Monday, April 9, 2018

S&P 500 Could Still Test 2009 Lows





 https://www.barrons.com/articles/s-p-500-could-test-2009-low-says-longtime-bear-1522957392

Look up “permabear” in the dictionary and you might just find a picture of Albert Edwards. Société Générale’s global strategist is undeterred by a nine-year old bull market and argues that a new financial Ice Age will take hold that more central-bank quantitative easing will be unable to stop. After the huge credit boom that has supported stock market gains, Western financial assets will experience a downturn similar to that felt in Japan beginning in the late 1980s. In Edwards’ scenario, U.S. Treasuries will eventually sport negative yields, the stock market will plunge below the previous lows of 2009, and corporate debt prices will fall. The result will be a recession. Given the recent volatility in world stock markets, we thought it might be a good time to chat with the 56-year-old strategist and get his recommendations on how to play the next big chill. 


Barron’s: You’re well known for your long-term bearish view based on your Ice Age thesis. Tell us about it.
Edwards: I put together the Ice Age thesis just over 20 years ago out of following Japan closely. In 1996, when the West was deriding Japan as incompetent, we came to the view that what happened in Japan would visit the West. Japan’s bubble had burst earlier, and as a result, it moved toward outright deflation earlier than anyone else.

In Japan, secular rerating of bonds took place with a very long journey of falling central-bank-controlled rates in the short term and declining long-term interest rates, with occasional strong cyclical recoveries during the past decade and a half. As each new recession came along, the bond yield would fall to a new low, and equities would reach new lows. From 1990, Japanese equities embarked on a long secular bear market in valuation.

In the West, stock valuations—not prices—reached their peak in 2000, and the very close positive correlation between lower bond yields and rising stock price/earnings ratios began to break down. As in Japan, bond yields continued falling because of central-bank easing. That would bring about an absolute and relative derating of equities versus bonds, interrupted by cyclical recoveries. In other words, bond yields keep falling as stock valuations drop. For that to happen in the West, the credit bubble supporting higher stock prices would have to burst.

These secular equity-valuation bear markets don’t occur often and take many recessions to play out. We saw that in Japan. The U.S. has had only three secular equity deratings in history. The shortest took four recessions to play out; the longest, six. A secular valuation bear market for equities is when you go from extremes of expense to extremes of cheapness. Since the peak of the bubble in 2000, we’ve had only two recessions. This extraordinary rally is an interruption.

U.S. and European stocks have done well. When is it going to get cold?
The Federal Reserve managed to short-circuit this derating process. In 2011, when quantitative easing, or QE, really kicked in, equity re-engaged with bond yields and P/Es expanded. Like an artificial stimulant, QE inflated all asset prices away from fundamental value and from where they would otherwise have gone.

We haven’t seen the lows in bond yields. In the next recession, bond yields in the U.S. will go negative and converge with those in Germany and Japan. The forward U.S. P/E bottomed at about 10.5 times in March 2009 on trough earnings. That was lower than the previous recession. In the next recession, I would expect the P/E to bottom at about seven times, a lower low with earnings about 30% lower because of the recession. That would put the S&P lower than the 666 low of the previous crash, versus 2671 Thursday afternoon.

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If a recession unfolds, easy monetary policy won’t stop the market from collapsing. It will play itself out.
When will the recession unfold?
 
The Conference Board’s leading indicators look OK for now. What’s different is that problems in the real economy aren’t being reflected in the stock and bond markets. What we may see is the reverse: The stock market and parts of the credit markets collapse and cause problems in the real economy. If confidence collapses because the equity market collapses, then a recession unfolds.

Will the next bear market be worse for the U.S. than for Japan or Europe?
It should be. Traditionally, if the U.S. goes down 20%, the German Dax, though it is cheaper, would tend to go down a little more. Maybe this time it won’t. Japan is the one market we do like now on a long-term basis, and one of the reasons is the buildup of U.S. corporate debt during these past few years. The big bubble is U.S. corporate debt. In contrast, Japan’s corporate debt is collapsing. Over half of its companies have more cash than debt.

When the Fed buys U.S. Treasuries, it pulls down all yields. There has been demand for yield, so investors look at corporate bonds as an alternative. Companies have been very keen to issue them, and they have used the money to buy back stock or as a way to enrich management. This is the way QE has washed through the system here

Corporate debt has ballooned out of control not just with larger companies, but with smaller companies as well. Net debt-to-Ebitda has rocketed to all-time highs.

In its Global Financial Stability Report of April 2017, the International Monetary Fund said that in the next recession, 20% to 22% of U.S. corporates would default. This is where the U.S is vulnerable. It isn’t just junk-bond issuers. It is the explosion that has taken place in corporate debt. Companies can be put under tremendous stress by the financial markets in an equity bear market, which means they cut employment and investment.

