Albert Edwards: «The stock market is just ignoring the economic shock»
The alternative SocGen global strategist expects for the US a deflationary bust and negative interest rates soon. His preferred investment remains gold.
He knows that, as an economist and strategist, he enjoys great privileges. At Société Générale, Albert Edwards has the freedom to express his own views which do not have to coincide with the house view of the French bank. This is precisely why a big part of the financial community is very keen to listen to him when he comments on the markets far from the mainstream. Not even in this in-depth interview with Finanz und Wirtschaft, he is not afraid to make clear statements. Among other things, Edwards expects the US Federal Reserve to introduce negative interest rates before the end of the year.
Albert Edwards, for years you have been warning about a crash. But the confirmation from the stock market plunge in March was quite short-lived. - It was quite amazing to see how the S&P broke through important levels. Up until 3000 points it looked like the usual recovery rally we see after this kind of setback. But now I am really becoming surprised. And believe me, it does need a lot to surprise me doing my job for 37 years. I admit that I often get it wrong, but I struggle to fit this into my view.
So you still feel comfortable to remain on the bearish side? - Equity markets always rally in the recession because of the stimulus. If you look at previous bear markets, equity markets repeatedly tended to react too early. You often get a, let’s say, 20% rally, and then markets fall again very sharply. This time has been more than normal. First the collapse came rather quickly, the recovery was very quick. What surprised people is the volatility and the rapidity of market moves,
Is there too much optimism in the markets? - The question is at what point it becomes an embarrassment for the Fed?
What’s the Fed’s problem from your view? - There was a lot of criticism for bailing out Wall Street at the expense of Main Street, they were criticized for doing this already in 2008 and 2009. Now it seems they do the same thing again. Always when you go into a recession, there is a shock. Have you ever seen that the market just ignores the shock? This time the recovery even started before we had the blow of the deep recession. Markets are high on liquid drugs.
Now, as the Fed is even buying junk bonds, what does that mean for the corporate sector? - We have a debt time bomb in the US. They try to support the corporate sector. But as often, profits are privatized, losses are nationalised. This is what’s happening time and time again. Let me be clear, people are fed up with this boom and bust credit cycle. When I joined Kleinwort Benson, we had a huge loan book to the US that had to be written off. The U.S. companies were leveraging up in the late 80ies, then in 1991 despite one of the shallowest recession the US has ever seen, massive bankruptcies and defaults occurred in the corporate sector because of excess leverage.
What does that mean for the current recession? - It will be much worse. The IMF said 2017 in its Global Financial Stability Report that in the next recession 20% of all US companies would default. The Fed created this corporate debt bubble and now, instead of letting companies go bust, the central banks are trying to bail them out by buying corporate bonds. In the 2008 crisis the central banks wriggled out their responsibility and blamed the commercial banks. This time, under the cover of Covid-19, they are wriggling it out again in my view.
What has changed? - Now we see the central banks almost directly financing the government. In Q2 the US issued 3 trillion dollars of government bonds and the Fed promised to buy it all. That’s a massive change.
Will markets continue to rally? - Yes, it could go higher. The key resistance point was 3000 points where the 200-day moving average was. But keep in mind that the bond market isn’t really buying it at all. The 5-year Treasuries has been between 0,3 and 0,4% which is the lowest level since the beginning of March. Bond markets haven’t really bought into this cyclical recovery at all.
What are the biggest risks? - The next big macro challenge for the equity market will be the realization in the next couple of months that the US is going into outright deflation with core CPI inflation year-on-year going negative.
You see rather a risk of deflation than a risk of inflation? - Both headline and core CPI inflation will go negative will go negative. I know the discussion that both supply and demand side got a hit but the recent data shows that the core CPI will fall below zero. In March CPI fell 0.4, it was only the fifth month of decline for the first time since the 1980ies. That’s huge. My calculation is that we see another couple of months like that and then we see deflation.
The stock market doesn’t share this view . - The equity market is sort of trying to look through of the 50% decline in GDP in Q2 and the collapse of profits. Forward earnings in the S&P 500 will go back from 175 to 100 $ or less per share. That would take the forward P/E ratio to 30 which would be a record.
Should we really see deflation, what would be the consequences for currencies? A fight for devaluation? - Absolutely, a currency war will be part of fighting a deflationary bust, especially in the US. Nobody wants to have a strong currency. Switzerland has been one of the leaders in this war but now others will join, acting much more aggressively.
For example by introducing negative interest rate? When will the Fed take such measures? - Probably within the next six months. Ahead of the US presidential election, we will see aggressive actions. In the next months it will be clear that the economy is slipping into deflation. As soon as this is acknowledged, the strong dollar will no longer be acceptable. Currently the dollar is 35% overvalued versus the Euro and 55% over the yen. This is tolerable while the US has a much stronger economy and inflation than anybody else. It is absolutely intolerable now as the US slips into deflation.
Are negative interest rates a sensible tool? - I agree with the view that it will be counterproductive because of the impact on banks and investments. But the number one priority is to avoid deflation, not to protect the banking sector and the money market mutual funds. US president Trump will eventually be more aggressive in terms of his reaction towards the weakness in the US economy. A trade war with Europe is an increasingly likely outcome.
At the same time, equity markets are decoupling from the real economy as fast as never before. Is this a worrying sign? - Indeed, equity markets seem to be able to brush off the real economy and the earnings decline. Neither is the market taking fully on board the drop in inflation. The main reason for that is that central banks have crossed the Rubicon in terms of monetization and fiscal and monetary cooperation. This will lead to higher inflation at some point, I would say in the next 3 to 5 years. At that point, we get to the end of the ice age in terms of secular stagnation. But as I said, in the meantime, we get a deflationary bust. I think, bond yield will start to move lower very quickly indeed over the next couple of months. I would be surprised if the equity market was able to shrug off the Japanification of the US.
