“Clients know from long experience that despite my depressing forebodings being unerringly premature, my outlandish visions can suddenly come to pass very quickly indeed”, Albert Edwards writes, in a new note reprising his “Ice Age” thesis in light of recent events.
Bond yields have plunged over the past several months, pushing the global stock of negative-yielding debt above $17 trillion.
Europe has led the charge. Negative-yielding debt now comprises nearly a third of debt globally.
(Goldman)
We’ve referenced Albert and his Ice Age thesis in numerous posts over the past three months. Crucially, what makes our coverage different from other portals documenting the same phenomenon is that we’re not perpetuating a doomsday narrative for the sake of doing it. Rather, we’re putting recent events in the context of the Ice Age thesis precisely because that’s the proper way to frame things. Edwards’s framework is not only applicable, but wholly instructive.
As such, it comes as no surprise that he’s out recapping the main tenets for those who might just now be coming around. And also for some of his critics, who are having a frigid summer.
“The Ice Age was born out my experience of following Japan’s lost decade in 1990s. We understand now that Japan’s inexorable slide into the outstretched arms of deflation and subzero bond yields was in fact just a rehearsal for the Japanification of Europe”, he writes, adding that “it is no longer a peculiar Japanese disease born of policy incompetence”. Here’s a passage from the executive summary to Albert’s Thursday note which is understandably lengthy:
My then colleague Kleinwort’s Japanese Strategist Peter Tasker, was instrumental in shaping my Ice Age thoughts. In his recent blog he notes that Japanification has gone from disease to epidemic and sees Galactic Japanification. The US is most certainly next in line for negative bond yields. But the Ice Age theory is not just about negative yields. It is also about the changing relationship between government bond and equity valuations. By 1996, investors were imbued with the close positive correlation between bond and equity yields which had been falling together since 1982 (the long bull market) after rising together from 1965-1982 (the dismal years, see chart below). This produced distinct investment phases for investors. What we said in 1996 was that the Ice Age would be a new investment phase, where the close 30-year positive correlation between bond and equity yields would break down. It was a strange call, widely ridiculed at the time. Bond yields would carry on falling, but equity yields would now de-couple and inexorably rise in a secular valuation bear market. I expected we would return to early 1950s relative valuations before The Culting of the Equity phase, with PEs around 7x. That has not happened – yet.
Having set the stage, Albert runs through a detailed history of the thesis. Recapping each twist and turn is beyond the scope of this post, but Edwards emphasizes that “the anticipated breakdown in the then 30-year positive correlation between bond and equity yields was a subtle nuance of the Ice Age which, if correct, had important investment ramifications for pension funds”.
After delving into the specifics, he rolls out the following chart, which at least one CNBC personality used as a punching bag earlier this year:
(SocGen)
After admitting that end-1996 “wasn’t a great starting point to go strategically underweight equities”, Edwards notes that “even taking that into account… the latest surge in bond prices means that since end-1996, the total return on global 10y+ government bonds has exactly matched the total return on global equities (in US dollars)”.
The read-through, in the context of the Ice Age’s origins, is as follows, from Albert:
Had pension funds switched at end-1996 to being strategically overweight government bonds, they would have exactly matched global equity returns with far less volatility. An Ice Age balanced portfolio, heavy in 10y+ G7 government bonds would have been performance enhancing on a risk (volatility) adjusted basis.
Back in April, a CNBC mainstay decided it would be a good idea to lampoon that chart and malign Albert personally over the course of a truly ridiculous YouTube video, which conveniently served as an advertisement for that person’s book and asset management “services”. If you missed that dubious episode, you can read my take on it here.
Albert is diplomatic enough not to mention any names, but he does cite “a blog post” and the excerpted passage is easy enough to Google – it’s from a colleague of the CNBC personality. Edwards also mentions the offending video although, again, he’s diplomatic and doesn’t call any names. To wit, from Albert:
Now I want to be totally transparent about the series I have used above, for on a couple of occasions clients and commentators have not been able to recreate them. Early this year I took a bit of a battering from one particular blog because they struggled to recreate the chart above, but mainly because they queried whether I had been right about my bullish bond call.
He then quotes the blog, which I won’t do – I’m not about to throw any traffic their way. Edwards proves that laughter is the best medicine. He employs some self-deprecating humor while simultaneously (and implicitly) chuckling at his would-be detractors one of whom is, by his own admission, “irrelevant”. Here’s Albert:
Apparently, I reek of bullsh*t! Eww. They then followed up with a spectacularly chippy video blog. If I had not become incredibly thick-skinned after the years of abuse and ridicule (and not just from my ex-wife), it might have hurt my very sensitive Bertie-Bear feelings.
Clearly, Edwards is not bothered. On the chart, Albert explains how he drew it. To wit:
As far as transparency on the chart above, for the equity series I am using the MSCI Global Equity Index (Datastream mnemonic is MSWRLD$(RI). And the bond series is the ICE BoAML 10y+ G7 Government Index MLGGO10(RI). For a US investor in the US market the same sourced series are shown below where the total return of US equities S&PCOMP(RI) still exceeds the total return on 10y+ US Treasuries, MLUS10L(RI) but perhaps for not much longer if the cycle is close to ending.
