Albert Edwards: Next crash baked in

The BIS is highlighting that QE and negative bond yields will ultimately have significant adverse repercussions on the financial system and beyond. Yet some highly respected market commentators, most recently Ray Dalio from Bridgewater, have raised the possibility that Fed rate hikes risk a 1937-like slump. It is indeed a dilemma but likely already too late to avert another crisis…. In that respect it is probably too late already. We believe that the die is now cast, the cake is baked and coming out of the oven, and the financially fattened goose is well and truly cooked!

…One of my ‘must reads’ for the past year has been The Downunder Daily written by one of the best commentators on the street, Gerard Minack. Formally on the sell-side he has gone independent and continues to write from his home in Sydney. (Actually ‘Daily’ is a bit of a misnomer – a bit like the Weekly in my title!). Minack makes the point that “monetary policy has been fairly ineffectual as a real economy stimulant in this cycle, but it’s been very effective reigniting the ‘financial economy’. I don’t think that real economy factors – such as inflation or growth – justify a tightening. But rates are too low for the financial economy: they are encouraging financial smarty-pants to do the same sort of things that got economies into a jam in the first place.” And indeed his chart below makes the point perfectly. While asset prices have rocketed upwards consumers are unusually reluctant to borrow and spend.

One of the reasons why QE has been ineffective, despite inflating household net wealth to a record $83tr in Q4 last year, is that the rich tend to own the assets but have a low marginal propensity to consume, while the poor with a much higher propensity to consume tend to own the debt. Even the central banks agree that QE has made inequality worse – hence the BIS warnings of increasing social unrest if these policies continue in extremis. But although the household saving ratio has not declined much despite record household wealth, the overall private sector net saving ratio (or technically the financial surplus) has declined much more sharply (see chart below). Unfortunately this is not borrowing for economic activities – this is borrowing to finance M&A and share buybacks.

Now you may have noticed from the chart above that large swings upwards in the red line (increases in net savings) are accompanied by recessions. Most economists see recessions causing increased saving by both households and companies, but I believe the causality has been reversed in the aftermath of Alan Greenspan’s bubble-blowing era – loose monetary policy drives asset prices, fostering increased private sector borrowing and spending. That was the disastrous policy that led to the unprecedented 2000 private (household + corporate) sector financial deficit of 4% of GDP (all corporate), and the same ruinous policy that drove the deficit up again to peak in 2007 (all households). The problem with using asset bubbles to drive an economy is that when the bubble bursts, private sector borrowers realise they have been taken for a mug and correct their savings behaviour aggressively, causing a recession. That same barbarically naive policy remains in place today.

…Should we be less worried now that the US private sector surplus is 3% of GDP – ie an historically high level and less liable to spontaneous retrenchment? No. The decline from a 9% surplus at the end of 2009 to 3% of GDP now is precipitous and almost entirely driven by another corporate sector borrowing binge to finance activities in the financial markets. Another spontaneous recessionary retrenchment awaits.

The ‘when’ is the question. I see no better base than that of Jeremy Grantham and his post-US election crash thesis at the end of next year. But it could come sooner via Grexit or two Fed rate hikes or China housing.

Good to see our own Mr Minack getting rightful credit.