Which in turn is not good for equities. - On the one hand, if the bond yield is going below zero, why can’t equity market go even higher, a bull would say. But what I would say that because you have US the corporate sector with these huge debts, whether or not the Fed is buying corporate bonds doesn’t stop these companies going bust. The Fed might delay it for a while, as companies can raise more liquidity in the bond market. But there is still a problem in the first place. You could be liquid but be insolvent. Excessive debt is toxic debt for companies, because outright deflation means revenue growth is stagnating or going negative. Companies can’t deal with this excessive debt on the balance sheet, that what’s happened to the Japanese corporate sector. They got zombified.
Your advice for investors? - I am very cautious about the deflationary bust and policy makers being forced to print even more. Short-term, this is an environment where bond yields go even more negative and is it also is favorable for gold and gold mining stocks.
Despite the recent rally in gold? - Gold can go much higher. In case we see the introduction of helicopter money, gold could go up beyond 3000 $ per ounce.
Any other buying opportunity? - Not now, but if we look longer term, five to ten years down the road, we could see a transition away from the ice age to a more inflationary world. In the US inflation could go up very sharply. This environment should be good for real assets, commodities and property.
What about equities? - My only question is, if we start an inflationary period while equities are still highly valued, then the profit growths could be used for a PE derating. Like in 1965 when the S&P was valued 25 times earnings. The lesson from the period between 1965 to 1982 is that when bond yields rise, the PE came down to around 6x and the market stagnated for 17 years. If the US market fell sharply in this recession, and was cheap, then it would be a good time to buy equities.
When will the Fed start to buy equities? - Not at the current levels. But if the S&P 500 (currently around 3000), fell below 2000, the Fed would likely start to buy there, absolutely. There is a point where they will do anything.
The Fed is even considering to introduce a yield curve control to keep longer-term rates from rising above its targets. - Do they really want to steepen the yield curve to help the banks? They basically are able to hold the yield, they done it before in the late 1940s. But we are talking now about yields falling below 0% in some months. They don’t need to control the yield curve. But as you know, at this stage, nothing is off the cards. Every year is a brave new world, it seems.
There is still abundant liquidity in the market. Could that prevent the deflation? - Not in the CPI, but maybe in asset prices temporarily. But equities cannot survive on liquidity alone. It could cover things up, but eventually you need the fundamentals coming through. It’s a whole new world. Nobody knows how deep the whole recession will be. The Atlanta Fed is now predicting a collapse in GDP of 50% in Q2. Equity markets do not care for the moment.
What will be the trigger for them to realise? - Who knows. Currently, markets are trading at 12-month forward P/E of 22 to 23 times. The record was 25 times during the tech bubble in early 2000.
So we are very close to that levels. - Yes, very close. Just imagine that most regular forecast forward earnings in the S&P 500 of 100 dollars a share. That would mean that at current prices the valuation goes up over 30 times. This is pretty mad. It‘s just an example of how markets are manipulated by central banks through quantitative easing. It’s so extreme, such a grotesque distortion that it’s almost embarrassing.
Central banks had to support the market to avoid a worse crash. - Sure, nobody could predict the coronavirus recession. But eventually it helped policy makers to cross the Rubicon and to take much more aggressive fiscal and monetary measures even faster and without resistance. They would have done it anyway but in a normal crisis, it would have taken much longer, and equity markets would have fallen much more sharply before these extreme measures would have been tolerated by the general public.
What’s the point for central bankers to cross the Rubicon? - Central banks built up a bunch of bubbles they can’t allow them to fall back to earth. They have to keep on printing money and now financing huge deficits. Previously in the US, the UK and Europe, quantitative easing has offset fiscal tightening. Now it’s more in the same direction. Money printing helps to finance directly government deficit. And in the recovery phase, it might be the universal basic income, the Green Deal, the social security deficit… any fiscal problem will be solved by printing money.
The next step would be helicopter money? - Eventually, if necessary it will be. But you might not need to get that far. Monetary experts say currently we do not even have proper monetization but the central banks could buy government bonds directly if necessary.
What would you have done differently as a central banker? - I am an economist. I can only predict what a central banker could do and what that means for the financial markets. I am not a central banker. People who are reading my reports sometimes think that I am an Austrian economist and therefore a liquidationist, but I am not. I am very much an interventionist. I have no problem with intervening if necessary. But central bank interventions have made things worse. By reducing interest rates and building up asset price bubbles to trickle down to economic growth, this has created a lot of inequality and anger. And at the end, everybody will ask how could this have been allowed to happen?
Have central banks gone too far? - There are people thinking that. I am saying that they are not meeting resistance at the moment. Are they going too far? It doesn’t really matter what I think but I believe they went too far a long time ago.
We have never seen so much political pressure on central banks before. - Sure, people are angry and as a result, populists are being elected. The equation is simple: Either central banks do now what populist leader want, or the leaders find other central bankers who do the job for them.
Will central banks ever be independent again? - No, they will be in service of the governments. I think that once you show populist leaders and the general public that financing that huge government deficit through money printing, they will be required to do it again and again and again until eventually it creates rapid inflation.
Like a vicious circle. - Initially most commentators will say, «what’s the problem doing it? It hasn’t created inflation so far. » Do you remember the last crisis? All the stuff we have been told about austerity, that we have to cut back government deficits and that there is no magic money tree. The consensus view now is that is all rubbish. Now they use the magic money tree. Monetary and fiscal policy are now one and this will lead to the end of the Ice Age, but not before a final deflationary bust.
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