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| Albert Edwards |
You’re in denial if you believe that U.S. stocks are fairly valued, the Eurozone does not face a crisis or a strong dollar will support stability in the global economy. Those themes were presented by Albert Edwards and his fellow speakers at the annual investment conference sponsored by Societe Generale.
Edwards spoke on January 10 in London, along with his colleague Andrew Lapthorne and Raoul Pal, publisher of the Global Macro Investor newsletter.
A year ago at the same venue, Edwards predicted a down market for equities and a weak economy in the U.S., driven by the strength of the dollar. He highlighted the instability in the Eurozone, focusing on problems in the French economy. Forecasts like those have earned him an “uber bear” reputation. But he has been right over the long term with his “ice age” thesis, which foresaw the outperformance of bonds over equities beginning over 20 years ago.
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| Andrew Lapthorne |
Let’s look at what the lineup of prominent speakers said this year.
Global overvaluations driven by the U.S.
Price-to-earnings ratios are modestly high for world indices, but enterprise value (EV)-to-EBITDA ratios show exceptionally high valuations – approaching those during the dot-com era, as illustrated in the chart below:
The overvaluation is driven by the U.S., according to Lapthorne. The above chart shows the metrics for the MSCI world index including the U.S., whereas if the U.S. is excluded the EV/EBITDA overvaluation is not as extreme.
Lapthorne said future returns will be lower at some point in time based on the historical precedent. He claimed quantitative easing (QE) and corporate debt in the U.S. are the culprits. QE has driven interest rates lower, increasing the demand for corporate debt, and that has been fueling share repurchases, which increases EPS. He said that the U.S. corporate sector is overleveraged and exposed; when the market does go down, they will cut back costs and contract.
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| Raoul Pal |
“Balance sheets have been swept away by the idea that we are going to get better growth in 2017,” said Lapthorne. He claimed that global profits were down 9% in 2016 and that, even if they went back to previous highs, the equity markets would still be priced at 19-times earnings.
U.S. corporates are underinvesting and consuming all of their cash flow after share buybacks. Lapthorne said there is no “mountain of underinvestment” in the U.S. Cash flow is decreasing, debt is increasing and is being spent on buybacks, although buybacks are declining now at a rate of approximately 9% annually.
The bulk of the cash among U.S. corporations is held by the largest 25 companies, according to Lapthorne. “Trump’s problem is corporate inequality,” he said. “The biggest U.S. companies are very profitable, but the rest are struggling.”
While QE is driving valuations up in the U.S., in Japan the effect is almost the opposite.
Indeed, the Bank of Japan’s QE has been the most aggressive among central banks. But it has used those funds to buy Nikkei 225 ETFs – essentially investing in Japan’s equity markets. That has depressed Japanese valuations, at least relative to the rest of the world:
Average profitability in Japan is high, said Lapthorne, “but the U.S. and EU are in a synchronized slowdown.”
In Japan, the median dividend is higher than in the U.S. and it has the lowest payout ratio of any developed country. In Japan, 50% of the non-financial companies have net cash.
“Japan is an interesting place to put your money,” Lapthorne said, “irrespective of what happens to the yen.”
The Italian problem
Albert Edwards began his presentation by remarking that the investment climate resembled those in 1999 and in 2006-2007, when clients didn’t want to hear a bearish story. But he had one to tell and, unlike last year, his focus was on Italy instead of France.
The main problem with the EU is unemployment, he said, which is now 9.8%. That is a seven-year low, but it masks the problem in Italy, where unemployment is 12%.
He said that Germany was “happy” about EU unemployment until a couple of months ago, when its inflation went from 0.7% to 1.7%. It now has 12% housing price inflation and deeply negative real rates. “The ECB may be forced to taper because of German pressure,” Edwards said.
Italy and France have low industrial production, he said, but Italy has been a “bust post-crisis” based on its real GDP growth. It has not grown since it joined the euro in 1999, he said.
“Italy will never grow,” Edwards said.
Productivity has contracted in Italy since the financial crisis. Based on the World Bank’s survey of the ease of doing business, Italy ranks 27th among 32 countries, above only Belgium, Israel, Chile, Luxembourg and Greece. “Italy is totally moribund,” Edwards said.
Edwards claims the crisis facing Italian banks, such as UniCredit, is only a symptom of the underlying economic problem. But there is a movement to bail out those banks. In Japan, Edwards said that the banks didn’t underperform until 1995-1996, a decade after its housing collapsed.
“Banks are a symptom of the real problem,” Edwards said, “which is deflation and stagnation. It is a waste of time and effort to recap Italian banks while Italy remains in the Eurozone.”
Italy and France are among the countries with the highest numbers of citizens that want to leave the EU and believe things are on the wrong track, according to survey data that Edwards presented. “Disappointing growth means an angry electorate and unhappiness with globalization,” he said.
Edwards reinforced the concerns that Lapthorne expressed about U.S. valuations.