Having dispensed with that, Edwards goes ahead and tackles the other criticism from the blog post (and Vlog) mentioned above. The blog post cites a 2011 Reuters interview in which Albert expresses a bearish view on bonds and tries to use that as some kind of “gotcha” moment. But because these particular detractors aren’t in the business of veracity and prefer to spend the majority of their time marketing themselves (and their asset management business) on TV and social media, they provided no context. Fortunately, Albert is here to help.
After noting that there are two ways to view the Fed’s success in prolonging the cycle (one is to simply say that it’s a sign of success, the other is to contend that the longer the cycle is artificially extended, the larger the imbalances, and the greater the eventual busts), Edwards writes that his “biggest Ice Age mistake was to assume that the US would be like Japan and that subsequent to the 2008 GFC, US policymakers would find it much harder to manipulate the economic and credit cycles”. Here’s a bit more (and again, I trust Albert will forgive the lengthy block quotes given that his Thursday note is quite long):
I thought we would return to normal economic cycles with lengths nearer to 40 months (see chart). And if I was right, perceptions of increased eps volatility would cause the equity or cyclical risk premium to rise i.e. the increased volatility of the economic cycle would cause PEs to decline for any given level of bond yield. But rather than seeing shorter cycles of around 40 months, the US is still enjoying the longest economic cycle in its history of 122 months and counting!
How wrong can one be? Yes, I know it is also one of the weakest in history, but that’s not the point. For I had pencilled in the next US recession as the time when we see the next intensification of the Ice Age (as occurred in Japan), where equity prices and PEs would fall to new lower lows and where new and unprecedented monetary measures would need to be taken in the face of outright deflation. That is why I have been so wrong for so long and that also goes for my bearish view on bonds, articulated in 2011 (see reference to blog criticism). I had by now expected the helicopters to have already dropped hundreds of trillions of confetti dollars onto the US economy and CPI inflation to have already begun to twitch into life like Frankenstein’s monster.
Suffice to say the critics Albert answers in his Thursday piece did not even begin to scratch the surface on any of this nuance. Indeed, the blog post in question is laughably short, and the video was clearly designed to entertain social media followers as opposed to engaging with the actual history of the Ice Age thesis and the concepts behind it. That would be forgivable if the critics in question were random bloggers (as Albert generously refers to them), but in fact, one has more than a million social media acolytes and appears on CNBC nearly every day, and the other one (the one who penned the blog post) is a CFA.
So, you’d be forgiven for suggesting that if Edwards’s critics aren’t prepared to address the issues in a serious manner, they’d be better off simply staying silent, lest they should find themselves in the situation they’re in now, where the global stock of negative-yielding debt has ballooned more than $7 trillion since April, when the blog post and YouTube video were published. (And yes, that’s just as amusing as it sounds – in the four months since two critics maligned Edwards’s Ice Age thesis, the global pile of negative-yielding debt has exploded by $7 trillion with a capital “T”.)
Moving along, Albert takes a look at where we are now in the Ice Age.
“Although the bond part of the Ice Age thesis has played out very much as expected, US equity yields failed to follow the dotted red line upwards as Japan did”, he writes.
(SocGen)
As alluded to in the chart header on the second visual, Edwards attributes the equity yield disconnect in the US from its upward Ice Age path “to one thing and one thing only: QE”.
After all, QE inflates the prices of financial assets, and as Albert observes, “QE started up just ahead of the reconnection of equity yields with bond yields”.
Thanks to that, we’re now “back to the pre-Ice Age scenario where anything that is good for bonds, is good for equities”, Albert continues.
That’s been the theme for most of 2019, as “bad news was good news”, to the extent anything that suggested more central bank accommodation was in the cards was treated as a positive development for stocks, even if the proximate cause for expectations of perpetual easing was lackluster economic data. Hence, stocks rally and bonds rally simultaneously.
Albert goes on to speculate on how things will pan out in the next US recession. While his prediction won’t surprise you, his assessment of the political ramifications and the read-through for Fed independence is well worth highlighting, as those topics become more germane with each passing week – and each passing tweet.
We’ll leave you with the relevant passage from Albert’s note which, if you can get ahold of it, is well worth every second you’ll spend poring over it. To wit:
So, what might happen in the next recession? Will equity yields continue to grind lower (PEs higher) in line with US bond yields falling into negative territory, and as the printing presses are started up again and running at such a frenzied pace you will be able to hear them from Mars? Or will, as I suspect, a slide into recession again be accompanied by the bursting of credit and asset bubbles and the ensuing recession be as surprisingly deep as the 2008 GFC? I maintain my view that the US equity market will fall to a new low in the next recession as investors witness yet another credit-induced, economic implosion. And, at the same time as the economy implodes, expect President Trump to explode with rage. Indeed, even before his election I felt it very unlikely that the Fed would be able to maintain its independence if it is the midwife for yet another credit-induced deep recession.
