Congratulations to Albert Edwards who this morning announced that he has once again placed first in the 2017 Extel Survey of analysts in the Global Strategy category, for the record 14th year in a row. As he adds “it is particularly gratifying that clients still seem to highly value our thoughts, especially during these cyclical intermissions in the Ice Age, when equities outperform government bonds.” This year’s victory appears to have been especially hard won because as he adds “you have to have a thick skin in this business, especially when our press office forwards our online press cuttings. Some of the reader abuse can get very, very personal. How do they know this stuff about me? The comments surely can’t all be from my former partner!”
Of course, this being Albert, not even his record victory can brighten up the mood much, and the SocGen strategist then adds that “the current QE-inflated, cyclical equity bull market may have gone on way longer than we expected, but equities have only just managed to catch back up with global 10y+ government bonds (see chart below). The secular equity bear market will inevitably reassert itself and that performance chasm will open up again.”
So, inspired by the record victory, Edwards is briefly reprising some of his favourite “Ice Age” charts, traditionally a source of rationality in an otherwise insane market, and lately, world.
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The macro underpinning for our Ice Age thesis is the West’s slow replication of Japan’s 1990s descent into outright deflation. Each cyclical recovery sees lower highs in both inflation and nominal GDP growth rates and the inevitable recession, when it comes, wreaks increasing levels of havoc in financial markets.
But when we put together our Ice Age thesis over 20 years ago, what distinguished it from other more recent similar ideas, such as Lawrence Summers’ Secular Stagnation thesis, was the massive change in financial market valuations we thought would accompany the new increasingly deflationary backdrop.
The big Ice Age call was that the tight positive correlation between equity yields and bond yields that market participants had enjoyed since 1982, driven by ever-lower inflation, would break down. The “long bull market” (see chart below) had been a mirror image of the 1965- 1982 period when yields on both assets had risen together. The Ice Age thesis, drawing on our observations of Japan, predicted that while interest rates and bond yields would continue to fall, equity yields would decouple and begin to rise on a secular basis. For those with a historical perspective the Ice Age would be a mirror image of the 1950-65 period, which had been dubbed in the 1950s “the culting of the equity market” – a term popularised by George Ross-Goobey – link. In the Ice Age, government bonds would rerate relative to equities, with the latter declining in absolute as well as relative terms.
One important implication of the Ice Age thesis was that widely used metrics from the 1980s and 90s, such as the bond/equity earnings yield ratio, would break down. Hence you should no longer buy equities when this ratio fell to 0.8 as they would be undergoing a secular de-rating.
These ideas seemed mad back in 1996, but having witnessed events in Japan through the 1990s we understood that the same forces would prevail in the West. Indeed on some metrics, what happened to the US bond/equity yield relationship closely mirrors that of Japan.
So why is it then that the US equity market has raced to all-time highs? Has the Ice Age thesis broken down? To be sure we saw strong cyclical rallies in the Japanese Nikkei within Japan?s own equity Ice Age secular bear market, but nothing as explosive as this.
The counter-argument to the Ice Age thesis is not just the unusual longevity of the current equity bull market- link. The key is that equity yields have re-coupled with declining bond yields (see chart below). If this is, as we strongly believe, an aberration and the equity yield reconnects with the red dotted arrow, then investors should be petrified of the next equity bear market.