Timing The Exit As Competitve Devaluation Looms; Is The Euro 25% Overvalued? More Thoughts From Albert Edwards
Soc Gen's Albert Edwards, who has never been shy about his cautious stance on equities, has released another report taking his cautionary posture to the next degree. This ties in perfectly with earlier observations by David Rosenberg which unmask the market for the jittery, volatile, headline-driven knee-jerk automaton it has become. Also, Edwards provides a response to readers who are confused by the strategist's endorsement of Richard Koo's mantra of fiscal stimulus as pertains to both Japan and the US. Somewhat tying it all together is the argument that the euro has yet to experience a 25% drop from current levels. That expectation makes the Morgan Stanley euro target of $1.25 seem timid by comparison. Yet in a world of competitive devaluation, as Albert Edwards points out, "it is the nation that devalues last which suffers the deepest deflation." We are confident that Ben Bernanke is all too aware of this mantra.
First, Edwards focuses on leading indicators and what "leading" implications their recent top may have for markets.
In a post-bubble Ice Age world, equity investors have to watch the cycle far more closely than before. One of the key lessons from Japan was that prior to their bubble bursting, equity valuations were dominated by movements in bond yields and hence there was only a very loose relationship between equities and the economic cycle.
But after the bubble burst and as The Ice Age unfolded, the close positive correlation between bond and equity yields broke down as equities suffered secular de-rating - driven by 1) the unwinding of unrealistic market-wide long-term earnings expectations in a low inflation world, and 2) a rise in the cyclical risk premium, as Japan?s own version of The Great Moderation gave way to highly volatile economic cycles.
Japan enjoyed some impressive 50% equity market rallies during their lost decade, driven by strong policy induced cyclical recovery. The secret was to exit as the cycle started to top out as this preceded the equity market dropping to new lows.
Early last year the safe re-entry back into risk assets was signalled by a clear upturn in leading indicators. So too now should investors be concerned that the leading indicators are topping out. The recovery in the leading indicator for China seemed to precede that of the composite for the OECD and similarly China has now topped out ahead of the OECD composite (see chart below). Indeed, other emerging economies such as India (below) and Brazil are also seeing clear warning flags of cyclical caution.
So are leading indicators to the leading indicators the key catalyst to follow in this market?
In a post-bubble world it is far more important for equity investors to follow the cyclical ebb and flow of the economic cycle. We know from the Japanese experience that the post-bubble equity market synchronizes extremely closely with the economic cycle. But, while in a post bubble world massive cyclical gains can still be made in a structural bear market, how does an investor know when it is time to get out of equities?
Certainly my former colleague, James Montier [whose latest, quite pessimistic piece we posted previously], derided the notion of investing on the basis of forecasts as they inevitably proved so inaccurate. It would not be too unfair to say that market and economic forecasters tend to hug the consensus and typically lag events. That is especially true at cyclical turning points. That is why it is useful to monitor proprietary leading indicators. These are especially useful in predicting economic turning points and allow the investor the opportunity to pile into or withdraw from cyclical risk assets.
We monitor a variety of such indicators and until recently they have all been giving an unambiguous green light to participate in risk assets. That has now changed. We noted on the cover the OECD leading indicators for China and other emerging markets have now topped out. But also in the US, some leading indicators have started to dive quite sharply, albeit from very elevated levels (see chart above). In Japan too, we note a topping out action (see below). Recent hard data in Japan such as the closely watched Tertiary (non-manufacturing) activity index has been surprisingly weak, suggesting their anemic recovery is already stalling.
Some more bullish commentators, while accepting that leading indicators are topping out, point to the extreme strength of the recent peak as suggestive of still more positive growth surprises in the pipeline. I think this is wrong. I was always taught that it was turning points that were accurate and hence should be watched closely, and not the magnitude of any directional movement to either the up- or downside.
Going back to macro opinions, and away from indicators, Edwards is extremely pessimistic on the overall economy: when the stimulus effects expire, the double dip will come.
No wonder small and medium-sized companies in the US are still locked in the grip of a massive credit crunch (see NFIB survey -? link). No wonder the US economy is nowhere near as strong as large-cap surveys, such as the ISM, suggest. And there should be no wonder if as soon as the massive fiscal and monetary stimulus wears off, the global economy lapses back into recession.
On to another topic du jour, the euro, A.E. anticipates something close to a 25% correction in the EURUSD pair. And yes, competitive devaluation of currencies will be the primary driver behind most macro risk relationships in the next year.
A word on the euro: we noted last week that the one-size-fits-all interest rate regime had led to a disabling loss of bilateral competitiveness for the so-called PIGS (Portugal, Ireland, Greece and Spain), within the eurozone due to rapid inflation -this in very large part through no fault of their own. Not only are the PIGS? real exchange rates uncompetitive within the currency zone but, on top of that handicap, the entire eurozone is suffering from an excessively strong euro exchange (see chart below).
It could be reasonably argued that the eurozone authorities should welcome a large decline in the euro. With growth in the eurozone looking particularly anemic, these are desperate times. Looking at the chart above, a dollar/euro exchange rate some 25% lower, nearer parity, seems far more appropriate. The end game for The Ice Age was always competitive devaluation and the US and UK have embraced this strategy to revive growth and export their own domestically generated deflationary impulses. Eurozone core CPI inflation currently is a dangerously low 1%. Albeit not quite as desperate a situation as Spain or Japan, this surely is too close to outright deflation for comfort (see chart below).
