The last time we heard from Albert Edwards at the end of March, the SocGen strategist explained that clients always want to know if they should worry "NOW?" His answer, as many would expect, was that "yes they should" as there are now "very worrying signs that yet another Fed-inspired credit bubble is beginning to burst", among which a surge in small bank delinquencies and mortgage delinquencies, as well as the recent sharp drop in economic indicators and the US personal savings ratio. Last but not least was the ultimate catalyst for every recession: rising rates.
The Fed generally tightens rates until something breaks. David Rosenberg points out that since 1950 there have been 13 Fed tightening cycles, and 10 of them ended in recession (while the others have often ended in emerging market blow-ups, like the 1994 Mexican peso crisis). Surging delinquency and charge-off rates for smaller banks suggest the breaking point for the economy may come sooner than the Fed and bulls expect.
Still, despite the prevailing doom and gloom... there was something missing: some of the good, old-fashioned fatalism that marked Albert's earlier days of this so-called recovery. Well, over the weekend he redeemed himself and then some, in a Barron's interview in which he touched on everything from his trade mark "Ice Age" deflationary singularity, to the market, to the coming recession (again), to Trump's tariffs, to where the trade war will go next.
Below we share some excerpts from the must read interview:
What happens to stocks during the next recession?
The Federal Reserve managed to short-circuit this derating process. In 2011, when quantitative easing, or QE, really kicked in, equity re-engaged with bond yields and P/Es expanded. Like an artificial stimulant, QE inflated all asset prices away from fundamental value and from where they would otherwise have gone.
We haven’t seen the lows in bond yields. In the next recession, bond yields in the U.S. will go negative and converge with those in Germany and Japan. The forward U.S. P/E bottomed at about 10.5 times in March 2009 on trough earnings. That was lower than the previous recession. In the next recession, I would expect the P/E to bottom at about seven times, a lower low with earnings about 30% lower because of the recession. That would put the S&P lower than the 666 low of the previous crash, versus 2671 Thursday afternoon.
If a recession unfolds, easy monetary policy won’t stop the market from collapsing. It will play itself out.
When will the recession hit:
The Conference Board’s leading indicators look OK for now. What’s different is that problems in the real economy aren’t being reflected in the stock and bond markets. What we may see is the reverse: The stock market and parts of the credit markets collapse and cause problems in the real economy. If confidence collapses because the equity market collapses, then a recession unfolds.
Will the US be hit harder than Japan and Europe in the next bear market?
It should be. Traditionally, if the U.S. goes down 20%, the German Dax, though it is cheaper, would tend to go down a little more. Maybe this time it won’t. Japan is the one market we do like now on a long-term basis, and one of the reasons is the buildup of U.S. corporate debt during these past few years. The big bubble is U.S. corporate debt. In contrast, Japan’s corporate debt is collapsing. Over half of its companies have more cash than debt.
When the Fed buys U.S. Treasuries, it pulls down all yields. There has been demand for yield, so investors look at corporate bonds as an alternative. Companies have been very keen to issue them, and they have used the money to buy back stock or as a way to enrich management. This is the way QE has washed through the system here
What about credit?
Corporate debt has ballooned out of control not just with larger companies, but with smaller companies as well. Net debt-to-Ebitda has rocketed to all-time highs.
In its Global Financial Stability Report of April 2017, the International Monetary Fund said that in the next recession, 20% to 22% of U.S. corporates would default. This is where the U.S is vulnerable. It isn’t just junk-bond issuers. It is the explosion that has taken place in corporate debt. Companies can be put under tremendous stress by the financial markets in an equity bear market, which means they cut employment and investment.
There is a massive corporate credit bubble out there waiting to be revealed in either a recession or an equity bear market that causes a recession from the disintegration of the corporate bond market. Normally in a bear market, if equities are down 50%, then junk is down 50%, and investment-grade debt is down about 15% or 20%. In the next downturn, junk will probably be down more than 50%, and investment grade will be down 30% or 40%. That will be the big surprise. In contrast, Treasury rates will rally.
What should one buy ahead of the next "Ice Age"?
If the U.S. 10-year Treasury goes from 3% to negative 1%, that is huge return. In equities, it would either be Japan or, if you can invest only in U.S., then gold miners, as gold will exceed its previous $1,900-per-ounce high.
But don't hold on forever:
People should look to hide in [US Bonds] as a haven over the next six, 12, 18 months. And, hopefully, if equities become cheap enough, then that is the real opportunity. But you have got to have cash to take advantage of those opportunities.
What Trump tariffs mean for markets, and will Germany be dragged into a trade war next?
Many thought after the election he would back away from these tariff promises. He has delivered tax reform, which is probably the most criminally insane piece of fiscal stimulus this late in the cycle. To take the fiscal deficit to 6% of GDP at this stage is utterly ludicrous, but he is delivering on his promises.
On tariffs, China will escalate. To a person, all economists think a tariff war is catastrophic for the global economy. This isn’t about economics; it is about politics, about appealing to President Donald Trump’s base. If China acts on its proposal to put on tariffs on soy exports to hit his base, or it switches from Boeing to Airbus, then you really know things are getting nasty.
Germany may become a target. It has the biggest dollar surplus in the world now. If you are looking for things that will knock the market, Germany is annoying everyone in terms of the size of its trade and account surplus, not just the U.S. The European Commission has complained about Germany’s trade surplus. The Germans don’t help themselves. When China and Japan are criticized, usually they do a little something to placate criticism. Germany’s politicians are dismissive: “We have an incredibly large surplus. What do you expect us to do? Make crappy goods like you?”
Finally, why the end of the Fed is coming:
In the last cycle, central bankers were lucky. They were able to blame the commercial bankers for the financial crisis, even though it was their job to take away the punch bowl. In the next one, the blame will stick to the Fed, and it may well lose its independence.
Full interview here.