Albert Edwards’ “ice age,” during which U.S. bonds outperformed stocks, is ending. But before a new regime sets in, U.S. capital markets are heading for a final meltdown that will leave equity investors much poorer.
Edwards is the global strategist for Société Générale and is based in London. He publishes a weekly strategy report, upon which this article is based.
Edwards is known for his “ice age” thesis, which posited that, beginning in 1996, the correlation between bond and stock yields would break down, and 10-year bonds would outperform stocks. His template was Japan and its lost decade of growth, which began in 1990. That forecast has been largely accurate, although it was disrupted temporarily by quantitative easing (QE).
When I last heard Edwards speak, in January of 2019, he foresaw the all-but-certain, unfolding recession (of course, he did not foresee that it would be brought on by a pandemic). Moreover, he predicted that the recession would be quite deep and accompanied by a deep trough in earnings.
In his recent writings, he has noted that in every recession since 1970, real S&P 500 earnings-per-share (EPS) have declined by a progressively greater percentage from their prior peaks.
The unfolding recession is the “final stage” of deflation, according to Edwards. The turmoil is so bad that it will force authorities to transition to a “new regime.” Those authorities will go from QE and monetary easing to monetization that will drive the “great melt” of fiscal deficits.
The OECD is forecasting a 25% economic retraction, he noted, and the virus has given the monetary authorities the “cover” to facilitate that monetization.
Monetization is not a precisely defined term, and Edwards clarified what he meant in an email exchange. Unlike the financial crisis, when much of fiscal stimulus, like the TARP program, wound up in banks’ balance sheets, this time the money is headed for consumer circulation.
The key difference from prior recessions, he said, is that fiscal and monetary actions are working in the same direction. In the past, QE was used to offset fiscal tightening, he said, but that is not the case now. Former ECB President Mario Draghi is saying the public deficits are “here to stay.” In the UK, the expansion of the central bank’s balance sheet is permanent. It cannot be reversed, according to Edwards.
“If you try to reverse it,” Edward said, “people will revolt due to the fact that Main Street received valuable benefits – public pensions will be fixed, businesses bailed out and the public will receive numerous handouts, which might include universal healthcare and a guaranteed basic income.”
The long-term danger with monetization that puts money in the pockets of consumers is inflation. But Edwards did not focus on the inflation risk. Instead, his concern was with the short-term deflation and a collapse in equity prices.
While In the short term, markets are focused on how deep a recession we will face in Q2 and Q3, there is little focus on the near-term deflationary outlook, according to Edwards. The market thinks secular stagnation will disappear and inflation will eventually arise.
Before we transition to the “great melt,” there is danger in the short term. There will be trouble getting funds to the small businesses, which have only one or two months’ worth of money. This spells deflation, according to Edwards.
Indeed, deflation is already showing up in the economic data. The core CPI fell 0.1% in March. Normally it is very stable. This was only its second decline since 1983; the other came in the aftermath of the financial crisis, in early 2010. The market is not focused on the prospects for deflation, Edwards said; instead, it is focused on the deficit and the resulting inflation surge.
Consistent with his near-term deflationary outlook, Edwards said the U.S. 10-year yield is heading lower, toward the 10-year German bund yield. Implied inflation expectations, which rose in late March and early April, will collapse into negative territory.
In mid-March, 10-year real yields spiked upwards, reaching nearly 1%. That reversed and real yields turned negative in April. Edwards said that nominal yield will follow and head toward negative territory. That is good news for gold prices, he said, which are inversely correlated to real yields and have not risen as much as many expected during the pandemic-induced crisis.
A bear market will play out in risk assets, Edwards said. He called the recent equity rally a “normal 50% retracement.” Equities will reverse and the Fed will buy S&P ETFs, he predicted.
“But even that would not spell the end of the bear market,” he said.
Adding to the risk of a collapse in equity prices, Edwards warned that populism is driving protests on a global scale. Citizens are being drastically hurt by the shutdown, especially the young and poor. He said that 20-year olds had three-times the amount of saving during the 2008 crisis compared to what they have now. But they can’t take to the streets because of lockdowns. When they see the bailouts of Wall Street, he said, there will be an explosion of protest and anger.
One worrisome signal of this era is that people are losing faith in leadership, Edwards said. There is no way these fiscal deficits will be unwound. They will be monetized away.
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Albert Edwards’ “ice age,” during which U.S. bonds outperformed stocks, is ending. But before a new regime sets in, U.S. capital markets are heading for a final meltdown that will leave equity investors much poorer.