Roylat.com

Lots of learned commentators are now explaining to us what has happened to the global financial markets. These commentators are making various predictions about what the future holds — and many who were dead wrong before the fact are cautiously to strongly optimistic.

Better to listen to those who had it right ahead of time. One of these is Nouriel Roubini, who is getting lots of media attention. Less well known are two British analysts, Albert Edwards and James Montier, who appear to have been at least as correct and even clearer about the underlying mechanisms and relationships that led to the collapse.

I highly recommend reading the entire interview, which is eight pages long, in Adobe Acrobat format. It is easier to read than the selected excerpts below. If you are busy and want to get a sense of the understanding of Edwards and Montier, read the excerpts below. I expect you will then want to read the entire interview.

Inflation Not The Problem
But Market Fundamentals “Appalling,” Edwards & Montier Say

…

Yet the sky-high valuations didn’t act as
much of a constraint in ’98-’99, say.

James: Absolutely not.

Nor do they seem to be constraining the
oil market currently. [Remember, May 2008]

James: No. Some of the basic materials are just manic. But they’re a perfect example of what I think is the most common fallacy that we encounter, which is overpaying for growth. Or, at least, overpaying for the hope of growth. One of the things that I’ve
observed recently is that the year two forecasts
on the basic material sectors
have switched. Normally, year two forecasts
are below year one forecasts for basic materials
companies because everybody expects the
prices in the spot market to come down. But
what we’ve actually seen in the last couple of
months is year two forecast growth go above
year one forecast growth. So we have a situation
where people are beginning to buy into “this
time really is different.” That changes the dynamic
of the market, from my perspective.

How so?

James: A lot of what we’d seen previously had
been what we’d termed a “cynical bubble.”
Meaning that people didn’t really believe what
was going on, but were prepared to go with it
because it was in their best interest to do so;
the relative performance kind of stuff. But this
now looks much more like a bubble of belief,
which is exactly what we saw in the tech sector
in ’98-’99, where you got these ridiculous
methods of valuation appearing, such as price
per click and price per eyeball, and that sort of
thing. I don’t know what the equivalent in mining
is, price per tractor tire perhaps, or something
else that seems can be used to justify
almost any growth expectation. But that’s
exactly what we’re seeing now. We’re seeing a
bubble of belief build that this time really is different;
that there is some long-term opportunity
within the emerging markets. Both Albert
and I — Albert from fundamental and liquidity
points of view and I from a market view — have
issues with the notion of decoupling. I just
don’t see it. People always, classically, forget
about lags at turning points. And if your chief
export market implodes, which is potentially
what we’re going to see the U.S. consumer market
doing— if it’s not already done so — it’s hard to
imagine why you’re going to continue to see
export growth. There are an awful lot of fallacies
that surround the emerging markets and the
basic materials, too. And these things aren’t
cheap. Emerging markets are trading on a 40
times cyclically adjusted P/E. Back in 2003,
they were at 10 times cyclically adjusted P/E. As
uncharacteristic as it is to imagine, I actually
got bullish on emerging markets back in ’03
because they were cheap. But now we find that
the reverse is true. Now that everybody else
wants to buy them— and is willing to pay top
dollar for them — I sit here and think, “No, I’d
rather not.”

Albert: That’s right. All I’d add is that from the
commodities side what has surprised me, as I
have written, was that when I looked at some of
the commodities indices, because I was sort of
relating the CRB to world growth, it’s only been
in the last six months or so that the CRB has
totally detached from the cyclical slowdown
we’re seeing and gone potty. And when I actually
looked at some of the industrial commodity
indices that exclude oil, like the Economist’s
industrial baskets, which includes agricultural
industrial commodities as well as metals, and
the IMF industrial commodity index, they’re
actually flat year-on-year, which, to be honest,
surprised me. So I dug around a bit more and
then found out — because I don’t keep my eye on
these things all the time — that actually things
like lead, zinc and nickel are down about 50%
from their peaks. As always, as James says, people
reach for growth, so as these sort of cyclical
risk dominoes tumble, they funnel into the
remaining stories that haven’t yet been disproved.
What is interesting is that this is now
very much a food and energy bubble. All the
speculation seems to have funneled in, even
within the commodity complex, to food and
energy, just those few commodities. Obviously
they are key commodities. But the oil price —
before I left London to come out here I read
through a stack of newspapers from this week,
and saw an interesting article in the Wall Street
Journal saying that actually there is a glut of
spot oil. Some Gulf states are hiring tankers to
basically park their surplus oil in the Gulf,
because they can’t find buyers for it.

Right. There’s reportedly an immense
amount of inventory afloat in the Gulf.

Albert: And the demand isn’t there for it at the
spot end. As James always says, pricing commodities,
unlike equities or bonds, is very difficult.
You might agree with the structural argument,
but where does that mean that the price of
oil should be? Should it be at 200? 400? 60? It
actually doesn’t tell you where oil should be.
Certainly nothing has changed structurally in
the last six months. Oil has rocketed up, yet the
only cyclical phenomena which has changed is
that the IMF forecast for global demand this
year has absolutely plummeted. The IEA has cut
their forecast for oil demand again and again
and again, compared to where they were at the
beginning of this year, and yet the price has
totally detached itself from those fundamentals.
So for me it is clearly a speculative phenomenon.
I mean, you had the Goldman oil guy coming
out saying “buy,” forecasting $200 on the
long-dated contracts. Lo and behold, they
jumped $10-$15 because everyone piled in. But
I don’t see it. What people forget is that there is
always a structural argument. They said in the
U.K. that house prices could not fall because
there is a shortage of land and we are having all
this immigration. Lo and behold, cyclically
house prices have just collapsed in the U.K. But
the structural argument hasn’t changed. I see
the situations in oil and food as similar. I am a
structural bull on commodities. But hey, I see
the cycle turning, and I think, “No, this has just
gone a bit potty.”

