Societe Generale strategist and resident permabear, Albert Edwards is revisiting his Ice Age thesis this month as US implied inflation expectations fell lower, following what he sees as a multi-cycle step down into outright deflation.
“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,” Edwards writes. “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.”
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Investors losing confidence that inflation will return, says Albert Edwards
One of QE’s ironies is that bad news is welcomed by the markets because it means that accommodative monetary policies will last longer, while unexpectedly good news can cause asset prices to dip. But Edwards argues that this is only true as long as inflation expectations don’t go too low. In particular, he says that when US 5y implied inflation expectations drops to 1.5% or so equities start to fall as well. You can see this effect pretty clearly over the last fifteen years.
There was also a jump in US 10y real yields in September, causing the spread between ten-year real and nominal yields in more than a year.
“This tells me that investors remain confident in the economic recovery but are losing confidence that the recovery will ever bring about a revival in actual inflation,” says Edwards. If that lack of confidence spreads to the recovery in general, then we will start to have a major problem.
Global debt has also increased since the financial crisis
The other problem that Edwards sees is that the level of public and private debt has only increased since the financial crisis. With the global debt-to-GDP ratio now over 220%. Even emerging markets have roughly a 150% debt-to-GDP ratio now, with most of the new debt in the private sector, setting the stage for hard landings not only in China.
If Albert Edwards’ Ice Age scenario plays out then the combination of falling inflation expectations and high leverage means that we are in for another recession relatively soon, but even then we will only be three recessions into an extended bear market that Edwards believes will need 4 – 6 to finally exhaust itself, with central banks papering over structural problems and increasing fragility with each iteration.