For years, SocGen’s permabear Albert Edwards was best known for preaching the gospel of terminal deflation, having introduced the “Ice Age” concept some three decades ago to describe a world trending toward monetary paralysis and the failure of conventional economic policies as central banks fail to stimulate “just the right amount” of inflation to kickstart growth, instead losing the war to deflation as attempts to boost wage growth fail time and again.
Which is surprising, because in his latest letter to clients from last week, the prominent SocGen strategist proposes that not deflation, but rather a unexpected episode of monetary tightening will be the catalyst that will trigger the next “Great Unwind”, bringing the record-setting global stock market to a screeching halt.
What is even more interesting is the country that according to Edwards, will launch this great monetary shock: Japan, also known as ground zero for every failed reflation experiment conducted in the past 30 years.
This time may be different and, far now, most investors fail to see it, according to Edwards.
As he explains, “with so much investor attention focused on the improving US economic outlook and the Trump corporate tax cuts, and with the eurozone having seen a rapid improvement in growth prospects over the past year, the other big developed economy/market has been somewhat overlooked”, that of Japan.
“Japan’s economic situation has been improving too although likely in a more durable fashion. Indeed the front-page chart shows a consistent improvement in consumer expectations that the great deflation in Japan has finally ended – despite headline inflation remaining close to zero. A change in the deflationary mindset may yet be at hand, and that in itself would stimulate the economy by reducing the incentive to delay purchases.”
To emphasize his point that Japan’s economy may indeed be on the cusp of secular change – for the better – and inflation is finally stirring, Edwards first points out just how tight the Japanese labor market is: “It is widely accepted that despite a reasonably subdued economic recovery, the demographic situation means that Japan’s labour market is one of the tightest of all the developed economies. Measures of tightness are close to or surpass those at the height of the late-1980s economic bubble (see chart below).”
And yet, just like in the US, despite the tightness in the Japanese labour market, wages have failed to accelerate despite much official encouragement, including tax breaks for companies that raise them. In fact, underlying wage inflation seems to have been stuck at about ½% for the past 2½ years, which although much stronger than before, is still disappointing.
That said, hourly earnings is just one part of the equation that feeds into personal income and employee compensation, the other being hours worked, which is important because despite the subdued pace of wage inflation, rising hours worked means income growth is growing by 2% yoy in nominal terms. Furthermore, unlike the US and UK where personal savings have plumbed decade lows and are fast approaching record lows, income growth in Japan is outstripping consumer spending by a wide margin and the savings ratio has risen (see chart below). Hence if consumer confidence in Japan remains buoyant, consumer spending should contribute to even stronger GDP growth than the above trend 2% yoy rate recorded in 3Q last year, the SocGen analyst concludes.
And yet, notwithstanding the unexpected recent strength of the Japanese economy (much of which appears to be largely thanks to intellectual property exports), the one consistent disappointment has been the inability to hit the 2% core inflation target. As Edwards notes, “The BoJ has failed despite hitting the monetary hyperspace button again and again.“
In his note, Edwards concludes that his own personal view is that the BoJ had made a major policy error in not forcing the yen below the 30-year support of ¥123 (chart below), which in itself would have led to a further slide and imported even more inflation.
But that was then. What about now?
Edwards concedes that it is now “entirely conceivable” that the improved economic and inflation picture noted above prompts a surprise BoJ tightening, leaving the market badly wrong-footed and prompting a massive 2008-like unwind of carry trades (CFTC data shows extreme short yen positioning). And, in an indication that Edwards may well be right, it was one week ago when the BOJ unexpectedly announced a material reduction in its monthly asset purchases, sending both yields and the USDJPY tumbling.
Edwards concluded in his usual, cryptic style:
“If investors are looking for the major surprise that could end this equity bull market, could this be it?”
Speaking at SocGen’s annual strategy conference in London last Tuesday, Edwards reiterated the key points from his what: “We’ve been looking for surprises and one thing that can catch us out is if the Bank of Japan starts tightening. If it actually follows the Fed and the ECB and announces some sort of tapering.”
He then again warned that not enough people are paying attention to Japan: “This could be far more important than the Fed. A lot of major trends start with Japan. People don’t focus on Japan enough in my view.”
Going back to the threat of surprise inflation, Edwards also warned that core inflation in Japan may have bottomed, as the following chart illustrates, while more than 60% of households now expect inflation rather than deflation, he pointed out.
And just in case his revised thesis was lost on some, Edwards concluded by asking rhetorically “what happens if the BOJ tightens instead of weakens as everyone is positioned for? What if the yen strengthens and [the dollar] breaks through ¥107? That would be a major surprise.”
Putting it all together, “If you are looking for something as a trigger for the great unwind, [tightening by the Bank of Japan] could be it.”
To be fair, never one to avoid mocking his own bearish forecasts, Edwards inserted the following self-deprecating snippet:
I have called the top of this equity rally several times and I have been wrong time and time again, so I am not going to waste your time calling another top for this week at least! The FTs chief leader writer, Robert Armstrong, participating in a round table outlook for 2018, described me as having “correctly predicted 10 of the last one market crash”. Ouch!
Who knows, maybe this time Albert will be right.