At the start of the year, we were surprised when SocGen’s Albert “Ice Age” Edwards, the biggest perma-deflationist on Wall Street, flipped his outlook on the US economy, and said he now expected a fast spike in inflation driven by wage growth, which in turn would prompt an even more accelerated tightening cycle by the Fed. We did not see it, and said so, pointing out that the bulk of US job growth in recent years has been among industries that have little to no wage power. More than half a year later, and several months after a puzzled Edwards asked “Where Is The Wage Inflation?”, the SocGen strategist has finally thrown in the towel, and in a note released this morning, admits he was wrong, or as he puts it “I was too optimistic“, to wit:
At this point in the US economic cycle a tight labour market would normally be producing a notable upturn in wage and CPI inflation. This would usually prompt the Fed into a tightening cycle that would typically end in a surprise recession. This is exactly what I expected to occur at the start of this year and I thought it would be that recession that would tip the US into outright deflation ? but I was wrong. I was too optimistic!
And while there has been a modest improvement in average hourly earnings according to the BLS, if not according to the BEA’s wage data, which according to the just released Personal Income data showed another drop in both private and government worker wages…
… broader inflation trends continue to disappoint.
Furthermore, when digging through the recent CPI data, Edwards noticed something unexpected: as he writes, although wages have accelerated due to the tight labor market, the last six months has seen consistent downside surprises. And then this: “this has come hand-in-hand with an unprecedented slump in underlying US CPI inflation into outright deflation – in stark contrast to the eurozone where core CPI inflation has decisively risen.”
Putting the finding in context, the “wrong, too optimistic” Edwards writes that never since the mid-1960s, when records began, has core CPI (less food, energy and shelter) declined over a six-month period, as demonstrated by the red line in the chart below.
Or, as he summarizes, “Deflation did not need another US recession to emerge. It is already here.“
Next, Edwards lays out why he – like so many others – were fooled into believing the reflation trade (think Trump) had arrived, and why it is all over now:
The reflation trades that surged in the second half of last year have struggled this year. As far as the bond market is concerned, the jump in 10y implied inflation expectations has unwound most in Japan and the US, while remaining resilient in most of Europe (see chart below).
The market?s changing inflation expectation has been driven by diverging actual inflation performances, especially at the core CPI level. US core CPI has been particularly weak.
It’s not just the Trump effect however: even more important is the recent downward inflection point in rent and shelter inflation, arguably the biggest surprise in upcoming CPI prints; unless the shelter inflation decline is stemmed, soon core CPI will be at level that may prompt the Fed into easing more.
Shelter dominates US CPI at over one-third of the total in a way it does not elsewhere. In the eurozone, for example, it comprises only some 7% of total CPI (predominantly rent). Excluding the dominant impact of shelter from US CPI reveals a shocking slump into outright deflation over the last six months ? the first since records began.
In the above chart we have removed from traditional core CPI (ie excl. food and energy), the entire dominant 34% shelter component of CPI. Instead of removing all of the 34% shelter, we can just remove the quirky (made-up) Owner Equivalent Rent (OER) sub-component (which comprises 26% of total CPI). This leaves just the rent component of shelter (8% of CPI), putting the US on an equivalent basis to the eurozone. Excluding just OER, core US CPI has also slumped. On a six-month basis core US CPI (less OER) is slightly stronger than it is excluding all of shelter, but it has still slumped to an unprecedented zero (see left-hand chart below).
As Edwards then points out, while the Fed?s preferred measure of inflation, the core PCE (Personal Consumption Expenditure) deflator, has also slid back recently to 1.5% yoy, if you look at the market-based measure of core PCE which excludes ?imputed? items, core PCE is only running at 1.2% yoy (“see righthand chart above, and as Edwards clears up, “btw ?imputed? items are commonly known in plain English as ?made-up? numbers, just as the OER is in the CPI data”).
Here the SocGen strategist has some advice to the Fed:
If I were a Fed Governor I would be pretty shocked/concerned/bemused at inflation developments this year. However confident the Fed is of a self-sustaining-recovery, there is growing evidence of a slide into outright deflation even ahead of the next recession which will likely unambiguously take us deep into deflationary territory.
Imminent deflationary prints notwithstanding, Edwards still thinks rates should be normalised. Why? “Well, because the longer the current credit excesses are allowed to continue, the deeper the next recession and deflationary bust will ultimately be.”
Which brings us to Edwards’ always somber, if comprehensive, conclusion, first for the economy and Treasurys:
Our Ice Age thesis has always called for US and European 10 year bond yields to converge with Japan. We still expect that to happen, with the downward crash in US yields likely to be particularly shocking. There is mounting evidence that underlying US CPI inflation has already slid into outright deflation in exactly the same way that Japan did seven years after its credit bubble burst. Hence we repeat our call for US 10y bond yields to ultimately converge with Japan and Germany at around minus 1%.
As for equities…
We are currently stuck in yet another lower high for nominal quantities. Investors should now be preparing for the next deflationary lower low in nominal GDP and what that implies for asset prices. It won?t be pretty.
Although to be honest, we’ve heard it all before, and while Edwards is spot on accurate, his conclusion makes one sweeping assumption: that central banks will abdicate their duty to keep asset prices propped up. If there is one lesson to tbe gleaned from the past decade is that just when it appears that the bottom is about to fall out of capital markets, central banks step in with an even more powerful intervention to keep the charade going just a little bit longer. It remains to be seen if this time will be any different…