Perma Bear Albert Edwards fra Societe Generale:Inflation expectations in the US have just followed the eurozone by plunging lower. Until very recently, the Fed and the ECB had been quite successful at keeping inflation expectations in their normal range – this despite their clear failure to control actual inflation itself, which has consistently undershot expectations. Investors are beginning to realise that contrary to their confident actions and assurances, the Fed and the ECB have failed to prevent a dreaded replay of Japan’s deflationary template a decade earlier in the West. The Ice Age is once again about to exert its frosty embrace on markets as investors wake up to a new and colder reality.
There were two key parts to our Ice Age thesis. First, that the West would drift ever closer to outright deflation, following Japan’s template a decade earlier. And second, financial markets would adjust in the same way as in Japan. Government bonds would re-rate in absolute and relative terms compared to equities, which would also de-rate in absolute terms. This would take many economic cycles to play out. Previous US equity valuation bear markets have taken 4-6 recessions to complete ? we?ve only had two thus far.
Another associated element of the Ice Age we also saw in Japan is that with each cyclical upturn, equity investors have assumed with child-like innocence, that central banks have somehow ‘fixed’ the problem and we were back in a self-sustaining recovery. Those hopes would only be crushed as the next cyclical downturn took inflation, bond yields and equity valuations to new destructive lows. In the Ice Age, hope is the biggest enemy.
Investors must pay close attention to the (second most important) chart below. Investors are beginning to see how impotent the Fed and ECB?s efforts are to prevent deflation. And as the scales lift from their eyes, equity, credit and other risk assets trading at extraordinary high valuations will take their next giant Ice Age stride towards the final denouement.
They may be impotent to prevent deflation, but they are quite omnipotent at printing money, either electronically or in paper format, and while so far they have focused on outside money, soon they will shift to “inside” money creation, also known as Bernanke’s helicopter paradrop. That will be the moment when the status quo finally uses the nuclear option at pervasive global deflation, leading to a collapse in sequential, or parallel, collapse in fiat.
But even before that, there is something, that to the current generation of traders may be even scarier: a return to normalcy, or as Edwards calls it: bad news being bad news again, something which traders haven’t experienced in nearly 6 years.
We believe that as long as inflation expectations remain ‘well behaved’ then the equity market can continue to interpret ‘bad’ economic news as good news. At this point we defer on this topic to the world renowned authority on equity bear markets, Russell Napier, author of the definitive book Anatomy of the Bear – Lessons from Wall Street’s four great bottoms.
Russell has recently explained that we should watch inflation expectations closely. His work suggests that once 5y US inflation expectations fall to ‘excessively’ low levels, bad news no longer is seen as good news by the equity market but becomes straight plain vanilla bad news. Russell?s work suggests that historically, once US 5y implied inflation expectations dive towards 1½%, the equity market typically starts to disintegrate (see chart below). US 5y implied inflation expectations.
Russell also warns that those investors who want to stay and party as long as possible in equities at the end of this cycle should keep an eye open for a falling copper price and widening credit spreads. Credit spreads are indeed now rising, especially in the high yield area; they are not yet at the levels at which Russell believes we should man the barricades – but maybe we should begin polishing our bayonets
