When last we checked in SocGen’s incorrigible (if affable) cynic Albert Edwards, the Kobe Bryant of market bears was busy explaining that the Fed was about trigger a veritable debt armageddon.
Specifically, this was the money shot from Edwards’ last piece:
Make no mistake. Unlike most in the markets, I remain a secular bond bull and do not think this 35 year long bull bond market is over. I believe the US Fed has created another massive credit bubble that will, when it bursts, lay the global economy very low indeed. Combine this with the problems of a Chinese economy dependent on increasingly ineffective injections of credit to produce increasingly pedestrian GDP growth and you have a right global mess. The 2007/8 Global Financial Crisis will look like a soft-landing when the Fed blows this sucker sky high.
So… not bullish, right Albert?
Well on Thursday, Edwards is back at it, likely unable to contain himself after watching risk rally hard on a “dovish” hike from the Eccles cabal.
As noted last week, there’s no point in trying to frame Edwards’ posts. It’s best to just let the master do his thing.
So finally the Fed has got its ‘a’ into ‘g’ and raised rates. Although this will be the first of many rate rises in a move to normalise rates, the Fed’s lack of verbal assertiveness means the market still cannot bring itself to believe the Fed’s own projections for interest rate hikes. Talking about dovish central banks, I’m heading to Japan at the weekend. One thing that surprises me is how resolute investors are at not re-rating the Japanese profits story — especially when compared to the US.
I’m packing my rucksack for a two-week combined business/pleasure trip to Japan. This is a real test of my packing skills as it’s pretty easy to squeeze two weeks of beachwear into a rucksack when I go for my annual hols to Barbados but Japan is a bit on the cool side at present. I’m more impressed with my wife though, who will also manage with one rucksack as hand luggage. But as she managed with only economy class cabin hand luggage on our three-week honeymoon, I’m sure she will manage this too (packing tips available)!
My first business trip to Japan was in 1986 when I worked for Bank America Investment Management. The big Japanese brokers used to invite fund managers every year for huge bond conferences and it was my turn to go. Remember in the late 1980s Japan was at the zenith of its economic power and their financial institutions were hugely rich and powerful. US business schools were running courses on why Japan Inc. would continue to dominate the world and why the US should replicate its example. I will never forget that 1986 trip as we were all taken by a new modern Shinkansen bullet train down to Kyoto at the broker’s expense and shown the historic sites. A few years later the Japan equity market peaked at over 50% of the world index. The rest is history as yet another seemingly unidentified credit bubble burst and laid the economy and stockmarket low.
Japan’s 1980s credit bubble was focused on corporate debt and when the bubble burst it took a little over a decade of deleveraging before the economy could shake itself free of this debilitating headwind only to be immediately confronted with the demographic headwind. But the latter has not constrained the profitability of Japan Inc. (see chart below).
My colleague Kit Juckes summed up the situation quite well: The Fed’s reluctance to send an aggressive tightening signal, instead preferring to again shuffle upwards its dots just slightly, has disappointed markets. But to be fair, the problem isn’t really with the famous dots. It’s with the market, which just doesn’t believe the Fed will tighten as fast as they say they plan to (see left-hand chart below). If the market took the FOMC at their word and discounted a 3% Fed Funds rate at the end of 2019 and beyond, then we’d probably have a 3% nominal 10- year Treasury yield by now.
Kit also points out after spending the 1980s defeating inflation, the Fed has allowed rates to spend progressively longer and longer below the nominal growth rate of the economy (see right-hand chart above). Trend nominal growth is only a first estimate of where the natural rate of interest might be and it’s definitely been dragged lower than that in recent years but depressed market volatility, and the strength of asset prices is a result of low rates. And nominal GDP growth is at 3½% while the FOMC’s range for the dots in 2019 was 3% wide, from 0.9% to 3.9% with a median at 2.9%.
One reason why the market doesn’t believe the Fed dots is that investors cannot conceive of Fed tightening to the point that it causes the stockmarket any serious damage. Time and time again over both this and previous cycles the Fed has backed off rate hikes as soon as the going got tough. Maybe that is why the S&P trades at such a huge PE premium to the rest of the world’s equity markets (see chart below), for only a small part of this divergence can be attributed to sector composition.
What is also significant from the PE chart above is how Japanese forward PEs are roughly the same as where they have been for the last six years whereas the US and the eurozone have seen considerable PE expansion. Yet Japan has seen much more rapid profits growth since the 2008 crisis. Some will put this solely down to the Abe-inspired weak yen, but the domestic-dominated whole economy profits measure shows exactly the same recordbreaking profile as the overseas-dominated stockmarket indices (see charts below).
Note also the whole economy profits in the US are not recovering anywhere near as quickly as the stockmarket measures. Indeed it is at this late point in the cycle that US stockmarket pro forma profit measures become increasingly manipulated and detached from the whole economy profit measures. This is why investors should now consult something equivalent in purpose to what James Montier calls The Cheating Score, which we call less controversially the Earnings Quality Score. It is at this point in the cycle that the US whole economy profits measure gives a more ‘truthful’ representation of companies underlying profit conditions the data comes from the IRS and companies don’t tend to lie to the IRS. The whole economy profits data is not so timely as the stockmarket data as the IRS and the Bureau of Economic Analysis have to give the data a good scrub. Hence the Q4 whole economy profits data will only be released with the 3rd estimate of Q4 GDP on 30 March. But we can get a sneak preview buried deep in the recently released Fed Z1 Flow of Funds release (you have to be a real geek to know this stuff). To that end we show the latest Q4 whole economy profits measures below. Much against expectations, whole economy measures slipped again in Q4 in line with unit labour cost data that show corporate margins are being squeezed. This is in contrast to the heavily massaged stockmarket measures which have been recovering briskly. We’ve seen this divergence before at the end of the cycle and I know which I believe. This adds to my concerns that US PE valuations are totally unjustified in stark contrast to Japanese PEs.