The market is ignoring President-elect Donald Trump’s trade protectionism and tariff threats, he said. But he pointed out that protectionist measures have already been surging globally – not tariffs, but other measures that protect industries. The U.S. is leading the way through measures that require the purchase of American products through public-sector procurement rules.
“Don’t think this isn’t already taking place,” he said. “Trump is going with the trend.”
China is the most affected by global measures, although Mexico is most exposed to U.S. policies. “Global policy uncertainty is rocketing upwards,” he said, “but markets are totally ignoring this.”
Edwards also added to the thesis that Japanese stocks are undervalued. He said that Japan is targeting zero bond yields, which is a major stimulus that gives the government a “blank check to borrow what it wants” and buy Japanese equities.
The yield differential between the U.S. and other developed markets is driving the dollar higher. The risk for the dollar, Edwards said, is if the Fed tightens more aggressively than people expect. It might do this because of wage inflation. He said that the Fed has usually found excuses not to raise rates, most recently because of subdued wage inflation. But the Atlanta Fed is now reporting 3% wage growth and it is much higher – closer to 4.5% – for prime-age workers, according to Edwards.
Unlike Jeffrey Gundlach and Bill Gross, Edwards said the U.S. bond market will fall to more lows. The 10-year yield can go above 3% – even as high as 3.5% – and still be in a bull market, he said.
The dollar shortage
According to Raoul Pal the business of macro investing boils down to getting two things right: the business cycle and the dollar. His talk focused on the rising dollar and its global ramifications.
“Unless you understand the dollar you don’t understand anything,” he said.
The dollar, as measured by the trade-weighted DXY index, has been relatively stable over the last 30 years, until about 2014, when a dollar bull market started. Prior to that there were two major dollar rallies: from 1980-19987 it rallied 93% and from 1994-2003 it rallied 48%, following the Asian crisis.
The dollar is up 29%, which would be the smallest rally in history if it stopped now. Pal claims that it is likely it will go much farther than anyone expects.
“This is not about the euro or yen,” he said, “it is about every currency other than the dollar.” The DXY is euro-over-weighted but the Asian currencies have been very weak, as have emerging-market currencies. China is trying to get its currency down to trade with the rest of the world, according to Pal.
“The big story people don’t understand is there is a dollar shortage,” he said. The Bank for International Settlements (BIS) has discussed this, he said, and it is because “enormous” foreign-dollar borrowing is fueling a “carry trade.” Investors are borrowing dollars to buy something else – often speculative assets. Approximately $10 trillion is behind the carry trade, according to Pal.
Pal identified a number of signs of market stress that illustrate the dollar shortage.
Emerging markets, particularly China and South Korea, are borrowing at their greatest level ever. Those borrowings are not by governments, as it was in the late 1990s, but by the corporate and household sectors. They will need to pay off that debt, he said, and that makes them net buyers of dollars.
LIBOR, which is the offshore price of dollars, is going up, he said.
Japan is having a problem funding swap lines. Those swap lines help Japanese banks access dollars, and the Bank of Japan has had to pay higher prices for dollars to fund them.
Then there is the “Trump effect” driven by protectionism, he said. “If you create a world where U.S. goods are less in demand in the rest of the world, or foreign goods are less in demand in the U.S.,” he said, “then price of the dollar goes up. It will destroy U.S. profits.”
“The U.S. has to be an exporting country,” he said. “Trump doesn’t understand this.”
Repatriation – eliminating the tax incentives for companies to locate outside the U.S. – means less dollars as well, he said. Only a few companies are affected, according to Pal, but enormous amounts of money are at stake. Much of that money is held in euros or other currencies, he said, but repatriation would cause the dollars held in the European banking system to move to the U.S. banking system, which would accelerate a dollar-funding shortage.
Fed policy has a role in this. “If you raise rates you create more problems for people who are short dollars,” Pal said.
Whatever the economic outcome, the dollar is going higher, according to Pal. The order of magnitude of the rally could be 75% from its low, somewhere between the two prior rallies. The euro will go to $.75 and the yen to 200.
What are the investment opportunities? Emerging markets are totally correlated to the dollar and are “overdue for a crisis.” According to Pal emerging-market valuations relative to the S&P correlates tightly to dollar strength.
“That is all you need to know to trade the emerging markets,” he said. “The probability is that emerging markets will weaken further. The probability is it won’t be done until there is a crisis, like the Latin American or Asian crises.”
Pal touched briefly on the business cycle, which he said is now a secondary consideration to the dollar.
“We are long overdue a recession,” he said, which is about 90% likely in two years. The election might be the cause of it, he said; historically there has been a 100% probability of recession within two years of an election following a two-term presidency.
“Everyone who extrapolates future growth doesn’t understand tariffs, the business cycle or election history,” said Pal.
Don’t be too bearish about bonds, according to Pal. The U.S. suffers from structural deflation. Boomers are being replaced by millennials, who don’t want debt. The deflation caused by a strong dollar is not going away. In 10 years, he said the 10-year yield will go to 50 basis points.
If you think that is bullish for bonds, consider that Edwards said the 10-year yield could bottom at negative 50 basis points.
Read more articles by Robert Huebscher
