What is the outcome when three market skeptics sit down for dinner to discuss the future of the global economy? Whatever it is, it’s hardly optimistic.
In his latest note released moments after the big CPI upside surprise and titled, what else, “We just had a small taste of coming financial collapse. Still feeling lucky?“, SocGen’s permabearish Albert Edwards writes that he had dinner this week with “two of the great, London based, sellside macro analysts,” George Magnus (formally UBS Chief Economist and now at the China Centre, Oxford University), and Nomura’s Bob Janjuah. This is what was discussed:
In the aftermath of last weeks surge in equity volatility among many of the topics we discussed was the extraordinary ballooning of the US budget towards 6% of GDP at this late stage of the cycle. My view is that this fiscal expansion is probably the most foolhardy escapade in modern economic policy history.
Here Edwards posits that while he agrees that US corporate taxation is anomalously high, “it is the timing of the fiscal stimulus that is utterly ridiculous and will only accelerate the collapse of US financial markets as the Fed hikes rates even more quickly.”
That also happens to be his key thesis: Trump’s tax cuts will so overheat the economy, that the outcome will be another deflationary crash.
While he returns to the topic of the unprecedented fiscal stimulus at a time when the economy already appears to be overheating, Edwards first points out two charts we showed last week, namely the technical breakout in the 10Y and what that could mean for risk assets. Quote Edwards:
We are on the cusp of two key technical breakouts. Although most believe the US 10y has already broken above its long-term downtrend when it rose above 2.64%, our Technical Analysis team believe 3% is the proper breakout level to watch. Nevertheless as the chart below shows kissing this downtrend has typically been very bad news indeed for equity markets (H/T to Zero Hedge).
How much do bond yields need to rise before equity markets break? After last week, I think we now know the answer; above 2.85% seems to be enough to cause equities to slump.
Alternatively, Edwards also points out something else we touched upon last week, namely the record speculative positioning in the 10Y, and notes that “huge speculative shorts have now been built up in the US 10y, which may reduce the magnitude of for any near-term selling pressure (see left-hand chart below).”
Besides the 10Y, Edwards also highlights the recent relentless surge in the yen (and plunge in the USDJPY) and says that unlike the US 10y, where speculative excess makes it less likely to cause a breach an important technical level, “the yen positioning makes it far more likely the dollar will fall below Y107.90, and the yen could quickly surge once this key trendline is decisively broken. Certainly it was dollar weakness that helped set off the recent market flap as Mario Draghi got the heebie jeebies and accused the US of not keeping to the G20 agreement.”
To be sure, the paradox of the falling dollar at a time of rising interest rates has stumped many. Here, Edwards offers his explanation for this ongoing phenomenon:
One explanation I have seen cited as driving the dollar (and US bond prices) lower is the reckless fiscal stimulus that is being enacted in the US. Normally one will expect a loose fiscal policy and a tight(er) monetary policy to result in a stronger, not weaker dollar, but I have seen dollar weakness being attributed to the likely inflationary implications of the fiscal stimulus.
Of course we all know that market moves are always justified ex-post by a plausible macro narrative and if the dollar decisively breaks below the Y107.90 support and yen shorts rapidly unwind, commentators will no doubt attribute this to the inflationary consequences of the Trump fiscal stimulus. Certainly the US manufacturing sector is booming as witnessed by the ISM hovering just below 60 level, and this economic expansion is set to become the second longest on record (surpassed only by that of April 1991-March 2001).
Edwards than hands the mic to the just as critical George Magnus, who likewise slams the Trump fiscal stimulus:
“Trillion dollar deficits are just over the horizon, which will cause US government debt as a share of GDP to rise in the next several years to over 100 per cent. While debt levels alone cannot predict what will happen to bond yields, the markets fear that significant unfunded government borrowing—especially when the economy is doing well—will cause the Federal Reserve to carry on raising interest rates, in turn pushing bond yields higher. On current trends, this cyclical shift will eventually, maybe in 2019, puncture the stock market, corporate profits, and most likely the economy.”
Similar to what we discussed here last week after the budget details were leaked, Edwards then quotes the Committee for a Responsible Federal Budget, which sees stubbornly high fiscal deficits for the foreseeable future despite rosy official projections. “They see the red ink rising in fiscal 2019 to $1.2 trillion. The -adjusted- deficit projection (adjusted to more realistic economic forecasts) was set to surge from 4% in this current fiscal year to 5¾% next year and that was before the latest two-year debt-limit budget agreement which will likely see the deficit breach 6% of GDP next year!
To be sure, the shocking thing is that most Republican fiscal conservatives signed up to the fiscal madness, something we asked earlier this week when we mused rhetorically if there are any fiscal conservatives left. There were notable exceptions such as Senator Rand Paul of Kentucky who waged a lonely filibuster accusing his party of hypocrisy after it railed against deficits under Obama.
