yields now approach negative territory) –and it is also a prerequisite for our anticipated jump to 1.1650 in EUR/USD before summer.

Equities had, to start with, a relatively hard time rallying despite a more dovish dot plot than expected and anend to QT signal, even though the upward trend seems to have resumed after a day. Hmmm...

The case for another leg down for equities

Since mid-2018 we have argued that the cyclical slowdown would pose problems for the equitymarket that in our view was seriously overvalued and where profit margin expectations were way tohigh. We partly based our outlook on the 2015-16 experience where equity markets dropped 15-20% on theback of a global slowdown (see various editions of Nordea View). Equities since tanked late last year but havein 2019 risen like a phoenix from the ashes on the softer Fed signals and cosy statements from USA/China. Ithas turned equities in to a market of hope and glory, but much like 2016 we believe that we will revisit thelows when earnings estimates in all likelihood get slashed the coming six months.

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Chart 7: The 2015-16 roadmap is still alive and kicking

We believe companies will be squeezed by both slower sales and higher wage costs, i.e. a muchhigher risk of an earnings recession than we have seen in a long time. That is what our macro-based leadingindicators tell us. This is a sales/cost setup that analysts really haven’t experienced since the early 2000s, i.e.there is a high probability that they will get seriously surprised.

On the growth/sales side of the equation, we have the diverging trends of looser financial conditions speakingfor a short-term bounce in sentiment surveys, such as ZEW, while our broader medium-term leadingindicators still warn about much too high growth expectations for 2019. Our broad US leading indicatorwarns about 1% GDP growth, the one for Euro Area is bouncing around between 0 and 1%. In Japan it isbelow -1%, and Sweden is zooming in on 0%.

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Chart 8: Our US GDP model warns that economists are too optimistic

If we add the upwards wage cost pressure to the growth/sales picture, our macro-based EPS indicatorfor USA is flashing RED. It is warning about a marked earnings recession. Currently the S&P 500 EPSexpectation for 2019 is +5.4%. Our model indicates we should at least put a minus sign before those 5%.

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Chart 9: Higher costs + slower growth = earnings recession

We doubt that a 12-month forward P/E of 16.6 for the S&P 500 will be able to swallow that type ofnegative earnings surprises. However, many argue that investors will look through a rough earnings periodand that central bank liquidity from now can be trusted to boost the upward equity trend again. This is a fairpoint and the continued upward tilt to equities after the Fed decision indicates that this assumption still ismarket consensus. Nevertheless, our take on liquidity is that the major trends still are negative and that ittakes a quite long time for shifts to turn economies and markets around. History tells us that interest ratechanges leads changes in the ISM by 18 months and ISM should thus drop to below 50.

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Chart 10: There is a long lag between monetary policy and the economy

Global M1 is in y/y terms still at its lowest point since the financial crisis and the lead to S&P 500 hasover time been around one year. Don’t forget that central banks had massively flooded the markets withmoney for over three quarters when the equity market finally bottomed in 2016, at a time when negativeearnings revisions had come a lot further than today. So far central banks are mostly talking a pause, notadding stimulus, and when they act it usually takes time before the equity markets react, especially in anearnings recession.

All in all, we expect the equity market of hope and glory to turn gory (read NEGATIVE) again, before settingup for a more benign 2020.

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Chart 11: Global money supply still too low for comfort

What is most important in the week ahead?

With some news stories out on a trade deal between China and USA getting closer at the sametime as Trump is all over the place with conflicting signals, markets will closely follow statements fromLighthizer’s and Mnuchin’s China visit 28-29 March. On the US data front, it’s mostly second tier releases witha focus on housing, a marginally negative Q4 GDP revision, financial conditions boosted consumer confidenceand a sideways moving core PCE deflator in y/y terms. There are, however, a large number of Fed speechesthat will be analysed from the perspective of what it would take for Fed to move into stimulus mode.

In Europe, the IFO is out on Monday. Financial conditions could give room for a temporary bounce afterthe rapid deterioration the last four months, but of course the cold shower from this week’s PMI isdisturbing. The ECB Watchers conference on Wednesday will include plenty of ECB speakers probably tryingto strike a positive note, while re-emphasizing that a rate hike has been moved in to next year. On Thursday,German numbers lead the way towards the Euro-area inflation figures in March (published 1st April). Thereis a high amount of uncertainty this time due to first, the revision of statistical methodology and second, theexceptionally late timing of Easter. Those facts may induce a lot of volatility to the EA inflation numbers inMarch-April.

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Chart 12: Easier financial conditions could lift IFO

Thursday is a big central bank day in the EM space with rate decisions from the Czech Republic, Mexico andSouth Africa.

In Scandiland, Sweden has the NIER survey on Wednesday and retail sales on Thursday. Interestingly,retailers are quite upbeat on current sales which could mean an upward retail sales surprise. If so, it couldprolong the current SEK “rally”. Norway has unemployment numbers and retail sales, more on all that in thecalendar segment

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Chart 13: Swedish retailers surprisingly upbeat

Key research pieces over the past week:

Euro area: Manufacturing recession deepens (22 March)

BoE Review: In waiting position (21 March)

Global: You may not be interested in liquidity, but liquidity is interested in you (21 March)

A window of opportunity for the RUB (21 March)

Norges Bank comment: Hawkish rate path (21 March)

Emerging Markets View: The Brexit stranglehold (21 March)

Fed Watch: Dovish (20 March)

Market Pulse SEK: Stibor reform and current themes (20 March)

Sweden: Defiant inflation (20 March)

Market Pulse DKK: Prepayments of DKK 59bn – are preliminary prepayments aligned herewith? And isissuance a concern? (19 March)

Market Pulse EUR: New TLTRO III implies bank independence of market conditions (18 March)

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Main Releases

Monday

The week kicks o with a print of the German Ifo indicators. Additionally, FOMC members (hawk, voter),Evans (neutral, voter) and Harker (dove, non-voter) speak.

Tuesday

Consumer confidence indicators from both the US and Germany are out. Both the National Bank of Hungaryand Reserve Bank of New Zealand will publish their latest rate decisions. The FOMC members Daly (neutral,non-voter), Evans (neutral, voter), Rosengren (hawk, voter) and Harker (dove, non-voter) speak.e-markets.nordea.com/article/48274/week-ahead-market-of-hope-and-glory

Wednesday

The ECB and its Watchers Conference is Wednesday’s main focus point with Draghi (dove), de Guindos(neutral), Praet (dove) and Mersch (hawk) all due to speak. From Sweden, we get the latest EconomicTendency Survey. Also, FOMC member George (hawk, voter) speaks.

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Thursday

Thursday is a big central bank day in the EM space with rate decisions from the Czech Republic, Mexicoand South Africa. In Europe, German inflation figures are in focus along with UK housing prices. Across theAtlantic, the third and final US Q4 GDP figures will be released and FOMC members Quarles (neutral, voter),Clarida (neutral, voter) and Bullard (dove, voter) speak.

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Friday

Friday is Brexit-day unless a delay has been agreed. We also get final Q4 GDP from the UK. From the US, weget core PCE and FOMC member Quarles (dove, non-voter) speaks.

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e-markets.nordea.com/article/48274/week-ahead-market-of-hope-and-glory

Mikael SarweDirector, Head of Strategy Swedenmikael.sarwe@nordea.com+46 8 614 99 09

Andreas Steno LarsenGlobal FX/FI Strategistandreas.steno.larsen@nordea.com+45 55 46 72 29

Martin EnlundGlobal Chief FX StrategistMartin.Enlund@nordea.com

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