2016 has thus far been a year characterized by remarkable bouts of harrowing volatility as the ongoing devaluation of the yuan, plunging crude prices, and geopolitical uncertainty wreak havoc on fragile, inflated markets.
With asset prices still sitting near nosebleed levels after seven years of bubble blowing by a global cabal of overzealous central planners with delusions of Keynesian grandeur, some fear a dramatic unwind is in the cards and that this one will be the big one, so to speak.
December’s Fed liftoff may well go down as the most ill-timed rate hike in history Marc Faber recently opined, underscoring the fact that the Fed probably missed its window and is now set to embark on a tightening cycle just as the US slips back into recession amid a wave of imported deflation and the reverberations from an EM crisis precipitated by the soaring dollar.
One person who is particularly bearish is the incomparable Albert Edwards. SocGen’s “uber bear” (or, more appropriately, “realist”) is out with a particularly alarming assessment of the situation facing markets in the new year.
“Investors are coming to terms with what a Chinese renminbi devaluation means for Western markets,” Edwards begins, in a note dated Wednesday. “It means global deflation and recession,” he adds, matter-of-factly.
First, Edwards bemoans the lunacy of going “full-Krugman” (which regular readers know you never, ever do):
I have always said that if inflating asset prices via loose monetary policy were the route to economic prosperity, Argentina would be the richest country in the world by now ?and it is not! The Fed?s pursuit of negligently loose monetary policies since 2009 is a misguided attempt to boost economic growth via asset price inflation and we will now reap the whirlwind (the ECB, Bank of Japan and the Bank of England are all just as bad). One of the main problems has been the overconfidence with which the Fed pursues their objective. Yet in the run-up to the 2008 Global Financial Crisis they demonstrated their lack of understanding of the disastrous impact of excessively low Fed Funds. Even in retrospect they remain in denial - as evidenced by Bernanke?s recent book. Why can?t these incompetents understand that they are, once again, the midwife to yet another global unfolding economic crisis? But unlike 2007, this time around the US and Europe sit on the precipice of outright deflation.
Next, after reiterating that the “impossible trinity” is called “impossible” for a reason, Edwards talks the RMB and exported deflation:
I have always thought that in order to revive a spluttering Chinese economy, the authorities would have to devalue, but not just because an overvalued exchange rate was squeezing their manufacturing sector (e.g. sector nominal GDP growth of zero in Q3 2015). Instead I felt that an overvalued exchange rate had steadily undermined competitiveness to the point that it had undermined the balance of payments. This was compounded last year by an accelerated capital outflow as anti-corruption measures intensified, and an unprecedented unwinding of dollar-denominated borrowings by Chinese corporates. All these factors have combined to take the Chinese balance of payments into deep deficit.
The BIS and IMF have both shown that rapid growth of EM dollar-denominated debt over the past few years was mainly concentrated in the Chinese corporate sector (unsurprising after years of steady, carry-trade inducing, renminbi appreciation). Hence despite the Chinese economy being sucked into a deflationary quagmire ? best illustrated by a declining GDP deflator ? many dismissed the possibility of devaluation because of the likelihood that this dollar debt would cause substantial corporate bankruptcies.
That risk to the Chinese corporate sector was substantially reduced by the end of last year. The Institute of International Finance (IIF) recently reported a huge unwind of this debt.
This prescient action means that many Chinese corporates have taken the signal from the initial August devaluation seriously and readied themselves for further renminbi fall. Hence China is now in a better position to transmit a massive deflationary shock to the West without damaging its own corporate sector. Indeed we can already see US import price deflation intensifying as the decline in the dollar prices of goods from China accelerates.
What comes next? The collapse of the US manufacturing “renaissance” (and we put that term in quotes for a reason):
The western manufacturing sector will choke under this imported deflationary tourniquet. Indeed US manufacturing seems to be suffering particularly badly already.
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"Where will it all end?", Edwards asks, before noting that in previous bottoms, the Shiller PE touched 7X or below, a far cry from the 13.3X seen at the supposed "bottom" in March of 2009.
I believe the Fed and its promiscuous fraternity of central banks have created the conditions for another debacle every bit as large as the 2008 Global Financial Crisis. I believe the events we now see unfolding will drive us back into global recession.
Valuation booms are followed inevitably by busts. But the key point is that these valuation bear markets take the Shiller PE back down to 7x or below.
Since valuations peaked at the most obscene level ever in 2000, we have only seen two recessions and at the nadir of the last one, in March 2009, the Shiller PE bottomed at 13.3x, way above the typical sub-7x bottom. In valuation terms the bear market was not completed in 2009 and indeed after only two recessions there was no reason to expect it to have been completed.
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If I am right and we have just seen a cyclical bull market within a secular bear market, then the next recession will spell real trouble for investors ill-prepared for equity valuations to fall to new lows. To bottom on a Shiller PE of 7x would see the S&P falling to around 550. I will repeat that: If I am right, the S&P would fall to 550, a 75% decline from the recent 2100 peak.
Needless to say, a rout of that magnitude would wipe out virtually everyone from Wall Street to Main Street and the malaise would invariably be exacerbated by bouts of flash crashing madness in broken yet increasing correlated markets where "all weather", risk parity strategies are no longer reliable umbrellas when the storm hits.
With rock bottom rates and a still bloated balance sheet, the Fed would be working with exactly zero counter-cyclical slack, which means there would be no way for Yellen to avoid an all-out unwind of the much ballyhooed wealth effect that's served to restore the 401ks for any Americans still foolish enough to retain a seat at a casino run by crazed PhD economists, vacuum tubes, and modern day robber barons.
