zondag 23 juli 2017

Albert Edwards: Only One "Aberration" Is Preventing A "Petrifying Bear Market"

One month after he shared his preview of the endgame of this current centrally-planned economic regime (expect no happy ending there, as "citizens will soon turn their rage towards Central Bankers.") Albert Edwards is out with a new note asking whether "H2 2017 will undo the trend of lower inflation, bond yields and the dollar?" and - if the answer is no - he cautions that "investors might give some thought to the fact that we are now just one recession away from Japanese-style outright deflation!" The creator of the "deflationary ice-age" concept starts off by noting that equities have risen to new all-time highs as weak US inflation data have reduced expectations of further Fed rate hikes. This has driven both bond yields and the dollar lower and in turn EM and commodity prices higher. But, Edwards warns, the trend might easily reverse as the second half of this year progresses.
# "This might dampen the impact of recent compelling evidence that core CPI and wage inflation seem destined to remain curiously weak throughout the remainder of this cycle." 
But as the SocGen strategist concedes, a far bigger question is how the recent equity highs sit with our Ice Age thesis, is it dead or just sleeping?" Before he answers that question, Edwards first reminds us that with the latest inflationary print, US core CPI and wage inflation have surprised on the downside for four successive months and argues that "only two data points are sufficient for most of us to be able to draw a trend, but four data points surely provide clear evidence of the decisive re-emergence of a deflationary trend. At the very least this recent data is grounds for a dismissal of the argument that ‘end of cycle’ inflationary pressures might make a brief appearance, before the long-term deflationary secular trend reasserts itself in the next downturn."
*) Which brings us to the first key question posed by Edwards: If inflationary pressures are indeed ebbing in the US economy, this begs the question that if the third-longest cycle in US history cannot produce a cyclical uplift in wages and prices, what on earth will happen in the next recession! Investors might give some thought to the fact that we are now just one recession away from Japanese-style outright deflation! The US is not alone however in failing to spur inflation: as Gerard Minack shows in the chart below, although the number of OECD countries in absolute deflation at the core CPI level has receded, those undershooting a typical core CPI target of 2% are at an all-time high. This, Edwards says, "is quite amazing given where we are in the global economic cycle"...


None of the above should come as a surprise: recall that the primary driver of global inflation in the past decade has been, without fail, China, the same China that as we showed recently has seen its credit impulse collapse, and is therefore once again no longer exporting inflation...


Assuming that Edwards is right, and that China will be stuck exporting deflation for the foreseeable future, and that the latest wave of inflation is about to be submerged, that means that Edward's patented deflationary "Ice Age" scenario is about to become the dominant topic again. As a quick reminder, Edwards' big Ice Age call was that the tight positive correlation between equity yields and bond yields that market participants had enjoyed since 1982, driven by ever-lower inflation, would break down. The “long bull market” (see chart below) had been a mirror image of the 1965-1982 period when yields on both assets had risen together. The Ice Age thesis, drawing on observations of Japan, predicted that while interest rates and bond yields would continue to fall, equity yields would decouple and begin to rise on a secular basis. For those with a historical perspective the Ice Age would be a mirror image of the 1950-65 period, which in the 1950s had been dubbed “the culting of the equity market”. In the Ice Age, government bonds would rerate relative to equities, with the latter declining in absolute terms as well...


The SocGen banker then notes that "one important implication of the Ice Age thesis was that widely used metrics from the 1980s and 90s, such as the bond/equity earnings yield ratio, would break down. Hence you should no longer buy equities when this ratio fell to 0.8, as they would be undergoing a secular de-rating"...


And yet that has not happened, which is the basis for question #2: why not. Here recall that Edwards devised his ice age thesis by looking at events in Japan, and while he admits that his "ideas seemed mad back in 1996, having witnessed events in Japan through the 1990s we understood that the same forces would prevail in the West. Indeed, on some metrics, what happened to the US bond/equity yield relationship closely mirrors that of Japan"...


Yes, but not all, and certainly not the most important one: stock prices. So if indeed Japan is the model, how is it then that the US equity market has raced to all-time highs? "Has the Ice Age thesis broken down?" Edwards asks and adds that "to be sure, we saw strong cyclical rallies in the Japanese Nikkei within Japan’s own equity Ice Age secular bear market, but nothing as explosive as this"...


There is one possible explanation: the counter-argument to the Ice Age thesis is not just the unusual longevity of the current equity bull market. The key, according to SocGen, is that equity yields have re-coupled with declining bond yields...


Looking at the chart, and speculating on what happens once equity yields decouple with bonds and with recouple with the trendline, Edwards says that: "If this is, as we strongly believe, an aberration and the equity yield reconnects with the red dotted arrow, then investors should be petrified by the next equity bear market." Maybe, then again at this rate an entire generation of traders will soon come and go not only never having seen a bear market, but even just a 10% correction, and if so, and if central bankers are so powerful they can keep a market artificially propped up for 10 years just by creating money out of thin air... then why not 100, 200, or more?