After all didn?t Ben Bernanke in his famous November 2002 ?helicopter money? speech highlight that “it's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt's 40 percent devaluation of the dollar against gold in 1933-34” (Deflation: Making Sure "It" Doesn't Happen Here -? link). In the Ice Age, it is the nation that devalues last which suffers the deepest deflation.
The following berating by Edwards of Europe's worthless political powers is worth its weight in Tungsten. Which once again brings the great debate to the fore - just who is it that is in charge of the developed world: politicians or bankers. Don't answer - it's rhetorical.
Eurozone politicians should stop bleating that the euro is too strong and blaming the deflation-leaning ECB for eurozone stagnation. The politicians should take matters into their own hands and instruct the ECB to intervene to drive the euro lower. In almost all developed industrialized economies, the politicians and not the central bankers decide foreign exchange intervention. And that is also the case in the eurozone, where politicians can direct the ECB to intervene ?after consulting? with it (n.b. consulting does not mean agreeing, see article 219, para 2 of the Lisbon Treaty - link see p101).
In this context a recent paper by Olivier Blanchard, the IMF chief economist, comes at a particularly interesting time. His suggestion that policymakers should be targeting 4% inflation rather than 2% is controversial but spot on in my opinion - link. For with inflation rates now running at such low levels, the risk is that a further ?shock? will tip the global economy into outright deflation. There is nothing sacrosanct about current targets. New Zealand, for example, the market leader in inflation targeting, raised their target from 0%-2% to 0%-3% back at the end of 1996 - link. But the problem for the eurozone, unlike the UK, is that the inflation target is set by a deflation leaning central bank rather than the politicians.
And as for the follow up on Edward's views on Greece as relates to a Richard Koo-endorsed policy action, A.E. notes:
Finally, a quick work on Japan. I had quite a large number of responses to the Richard Koo article I posted about the need to continue to fiscally stimulate throughout the private sector?s de-leveraging process. Many readers rightly commented that the alternative to a relapse into recession is ending up with a wholly untenable Japanese-style public debt situation.
My colleague Dylan Grice'?s view on this is interesting. He believes that Japan?s private sector de-leveraging process was concentrated in the 1990?s. But over the last decade the semi-deflationary, low-growth environment is very much down to the rapid deterioration in the demographic situation. Hence when we contrast the terrible GDP growth Japan has suffered over the last decade (see left hand panel below) with the situation per head (right hand panel below), it is clear that the Japanese economy has in fact been performing perfectly well. Its outsized public sector debt/GDP ratio may be a consequence of poor demographics. In contrast, the US demographic outlook shows a continued expansion of the working age population through this century (Europe is similar, but not as bad, as Japan). So maybe Koo?'s prescription may not result in the US hurtling off into a Japanese-style debt debacle, maybe!
Some additional perspectives on a Japanese comparison, courtesy of David Rosenberg's early AM note:
To be sure, it does look as though the U.S. economy has moved into an expansion phase, but like the markets, it is volatility around the downward trend. This time last year we are seeing -6.4% GDP growth and then by the fourth quarter of 2009 we are at +5.7%. What a swing. It does remind me of Japan, which has experienced no fewer than 12 quarters of 5%+ GDP growth since its bubble burst in 1990 and one-third of these occurred in the initial years after the crisis began. But there have been twice as many quarters with negative growth. Therefore, volatility is the only certainty in the economy following a credit collapse — and the markets as well.
We recall that the Nikkei enjoyed 230,000 rally points since 1990 and the market is still down 70% from the peak at that time. It’s no different for the U.S.A. following the prior credit collapse in the 1930s — the decade saw 20 quarters of 5%+ sequential GDP growth! That’s a depression? Of course it was because there were 13 quarters of contractions mingled into those intermittent positive spasms. Real GDP did a bungee jump of 11% in 1934 and yet if memory serves me correctly, the level of economic activity was basically no higher in 1939 than it was in 1929; and because it was deflation and not inflation that predominated in that period (even with the New Deal!) nominal GDP finished the decade with a 13% loss.
It was not until the first quarter of 1941 — with the help of the war effort — that the prior 1929 Q3 peak in nominal economic activity was taken out (despite seven years of massive FDR stimulus and the odd extremely whippy positive GDP quarter). Moreover, the next secular bull market in equities did not begin until 1954 — 25 years after the prior peak. So the message here is to focus on the forest, not the trees … and to look at an inventory-led 5.7% growth rate in Q4 in the context of wiggles around what is still a fundamental downtrend.
At the end of the day, the focus is precisely on the competitive FX devaluation in a fiat world. Recent frequent overtures by the Swiss National Bank indicate just how seriously this issue is starting to resound. Japan has been posturing as well (yet after 20 years of more of the same, nobody really cares) about incremental monetary policy to break deflation's back. Europe will soon be in the same boat as the US, and with China pegged to the dollar, and very likely to seek a devaluation instead of a currency inflation policy, the dollar will once again be alone as currency flows have no alternatives. Which means that the Fed will have to come up with something very creative in its quest to break the dollar's back (or else kiss Obama's export-led recovery goodbye). We are fairly confident that something will become very evident over the next 6 weeks, with the catalyst being the end of MBS QE, which as we pointed out yesterday is already 96% completed.