One Recession Away 'from Japanese-style outright deflation': SocGen - Hedge Fund Alpha (formerly ValueWalk Premium)
inflation vs deflation Eurozone and US Chart

One Recession Away 'from Japanese-style outright deflation': SocGen

will have begun to be squeezed far harder than many expect.

US unit labour cost inflation has risen above core PCE, squeezing corporate margins

labor costs inflation

We have long believed that the post-bubble economic outturn would closely resemble what we saw in Japan. Indeed since the peak of inflation in the early 1980s, each cycle has seen inflation progressively squeezed out of the system and nominal cyclical variables registering lower lows in the downturn and then lower highs in the recovery. Since the bubble burst the trend towards lower nominal quantities has continued despite massive QE. US nominal GDP growth may have peaked out in this recovery at an unprecedentedly low 4% yoy (chart below).

US nominal GDP and wage bill show a series of lower highs and lower lows (yoy% 6mmav)

GDP

The trend towards low nominal quantities is an essential plank to our Ice Age thesis. The equity bulls, using the Fed valuation model (bond/equity earnings yield ratio), see lower inflation and bond yields pushing PEs higher. But in the Ice Age we said that this would be more than offset by lower long-term profit expectations (profits and nominal GDP rise in line in the medium term), and the equity risk premium would rise as the economic and profits cycle became more volatile in a world of very low inflation. In the Ice Age, equity PEs contract despite falling bond yields. This was a maverick view back in the late 1990s.

Another maverick view we had back in 2007 is also very relevant today. Back in 2007 investors were convinced that markets would remain buoyant because there was ample liquidity. In a note back then we said that this was a false crutch for investors and that the liquidity would vanish from the markets if price momentum took a turn for the worse. I have exactly the same view now. In the same way that QE seems, in large part, to be bypassing the real economy, liquidity will evaporate from equities if we dive into a deflationary recession. Where will all the liquidity then go as QE is ramped up still further? It will go into ridiculously expensive bonds. Copper is acting exactly as it did when I wrote about the impotence of liquidity in the face of the (then imminent) 2007 recession. Once again it is giving us an early warning that liquidity will not save risk assets: time to get out of equities.

‘Dr Copper ’ telling us that the party’s over – Don’t be the last to leave

copper

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