There is a massive corporate credit bubble out there waiting to be revealed in either a recession or an equity bear market that causes a recession from the disintegration of the corporate bond market. Normally in a bear market, if equities are down 50%, then junk is down 50%, and investment-grade debt is down about 15% or 20%. In the next downturn, junk will probably be down more than 50%, and investment grade will be down 30% or 40%. That will be the big surprise. In contrast, Treasury rates will rally.
We’ve got a new president of the Federal Reserve. In the last cycle, central bankers were lucky. They were able to blame the commercial bankers for the financial crisis, even though it was their job to take away the punch bowl. In the next one, the blame will stick to the Fed, and it may well lose its independence.

What asset class do you favor in the Ice Age?
If the U.S. 10-year Treasury goes from 3% to negative 1%, that is huge return. In equities, it would either be Japan or, if you can invest only in U.S., then gold miners, as gold will exceed its previous $1,900-per-ounce high.

Is there a way to avoid this Ice Age or mitigate it? If you were the new head of the Fed what would you do? 
 
I would stop worshipping at the altar of the financial markets. If pulling an economy along were the route to economic prosperity, then Argentina would be the richest country in the world by now. This is failed policy. What I would do is not intervene so much.

QE2 and QE3 were totally unnecessary. The leading indicators were turning up before QE1 was done.

There is weak economic growth because you have the biggest bubble in history, and we know from Japan there is a long unwinding period, and you are condemned to weak growth. You need fiscal balance, which the U.S. avoided.

This interference—even well-intentioned—causes other problems because the policy makers used credit to drive the recovery. You can never normalize interest rates. You try to normalize interest rates in the next upturn, as they are doing now, and eventually you blow things up.

Of the last 13 Fed tightening cycles since 1950, 10 have ended in recession. It tightens until something breaks, and it breaks sooner than they expect.

What is your reaction to the Trump tariffs?
Many thought after the election he would back away from these tariff promises. He has delivered tax reform, which is probably the most criminally insane piece of fiscal stimulus this late in the cycle. To take the fiscal deficit to 6% of GDP at this stage is utterly ludicrous, but he is delivering on his promises.

On tariffs, China will escalate. To a person, all economists think a tariff war is catastrophic for the global economy. This isn’t about economics; it is about politics, about appealing to President Donald Trump’s base. If China acts on its proposal to put on tariffs on soy exports to hit his base, or it switches from Boeing to Airbus, then you really know things are getting nasty.

Germany may become a target. It has the biggest dollar surplus in the world now. If you are looking for things that will knock the market, Germany is annoying everyone in terms of the size of its trade and account surplus, not just the U.S. The European Commission has complained about Germany’s trade surplus. The Germans don’t help themselves. When China and Japan are criticized, usually they do a little something to placate criticism. Germany’s politicians are dismissive: “We have an incredibly large surplus. What do you expect us to do? Make crappy goods like you?”


Will Trump turn to Germany eventually on the surplus?
He will. It is negative for stocks, with an equity market so overextended in valuation. I compare this to 1987, when the bond market sold off after many years of falling yields and stocks rising on the back of it. The Fed started to raise rates. The economy was strong, just as it now. The manufacturing ISM was over 60, just as it is now, only the second time the ISM has gone above 60 since 1987. Oil prices recovered from a slump the year before.

The past year and a half is very similar. Equities were going up, ignoring the selloff in bonds, which leaves them vulnerable. Now, central-bank liquidity stimulus is gone, leaving financial assets vulnerable to a panic attack. And if you take out tech, the market has been looking horrible for quite a while. Breadth is deteriorating. We are in real trouble here.

Where might you be wrong?

The end game for the Ice Age in the next recession is always going to be currency wars, negative interest rates, and negative federal-funds rates. This recovery could go on for longer. You could get inflation that actually gets bonds sufficiently disturbed that yields break above 3% and enter a bear market. If bonds enter a bear market, I would be wrong on bonds, but that isn’t good news for equities.

Policy makers could always create inflation. Give everyone a check and print money and you will create inflation. Even though I’ve been calling for the Ice Age slipping into outright deflation, that is a signpost on the way to total global debauchment of currencies. Policy makers look in the rearview mirror and say easing hasn’t created inflation so far, so we’ll do more. People look in the rearview mirror too much.

You like U.S. bonds, but then eventually the government response will make them a bad bet.
Absolutely, people should look to hide in them as a haven over the next six, 12, 18 months. And, hopefully, if equities become cheap enough, then that is the real opportunity. But you have got to have cash to take advantage of those opportunities.
https://www.barrons.com/articles/s-p-500-could-test-2009-low-says-longtime-bear-1522957392
On that optimistic note, thank you. 
Email: editors@barrons.com

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