Albert Edwards at Societe General with the note:
The unravelling Chinese Credit Impulse we highlighted earlier this year accurately foretold the stalling of the global reflation trade. Is this a pause that refreshes or are we in a re-run of a decade ago? For back in 2011 a bubble of reflation enthusiasm burst, and bond yields quickly slumped from 3¾% to 1¾%–a new Ice Age low.
Over recent months as real bond yields revisited record negative lows and breakeven inflation ‘expectations’ retreated from recent highs, equity sector rotation has reflected these changes, with growth stocks regaining their footing relative to value stocks.
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Investors are grappling with one key fundamental issue (the $64,000 question), namely,are we merely experiencing a temporary pause in a new (secular) reflation trade (ie The Great Melt), or are we, as in the aftermath of the GFC, once again succumbing to the gravitational pull of deflation (ie The Ice Age)? Despite the surge in headline and core inflation rates around the world the investment jury is still out on this issue.
If it is the latter (more of the Ice Age), investors will see a repeat of the multiple QE interventions which will drive bond yields to yet new lows and the equity market overall (and FAANGs in particular) to explore evermore extreme multiples.
Anyone who demonstrates confidence in the outcome to this question is likely to be either a charlatan or a central banker (or both). I wrestle with starkly contrasting andfirmly held views, yet the situation emerging fromthe pandemic is unprecedented and extremely hard to predict.
To be clear, my own view is that we are shifting away from the Ice Age. This means we will see higher highs in bond yields by the end of this cycle (ie higher than the 3¼% 10y high of the last cycle seen in Oct.2018), but not before we see another major growth and deflation scare.
Shorter term, earlier this year we highlighted the slump in the China creditimpulse and more recently the G3 credit impulse, as shown below by our friends at Nordea-link. (The credit impluse is the second derivative of the stock of credit, ie it is the change in the credit growth). Andreas Steno Larson calls the chart below the “chart of charts”. It’s certainly food for thought and suggests the reflation trade might unravel for a while yet.
Back to Nordea’sAndreas Steno Larson who shows that what we are now seeing is the tightest credit impulse since the GFC–even tighter than when Powell did his famous end-2018 pivot.
The good folks at Macro Markets Daily(@macro_daily) usefully break down the global impulse (this time G5-link). What is notable is that this latest reading is even lower than the GFC low!
To be fair Macro Markets Daily note that “The global credit impulse fell sharply in Q2. Caution is needed in interpreting recent trends though-much of the borrowing in Q2 2020 was for precautionary cash and the repayment of those loans since-which suggests the sharp fall in the US shouldn’t materially affect GDP”. I think they have a good point, but looking at the charts below from Nordea, if the usual correlation were to hold, we are in for one hell of a ride!
What is certainly true whichever chart you look at is that the current decline in the credit impulse is steeper than at the time of the infamous end-2018 Powell Pivot. That brings me round to the excellent work my Quant colleague Solomon Tadesse did in early-2018, when he accurately predicted (using ‘Shadow Fed FundsRate’methodology) that Fed Funds rates would peak at 2½% (see Market Watch article here).To cut a long story short, the shadow Fed Funds rate is what the Fed Funds rate would have been if it could include the impact of QE (e.g.Wu and Xia 2016).
In Solomon’s latest update he employs the most recent academic thinking to calculate a “second generation”shadow Fed Funds rate(FFR) using De Rezende&Ristiniemi (2020)–see left-hand chart below. As I understand it, the issue with the first generation shadow rate is that it only allows the QE impact to kick in once the actual Fed Funds rate reaches the zero lower bound. Solomon explains, “In the current pandemic-induced monetary easing cycle, despite a series of large-scale monetary stimulus injections starting in March 2020 (while the FFR was effectively bounded at zero), the first generation shadow rate estimates turned negative (-0.23%) only in November 2020, whereas the second generation estimates registered a drop in the short rate to about-3%in March 2020, reflecting the scale of the liquidity injections at the time.” The cumulative easing of the shadow Fed Funds rate to date is at 7½%, on a par with that seen after the GFC (see right-hand chart). On this measure,tightening has yet to start, yet on the Credit Impulse measures discussed above we have already experienced a ferocious tightening. Let the markets decide.
Sometimes you just have to look out your window. Because China has led the crash in credit impulse, and its growth is clearly going to follow as it property market reels, crashing commodity prices along with it, looking for another round of reflation at this point makes no sense.
That’s not to say that the Chinese property hard landing won’t trigger another reflation if it turns back to broad credit stimulus. It will. But there is nothing secular in it.
Indeed, given China is running out of credit rope if it wishes to avoid the middle-income trap, the secular forces are all deflationary.
Albert’s Ice Age is intact…
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