Here, Edwards gives his own view:
Whatever the arguments are in favour of tax reform in the US (and there are many), this is probably the singularly most irresponsible macro-stimulus seen in US history. To say it is ill-timed and ill-judged would be a massive understatement.
Stating that his forecast is not clouded by political bias, the SocGen strategist doubles down, “warning that the outcome of this front-end loaded stimulus package is patently obvious. It will rapidly accelerate the end of the economic cycle.“
Edwards then points out what we showed previously, namely that “things changed” not on February 2 with the spike in hourly wages, or with the passage of the Senate deal, but well prior:
Even before Congress passed the expansive two-year debt-limit budget agreement last week, bond markets were belatedly recognising the irresponsibility of the fiscal package. The surprise surge in wage inflation in the payroll report may have been the match that lighted the equity market turmoil, but it was the irresponsible fiscal stimulus that provided the kindling.
The genie is now out of the bottle and the markets will react very badly to any sign of inflationary pressure. Tim Lee of pi Economics opined recently on why the Vix will struggle to regain the very low levels of a couple of weeks back (H/T The FT’s Authers’ Note), “We are much further into the cycle of what might be thought of as underlying tightening of monetary conditions. The Fed is contracting its balance sheet and raising interest rates. On top of that … US imbalances are worsening with the personal savings rate set to fall to a new low while US government finances deteriorate further. Nominal and real bond yields are rising.”
Edwards then goes on to make another prediction on the US deficit:
Because of the starting point of US fiscal policy, I have a very high confidence that in the next, not so distant, US recession, the US general government deficit will soar way beyond the 13% the OECD say was the peak for 2009. A ruinous fiscal deficit in excess of 15% of GDP will be Trump’s legacy.
At the end of the day, however, the biggest risk comes from an acceleration in the Fed’s hiking intentions, as Edwards admits.
I was chatting to my colleague Kit Juckes about this and he pointed out the Fed Reserve own blog (Liberty Street Economics) had just published a three part series on the appropriate natural rate for real interest rates (or r* as the eco-geeks call it). Essentially they, like most central banks, fully subscribe to Larry Summers’ secular stagnation view of the world, which means that the equilibrium real rate of interest rates is lower than before (see chart below)
Now that the Fed Funds futures strip has converged with the Fed dots, the risks to the equity markets from a further bond sell-off are twofold. First that the market raises its prediction of the number of Fed rate hikes it expects this year, and second and much more problematic, will there now be a re-appraisal of where Fed Funds are heading in the long-term?
What can force the Fed to reassess its rate hiking timeline? A burst in wage inflation, which was already observed earlier this month.
We have reported previously that the US Phillips Curve is not dead. Instead of looking at the headline unemployment rate, we should be looking at the prime-age employment rate relative to the total population and not the labour force – ie to take account the low participation rate. Certainly, as the St Louis Fed charts show below, recent wage data has not been anomalously low over the last two years and should carry on accelerating as the tightness in the labour market is exacerbated by Trump’s fiscal stimulus.
But what about the nearly 100 million Americans out of the work force? Don’t they provide a natural buffer to rising wages in terms of cheap potential employment? Edwards is not convinced, and cites a recent article by the FT’s John Authers to make his point:
John Authers’ blog posits a disturbing thesis that “there is a group of people who have been unemployed for a long time and are now unemployable. This implies that “underemployment” is not as severe as it seems, because many of those shown in the statistics as not seeking work would – indeed be incapable of – holding down a job. They lack the skills and they have been left behind. This latter theory implies a human tragedy. It also implies that the labour market is tighter than it looks, and the supply of qualified workers is limited—meaning that there is a risk of inflationary wage rises as the economy improves.”
At this point even the deflationary bear who coined the “Ice Age” term throws in the towel and predicts that either way, “wage inflation will begin to rise more quickly, driving market expectations of longterm Fed Funds higher. Just like the peak of the last two economic cycles, it will be the implosion of financial markets that causes the next recession. And President Trump’s grotesquely ill-timed fiscal stimulus will be identified in retrospect as a – if not the trigger.”
And just in case it was not clear how, in Edwards’ opinion Trump will be the reason for blowing up the stock market that he used to swear by on twitter almost every day, here is the SocGen analyst’s conclusion:
After some eighteen months of surprising to the downside, US wage and price inflation are rising briskly, putting intense downward pressure on financial markets. Yet another Fed-inspired financial Ponzi scheme now looks set to collapse into the deflationary dust. But the post-mortem will identify President Trump’s ludicrously timed fiscal stimulus as a key trigger for the collapse. A 15% deficit will be his legacy.
Maybe… but not just yet: after tumbling on today’s stagflationary reports of surging inflation offset by slumping retail sales, stocks stayed in the red barely for half an hour before they burst in the green as “someone” decided to slam the VIX sending it back under 20 for the first time since Volocaust Monday. Rinse and repeat.