It’s been nearly 18 years since Albert Edwards forecast an “ice age” in which bonds would outperform equities. He’s been right until just recently, when cumulative returns on the two classes converged. But Edwards insists that his thesis is still accurate – deflation will be the force to propel bonds over stocks, he says. Dylan Grice, meanwhile, warns that the markets operate on an unstable equilibrium that could devolve into apocalyptic conditions.
The two spoke at Societe Generale’s annual research conference in London on Jan. 14. Edwards is the firm’s global strategist. Grice is the director of research at Edelweiss Holdings, a Zurich-based investment manager. Prior to that, Grice worked alongside Edwards at Societe Generale.
“We are one recession, one slip away from outright deflation, both in the euro zone and in the U.S.,” Edwards said. That would adversely affect equities, he said.
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If that message wasn’t sufficiently foreboding, Grice warned of a societal breakdown that would be far more disruptive.
The financial markets measure trust through yield, according to Grice. Investors should not be lulled into assuming today’s record-low yields (in both equities and bonds) imply similarly low degrees of risk. That is incongruous with current political developments, he said.
“It is wrong. It is the last hurrah,” Grice said. “This is not just an economic but a social phenomenon.”
Beware a deflationary bust
Edwards cited a number of indicators indicative of impending deflation.
“Actual inflation is crumbling away downwards,” he said. Both core and headline inflation – including measures of food and energy – are trending lower in the U.S. and the euro zone, according to Edwards. He claimed that the European Central Bank is not worried about this and, in fact, might believe deflation would help Spain or Italy become more competitive. Edwards said this line of reasoning was “ludicrous,” given the debt burdens those two countries bear.
Weakness in the U.S. labor markets is another indicator. Edwards cited a recent commentary by PIMCO’s Bill Gross, who wrote that household employment, which has been a reliable leading indicator of non-farm payrolls, has been very weak for the last year – running at a pace of approximately 100,000 new jobs per month.
Economists’ projections for inflation have trended down steadily over the last year, according to data Edwards presented. But in the U.S., economists continue to expect inflation above 2%, which he said is seriously disconnected from the data.
Edwards sarcastically remarked that he knows there is a deflation problem when, in his own country, the Bank of England was able to hit its inflation target of 2% for the first time in almost four years. But investors remain confident in the central banks’ ability to avert deflation, which Edwards said explains why markets have not priced in this scenario.
Japan will pay a key role in the oncoming deflation, according to Edwards. “Japan is fiscally bust and they have no option but to print, print and print,” he said. That will weaken the yen, and Japan will export its deflation to the rest of the world.
Other Asian exporters – Edwards mentioned Korea and Thailand – will be forced to weaken their currencies, pushing more deflation into the developed markets. A similar phenomenon occurred in 1995-97, according to Edwards, when Japan’s weakening of the yen triggered the Asian crisis.