Contrary to conventional wisdom the SocGen duo of Edwards and Grice has not turned bullish (despite Dylan's "call" for a 63 million Nikkei). In the following note, Edwards debunks this recent fallacy. More importantly, Albert provides a geographic locus of where the next bubble pop will come from, which is no surprise as it is the focus of all capital flows - Emerging Markets. As he says: "The simple fact is that if, as I expect, QE2 fails and fiscal tightening sends the fragile western economies back into recession, we will see the unfolding liquidity driven EM and commodity bubble burst just as violently as it did in the second half of 2008." Sorry Albert, with every central bank now all in, and ammo for additional operations now gone, the next blow up with make the H2 2008 implosion seem like a walk in the park. This will be infinitely worse than Japan. Which is why the last ditch to preserve the Ponzi will be unlike what anyone has ever seen before.
From Albert Edwards:
A very good client complained that we were doing a U-turn, ditching our previous Ice Age bearish stance on equities and becoming vastly more bullish – using QE as the excuse. And to be fair, Dylan’s last two notes, suggesting that the Nikkei could go to 63 million in 15 years and that emerging markets could double, might be construed as being a tad bullish. In this note I will make MY view crystal clear and tie it into Dylan’s recent work.
Our Ice Age views have driven our asset allocation for over a decade. We still believe we are locked in a secular valuation bear market for equities that will take many cycles to play out. We believe that we are now one recession from outright deflation in the west and that cyclical failure will take us to new lows on both equity prices and bond yields.
It remains my view that recession looms and will trigger yet another 60% decline in equity prices - the third in just a decade. But to be sure, the latest US ISM was better than widely expected, and the ECRI$s weekly leading indicator has just begun to turn upwards after reaching very weak levels recently that are normally consistent with recession (see left-hand chart below). The excellent folks at the ECRI recently declared "definitively" the risk of a double dip has now passed. But while I commend their lack of prevarication, I think this is a premature call given the degree of fiscal tightening coming down the tracks. In addition, the Conference Board leading indicator has also now moved into recession territory when the now defunct yield curve sub-component is excluded (because at zero Fed Funds the shape of the yield curve will now always add positively to the lead indicator, see right-hand chart below).
Meanwhile, bull-bear indicators suggest that the equity rally is now exhausted and crying out for a major correction (see left-hand chart below) at a time when the Conference Board measure of the jobs market suggests that the unemployment rate may be close to heading back up again, stoking further trade tensions with China (see right-hand chart below).
Dylan Grice and my erstwhile colleague James Montier have one key point in common when it comes to their investment approach - namely they both recognise the futility of economic forecasting. Dylan's mantra (apart from "make the tea Albert") is !there is no such thing as toxic assets, only toxic prices". Hence, like James, he is happy to invest if the asset is cheap enough. This approach also applies to insurance. Where there is a credible risk and insurance IS CHEAP, then one should buy that insurance. Hence his recent note on the high risk of runaway inflation in Japan sending the Nikkei to 63,000,000 in 15 years came to the conclusion that insurance is cheap and it is available.
However, as we first said about a year ago, the only statements that matter are the H.4.1 and the H.3. Everything else is now ignored. Which is why the hedge fund community will soon lose a bulk of their analyst pool: their services are now redundant (unless they are good at ferreting out insider information of course). They will be replaced by former Fed workers who can at least pretend to think like the bearded madman.
In the same context, his note last week showed that to the extent that EM had become the liquidity and momentum trade de rigueur, valuation was not a binding constraint and prices could rise significantly if we were to reach the same excesses seen in 2008 (see charts below). Even a wizened bear such as myself would buy out of the money calls if they were cheap enough as a hedge against my central case being wrong or, indeed, too early.
But for me, despite all this liquidity pouring into EM equities, they are just another high beta trade, outperforming on the way up and underperforming on the way down (see charts below). Show me a period when developed markets are down 20% and EM equities rise by 20% and I might be more of a believer. The simple fact is that if, as I expect, QE2 fails and fiscal tightening sends the fragile western economies back into recession, we will see the unfolding liquidity driven EM and commodity bubble burst just as violently as it did in the second half of 2008.