Albert Edwards On The Problems Facing The US, Italy And China

Expect a recession in the next 18 months, said Albert Edwards. Bond yields will converge with those in Germany and will go negative. The economy will be in deflation – or at least face a significant deflationary “scare.” Those factors, he said, will create a terrific opportunity for fixed-income investors.

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Edwards is the global strategist for Societe Generale and is based in London. He spoke at his firm’s annual investment conference in London on January 15. Also speaking were Andrew Lapthorne, who runs quantitative analysis for the firm, and Gerard Minack, an Australian-based global strategist.

In addition to his forecast for the U.S. economy and markets, Edwards said two countries are poised to deliver destabilizing shocks to global growth: Italy and Japan.

The ice age and the threat of a recession

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. While his forecast has been largely accurate, he noted that it has been disrupted by quantitative easing (QE) since 2011. Now, with the Fed, ECB and Bank of Japan all tightening, he expects the ice age to continue.

But Edwards cautioned against underestimating the effect of central-bank tightening. Recessions are more likely to be caused by events in the markets – not the other way around, he said, as is commonly assumed.

The economist Brad de Long has noted that three of last four recessions were from unforeseen shocks in financial markets (the collapse of the dot-com bubble, the real estate bubble and the S&L crisis). The exception was the 1979-1982 recession. Edwards pointed out that the very minor episode of quantitative easing (QT) that started in October 2018 caused a very rapid unwinding of equity valuations – illustrating the outsized effect such actions can have on markets.

“We underestimate the amount of QT,” he said. He cited an academic study that shows that QE effectively pushed the Fed funds rate to -3.0%. The effect of QT has been to push the rate to effectively 5.5%, according to Edwards.

Edwards noted that the fiscal policy deficit has gone to 4% of GDP. He said that it is not the level, but rather the change in the deficit, that matters. In the U.S., there was a 1% discretionary expansion in fiscal policy last year, but this is now reversing. In Q4 of last year, he said the change in the deficit went form 0.5% of stimulus to 0.5% of tightening in Q1 – “a massive foot on the brake.”

“The U.S. will follow everyone else with a very rapid economic slowdown,” Edwards said.

The economist Larry Summers has asked rhetorically, with 3% growth last year, “How could there be a recession?” Edwards answered by pointing out that 75% of recessions have had 3% or greater growth in the previous year.

The IMF is predicting “barely a slowdown at all,” he said, “but commodities – particularly base metals – are telling us it could be a lot more severe.” Edwards added that metrics such as CEO confidence and the manufacturing ISM are poor, and that the ECRI also suggests a very sharp slowdown.

Ten of the last 13 Fed tightening cycles have ended in recession, Edwards said. Ahead of a downturn, as the Fed tightens, the yield curve steepens. “That is the phase we are in now,” he said. “Just because the jobs market is buoyant, as it was preceding the last two recessions, doesn’t mean there won’t be a recession.” Typically payrolls accelerate ahead of recessions, he said. “Strong payrolls don’t necessarily mean a recession is not coming.”

In terms of the bond market, there was a lot of panic when the 10-year broke out of the upper bound of its long-term downtrend, he said. There were extreme speculative shorts, he said, which led him to believe yields could snap back sharply. The same happened in June 2006, and six months later the economy was in deep recession.

“Little did we think that Fed Chair Powell would encourage the whip-around in interest rates that we’ve seen,” he said. Other Fed speakers have since echoed the dovish posture, helping prop up equity valuations.

His key prediction was that over the next 12- to 18-month period, U.S. bonds yields will decline and converge with those in Germany and Switzerland. Those yields will end up in negative territory, according to Edwards.

Read the full article here by Robert Huebscher, Advisor Perspectives


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