Albert Edwards admits that his “über bear” reputation is well deserved, at least with respect to equities, an asset class he has dismissed for the last 10 years. His bearishness has not abated, and for the coming year, he fears that “deflation will overwhelm the west.”
Markets, he said, will riot.
Edwards is the chief global strategist for Société Générale and he spoke at that firm’s annual global strategy conference in London on January 13. Andrew Lathrope, the firm’s head of global quantitative strategy, and Dr. Marc Faber, the publisher of the Gloom Boom & Doom Report, also spoke.
Global markets face three risks, according to Edwards: bearishness in the U.S. government bond market, a flawed confidence that the U.S. is in a self-sustaining recovery and undue faith in the relationship between quantitative easing (QE) and the equity markets.
Deflation is the main threat, though, according to Edwards. “This is the year the markets really panic about deflation. You haven’t had that panic yet.”
Edwards said that U.S. equities are “stuck in a secular-valuation bear market” and have been inflated by QE. Though he did not predict a recession, he said stocks would react very negatively if one were to happen.
“The market embraces a recession by going to a new lower low on valuations,” he said.
He offset that pessimism with a bullish view on the U.S. bond market. He said the 10-year yield could go below 1% and “converge on what is happening in Japan.”
“Markets move on extreme surprises,” Edwards said, “and when expectations are so firmly held and they are shown not to be the case, you get these extreme moves.”
Let’s look at some of the candidates for surprises that Edwards identified and the path he expects major economies to follow.
Edwards’ three big risks
The net short position on the U.S. 10-year bonds is at a very high level, Edwards said, similar to the level at the beginning of 2014.
Edwards predicted an “extreme move down in yields” even if those bearish views are “justified fundamentally” – meaning if the U.S. economy were to significantly weaken.
Falling oil prices are driving yields lower, Edwards said, but he disagreed with the consensus view that oversupply and OPEC production are to blame. Weak demand, particularly from China, is playing a bigger role than most people assume. He provided the chart below, which shows that iron ore prices have fallen almost in parallel with oil prices:
Oil prices are just catching up with other commodities, Edwards said. He added that the same pattern is present in the relationship between oil and copper prices.
“A lot of the oil price weakness really does reflect what is going on in China,” Edwards said. “To the extent commodity prices are slowing because of weak growth in China, it’s a global demand effect.”
Edwards acknowledged that much of the published data on China are unreliable, but he said that its growth will be “far weaker” than the 7% level it has experienced for the last couple of years.
Edwards cast doubt on the view that the U.S. recovery will be self-sustaining. “If anything comes along to question that axiom, especially at these very elevated valuation levels,” he said, “you don’t even need an actual recession – just a near-recession can cause a very outsized reaction in the financial markets.”
One reason for his skepticism is the length of the recovery, which is already 64 months old. He said the lesson from Japan is that once the “bubble bursts,” as it did with the financial crisis, then a deleveraging cycle sets in and cycle lengths return to normal – much shorter than the current recovery.
Leverage among U.S. corporates reinforces Edwards’ skepticism. Lathrope presented data showing that corporations have levered up. They have used most of their profitability to fund share repurchases, and capital expenditures have been funded through debt issuance.
The profit cycle is worrisome, according to Edwards, because profits and margins are “struggling” in the U.S. Edwards said this is not evident from analyst data because corporations “cheat” in their reporting. It is evident, however, in data from more reliable sources that provide statistics for the whole economy like the IRS. Flow-of-funds data from the Fed support the slowdown in profits, Edwards said.
Profits are important, according to Edwards and Lathrope, because they are the biggest determinant of year-on-year growth in business investment. Even though business investment is only 15% of GDP, Edwards said it is the most reliable predictor of recessions in industrialized economies.
“Recessions are not caused by consumption, government spending or exports – none of those things,” Edwards said. “It is caused by the business investment cycle.”
Deflation from China
China is the tipping point that could drive a downward move in U.S. profits and trigger a recession, Edwards said. More specifically, he said the danger is in China’s real trade-weighted exchange rate, which is too high to support the level of growth China needs.
China’s reported 10% year-on-year growth in exports is “suspect,” Edwards said, and it will need to weaken its currency to drive growth. It is having issues versus competitive economies. This is why, for example, the U.S. has been on-shoring some of its manufacturing. The strengthening of the U.S. dollar is adding to this pressure.
In addition, overinvestment is leading to deflation in China, Edwards said. Its PPI has been in deflation for 35 months, similar to what happened prior to the Asian crisis in the 1990s.
Japan’s QE is adding to China’s woes, according Edwards. He said Japan’s QE is certain to devalue the yen and will likely cause the ECB to engage in its own QE program. As Lathrope pointed out, Germany and Japan are direct competitors with very similar export sector compositions.
“The big story will come when the Yen decisively breaks down through 121,” Edwards said. “Then you will get another round of deflation being sent from Japan to the rest of the world. Japan has had enough importing everyone else’s deflation for the last 20 years. They are giving it back to the rest of the world.”
China will be forced to devalue its currency, Edwards said.
Will markets lose faith?
Edwards said the leading indicators for the U.S. economy are not signaling an imminent recession. “It is the fear of recession which I think could hit the markets,” he said.
He said that some of the data reported over the Christmas period – the PMI and durable goods – were “weakening off very rapidly.”
“If that happens at a time when you’ve got this extreme level of bearishness in bond positioning,” he said, “that is easily going to drive the 10-year down very rapidly toward 1%.”
But if that were to happen, wouldn’t the Fed react by restarting QE?
While QE has been kind to U.S. equity investors, Edwards warned that it has not been as generous to owners of commodities.
“It was axiomatic for commodity investors up until 18 months ago. The QE was good for all risk assets including commodities,” he said. “And then it stopped. It stopped because of fundamentals – the fundamentals being China.”
QE might help equities if the fear of recession or deflation can be avoided, he said. But if profits fall into a “crevasse,” Edwards believes the markets will react.
“It doesn’t matter how much QE is spewing out of the US,” he said. “The markets will lose confidence that the policymakers are in control of events, just as they did in Japan in 1990. They lost faith that the policymakers were in control. This is the biggest risk out there.”
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And some final words of parting from Albert himself:
"While the western world frets about the imminent deflation threat investors seemed relived that headline Chinese real GDP was unchanged at 7.3% yoy in Q4. But in focusing in this data they miss the sharp slowdown in nominal GDP growth which decelerated to 7.8% yoy from 8.5%. That means economy-wide inflation in China as measured by the GDP deflator fell from 1.1% yoy to a mere 0.4%."
"The market has missed, once again, the fact that the greatest clear and present deflation threat to the west comes from China. Like Japan they will eventually be forced to export this deflation westwards."
"The weak oil price, which many commentators see as "good deflation" is in large part a Chinese demand led phenomena that is effecting the whole commodity complex. Weak oil prices are telling us China has a major deflation problem - as witnessed in the Q4 GDP inflation data - and just as in the minutes before a tsunami the tide goes out and all seems quiet (ie good deflation) only later will we, in the west, realise that this is a prelude to being overwhelmed by a deflation tidal wave cascading from China to the west."