June 9, 2017
This Insights will focus on some of the research highlights from Albert Edwards. I’ve followed Edwards for a long while and love what he does – his pieces are entertaining and his views often counter-trend. Going against the ‘herd’ is a tough game and Albert does it well. He recently came 1st in the 2017 Extel survey. For those that don’t subscribe to Socgen, a lot of his work gets onto www.zerohedge.com.
Edward’s views are that we are in the midst of a financial ‘Ice Age’ and he is a proponent of long-dated US government bonds, on the expectation that inflation and yields will fall. He’s probably had a tough ride over the last few quarters as market expectations have shifted dramatically, with yields of long dated ‘risk free’ assets spiking up on the expectation of improving growth and rising inflation.
His views though haven’t changed and he often highlights a chart that shows the total return for US equities, over the last two decades, have only just caught up with the performance of long dated US government bonds. And with a lot less volatility it should be added.
His view is that during the ‘Ice Age’ the relationship between bond and equity yields will break down, with ‘risk free’ bond yields declining whilst equity yields expand. This played out well from 2000 to around 2013, but more recently equity yields have been declining (largely due to higher equity prices).
A backdrop to Edward’s analysis is, in part, that the US will follow the trend of Japan, a decade or so later. Edward’s chart below highlights the relationship between US Bond and Equity yields which shows, baring the volatility around the trend, there is some relationship to Japan.
Before readers get too adamant that the two markets are totally different and that the US government is and will do a lot more to support growth, driving higher inflation, it should be noted that the Japanese government has carried out a massive fiscal deficit program for the last two decades.
Japanese government debt to GDP since 1990, the height of euphoria in the Nikkei, has risen from around 60% to 250%. In the case of the US, since 2000, debt to GDP has risen from around 60% to 105%. While still lower than Japan, its trajectory is the same. Not only that, but global government debt to GDP has also risen exponentially since 2000. This trend could continue for a while still.
In a nutshell, Edwards is of the opinion that the correlation between bond and equity yields will once again break and that the next US equity market sell off will be severe.
We would note that BCA Research’s Investment Strategy Report has also come out with something of a similar view. They expect that, while the US equity market will move higher, it will peak in mid 2018 and sell off during a period of deflationary fear.
Source: BCA research
It’s always tough to time these sorts of events and their size, but it’s interesting that there is an increasing consensus that the current rally can’t last. Where BCA differs from Edwards is the size of any eventual equity correction.
I believe the next major down move in the equity markets could be worse than BCA predicts, simply because of the amount of leverage out there – more of that in the next Insights.