I’ve just been reading the latest piece from Albert Edwards at Societe Generale. Edwards has a long-running reputation as one of the market’s biggest bears. He’s also stuck stubbornly to his view that bond yields would continue to collapse around the globe, with huge consequences for global financial markets and the economy.
And guess what? He’s been proved absolutely right so far. So what’s he saying now? Brace yourself to be terrified.
The Ice Age is drawing closer by the minute
Albert Edwards has a well-earned reputation for being something of an uber-bear. He’s claimed on a few occasions that he expects the S&P 500 to revisit its “666” low, seen in the wake of the global financial crisis in 2008. Given that stockmarkets have surged since 2009, that has sometimes led to him being lumped in with other “permabears” who are always looking for the next crisis.
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However, that’s very unfair. For one thing, Edwards has had a long-held and logical thesis behind his views. His long-running “Ice Age” theory has been that, in effect, Japan was just a dry run for the rest of the world. Eventually, we’ll all end up in a deflationary pit, which in turn means that bond yields across the globe will collapse.
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So far he’s been absolutely right on this. Yields just won’t stop falling. I thought that the madness of the likes of the governments of Japan and Germany and Switzerland being paid by lenders to look after their money was the nadir. I was wrong.
Yields on US government debt – the most important set of interest rates in the world – have collapsed this week, to unprecedented lows. This morning, the US government’s cost of borrowing over ten years has dropped to below 0.7%. In the jargon, the ten-year Treasury yield is now below 0.7%.
Given that the Federal Reserve is meant to do all in its power to make inflation average around 2% over the long run, this suggests a huge lack of faith on the part of investors. By one view, they are queuing up to lose money in “real” (after inflation) terms.
There’s more. The real yield on inflation-linked 30-year Treasuries has fallen below 0% for the first time ever.
If all of this is baffling you a bit, don’t worry – it’s technical and it’s unprecedented, but, long story short, it’s saying that the market expects to see rampant deflation and it doesn’t think that central banks can prevent it.
That leads me onto my second point about Edwards, which is that, despite his bearishness on equities, if you’d followed his advice to stick to bonds over the last few decades, you’d have done just fine.
So all in all, for all the grumpy-sounding headlines, Edwards has been far more right than wrong. (And – hands up – the more inflation-inclined like myself have so far been wrong.)
So what’s he saying now?
The coronavirus could be the pin that bursts the corporate debt bubble
Here’s the problem in a nutshell: the global economy is heavily indebted. Companies have loaded up on debt because it’s cheap. Unlike the last financial crisis, the debt now is in “proper” companies rather than the banking sector.
The risk, as John Plender puts it in an article for the FT that Edwards references, is that the coronavirus batters earnings and makes it harder for companies to service their debt. In turn, investors would suddenly take fright when they wake up to just how low quality a lot of this debt is. That’ll drive up borrowing costs and make it even harder for troubled companies to make their interest payments.
“In effect, the coronavirus raises the extraordinary prospect of a credit crunch in a world of ultra-low and negative interest rates,” says Plender.
Spiking interest costs for companies would of course be bad news for shareholders too, because bondholders get paid first – if they can’t get their cut, the equity is worthless.
And even then it would still be bad news for anyone who owned said debt, because its poor quality means that recovery rates (the amount of money you get from a bankrupt company) would be much lower than we’ve seen historically.
That’s scary. The underlying issue is that the entire financial market is structurally short volatility, and that’s the fault of central banks, led by the Federal Reserve.
What does “structurally short volatility" mean? It means that because central banks always step in to prop up markets when they fall, investors have decided that there won’t be another crisis. So they take bigger risks – because why wouldn’t you, when there’s always the Greenspan safety net to catch you?
So investors are very long complacency, and very short black swans. And when you get yourself into that position, it doesn’t take much of a black swan – maybe a black cygnet even – to swoop down and knock over your carefully constructed portfolio.
I suspect we’re not far from the point now where we move from crisis prevention mode to “preparing for the clean-up” mode. We’ll almost certainly see unprecedented monetary and fiscal policy coming out of all this – but we're probably going to have to go through some pain first.
