A chilly outlook for the global economy
Renowned economist Albert Edwards offers his thoughts on the world's modern problems and voices his fears about deflation
Why are markets apparently so unfazed by falling inflation around the world and the growing risk of deflation, which could be extremely damaging for heavily indebted countries, companies and households?
Albert Edwards, the bearish Société Générale strategist, believes the apparent disconnects - such as ten-year inflation expectations derived from the bond markets of about 2.5%, compared with levels of 1% or less in the US and Europe - can be put down to a basic misconception among investors.
"The market appears to be ignoring the risk of deflation ... because it thinks we are in a self-sustaining recovery," argues the economist whose 'Ice Age' thesis has been warning for the past 18 years that equities are heading for a collapse and bonds a huge boom because of global deflationary pressure. His unwavering belief in this prediction has earned him a following of investors along with the derision of some fellow economists.
"It takes many economic cycles for the de-rating process to fully play out"Edwards maintains that the recent unusually long economic cycles have lulled investors into a false belief about where we are in the cycle. The next downturn, he says, is closer than most people believe and could easily be sparked by a deflationary impulse from Asia.
"If the market thinks we are getting an interruption in growth, then it will very rapidly focus on what is going on: deflation. We are one recession away from negative inflation in the eurozone as a whole, and in the US, I think. Germany will be hit worst of all by the emerging-market slowdown and devaluation from Japan."
It is during recessions that equity markets give up their gains from bear market rallies, he says. "Markets have been buoyant for exactly the same reasons we used to see strong rallies in the Nikkei in the 1990s. We are in a cyclical recovery caused by government policies, in this case quantitative easing (QE) specifically designed to drive up asset prices. History suggests that each bear phase of this structural valuation bear market occurs in recession. The equity market embraces it to take its next leg down."
Ice ideaThe key element of the Ice Age thesis, which was formulated in the second half of the 1990s while Edwards was at Dresdner Kleinwort, is the idea that Japan's experience of a credit-fuelled boom in the 1980s, followed by a savage bust and a long period of deleveraging, provided a template for the rest of the world.
"At the end of 1996, we said we knew from Japan that, with price stability having been reached, lower inflation would stop leading to price/earnings expansion in equities, but that bond yields would carry on falling," says Edwards. "We went one step further. We thought that, as we got nearer to deflation, the economic cycle would become more volatile and equities would de-rate in absolute terms and relative to government bonds."
As the name suggests, however, the unfolding of Edwards' Ice Age theory is likely to take decades and will be characterised by lower highs followed by lower lows in equity valuations and bond yields.
"The bull market in US equities ended in 2000," he says. "Then it takes many economic cycles for the de-rating process to fully play out. This ends with equities going from extremes of expense, as in 2000, to extremes of cheapness, as in 1982, with the [ten-year average] price-to-earnings bottoming out at about seven times. The US has had three structural valuation bear markets like this before in equities. They take between four and six recessions to be completed. We have only had two ... the S&P did not see its bottom at 666 in March 2009. It will go lower still."
Downward spiralCurrently, developed-world stock markets are largely heading in the opposite direction, recording post-crisis or even record highs - even as inflation around the world edges steadily lower. Parts of the southern periphery, including Spain, are already suffering deflation. What does Edwards believe is happening?
A key element of his current view is that major Asian economies, particularly Japan and China, are attempting to deal with their internal problems, including huge excess capacity and inflation that is persistently too low, via their currencies. By weakening their currencies, Edwards says, these countries are driving down the price of their exports and effectively imposing falling prices on their trading partners, particularly in Europe and the US.
The only apparent defence the developed world has against the threat of renewed recession is QE - or "spraying money into the economy", as Edwards describes it. The problem is that no one really knows how and why QE works (or does not work), although Edwards believes that if QE carries on long enough, central bankers will eventually succeed in creating inflation.
"They have no other tool to use. There is already lots of inflation in financial markets from QE; it just has not spilled out into goods and services yet. In three to five years' time, it probably will start to do so. On that time horizon, government bonds are toxic assets, but on a 12- to 18-month view, I think yields will go lower."
Although Edwards concedes that the first round of QE in 2009 probably was necessary, he says subsequent rounds have done little or no good - and carry huge unknown risks.
"The economy is not in meltdown; it is just experiencing weak growth. The Bank of England is printing unlimited quantities of money, but the consequences of what it is doing are very unpredictable in creating asset bubbles that may eventually burst and blow up in its face. It could be making things ten times worse."
The original version of this article, written by Andrew Davis, was published in the June 2014 print edition of the Review.