It’s silly season. I saw a headline this morning
saying that the IEA is about to slash its
forecasts of peak production capacities —

Albert: Sure, that’s a methodology change,
just like Moody’s has to keep doing. On the way
up, methodologies are changed to justify higher
prices. When we’re back at $60, and given a
global recession, we will be back at $50 or $60
in a year’s time, they’ll be changing the
methodology back again. [Emphasis added.]

James: That’s the equivalent of moving up the
income forecasts to try to justify valuations.
One of the things about commodities that I
don’t think is getting anywhere near enough
attention is the whole idea that because people
have suddenly seen commodities as an asset
class, and you have had these huge institutional
investment inflows into commodities, those
inflows themselves have changed the structure
of the markets. If you’re investing in futures,
which most of theses funds tend to do, it used
to be that the market was generally in backwardation,
so you collected a positive roll on your
contracts. But now, because these guys have
driven up the spot prices so much, a lot of
these markets tend to end up in contango,
which means you get a negative roll. That
means that you’ve got to make 15%-16% per
annum in price move — just to cover the negative
roll. The consultants missed that. The very
process is sort of a demonstration of the
Heisenberg Uncertainty Principle; you cannot
observe without influencing. These guys have
forgotten that their own actions matter. It’s
poker, not roulette, that we’re playing here.
The behavior of others, their actions, have an
impact on the outcomes.
[Roylat: This observation is one made strongly
by George Soros, a mythically successful
speculator.]

Albert: One other thing that I like to point out
is the liquidity effect on commodities and
emerging markets. We’ve had one liquidity
bubble go pop with the credit crunch. But
there’s another one still to unravel, which is
the change in the U.S. current deficit. While it
was blowing out, it acted as a huge liquidity
pump for the rest of the world because the
emerging economies intervened to hold their
currencies down. So a chart of EM reserves
goes up vertically and hasn’t come down yet.
But what I am highlighting is, hey, if the U.S.
economy is going into a recession now, which it
probably is, then we’re moving to a different
phase. Housing was the least import-sensitive
component of U.S. domestic demand. So the
housing crash hasn’t really impacted the trade
deficit all that much in the U.S. But now the
credit crisis’ impact is moving into consumption,
which is the most import-sensitive component.
So it’s likely that you’re going to get a
rapid decline in the U.S. current account
deficit over the next 6 to 12 months, which
means the emerging economies’ surpluses
come down very sharply, so they don’t have to
intervene so much in their currencies — which
means the growth in their money supplies collapses,
which means the growth of liquidity in
their economies collapses. Any analysis of what
drives emerging market growth rates and
emerging market equities and bond performance,
shows that the printing of money by
these emerging economies’ central banks has
been a huge factor in bolstering their
economies. But that is going into reverse in the
next 6 to 12 months, in a major way. The
reserves will still grow, but at a much, much
slower rate. That will produces a big sucking
noise in terms of the impetus for emerging market
growth, and actually put downward pressure
on commodities. If you blow up the emerging
market growth story, then you kick away the
crutch for the secular bull market in commodities
for a while. [Italics in original]

Not to mention, demolish decoupling.

James: I actually have come up with a wee bit
of data that shows, even if you somehow still
believe in decoupling, that the emerging markets
still have a huge problem: There’s an
inverse relationship, historically, between economic
growth and stock returns in emerging
markets. The slowest-growing emerging markets
have generally generated the best stock
market returns for investors, while returns
from the fastest-growth emerging markets have
lagged, because people overpaid for growth. Yet
the whole reason, today, for buying into the
emerging markets and commodities seems to
hinge on rapid growth in China, India, Brazil and
Russia — which I think is utter madness.

There seems to be a lot of that going
around—

Albert: Yes. Another thing we’ve flagged on
this, which we find amusing — because so many
pin their bull stories for commodities on
demand from China and India and so on growing
so fast, even if the U.S. and U.K. fall into
recessions – is that the IMF came along several
months ago and dramatically reduced its estimates
of the emerging markets’ purchasing
power parity. They actually cut their estimates
of the relative size of the Indian and Chinese
economies by 40%. They shrunk them,
overnight, by 40%. James has a name for it, the
way you reject information which doesn’t agree
with your view.

James: Confirmatory bias…

Yet I hear people all the time comparing
valuations to the tech bubble and declaring
stocks, “Cheap.” Isn’t there a neuroscience
explanation for that behavior?

James: Absolutely. It’s classic anchoring. This
whole habit of hanging onto irrelevant benchmarks.
That’s exactly what you’re seeing.
People say things like, “Well, 24-25 times Ford’s
earnings is perfectly reasonable.” That was the
peak they reached in the bubble. Today, at 13
times, even if I believed the Ford earnings forecasts,
which clearly we don’t, you’d have to
question whether those numbers are actually
cheap. Relative to the peak in the bubble, yes.
Relative to a decent long-run history, clearly,
no. That’s the problem. People have very, very
short-term memories here. We’ve got a serious
myopia problem within the markets. The analysts
are just in cloud cuckoo land. They keep
telling us that things are going up. I do a chart
of actual earnings and forecasts, which shows
that the analysts very clearly lack reality. They
only ever change their minds when there is
irrefutable proof they are wrong, and then they
only change it slowly. It’s a classic pattern of
anchoring and slow adjustment that we see.

…

You mentioned the Street’s “conspiracy of
optimism” earlier. Why are you so convinced
there’s worse yet to come from the credit crisis?

James: From my perspective the whole idea of
the credit crunch could be seen in the Fed’s
senior loan officer survey. There’s not only a
supply of credit constraint, banks not willing to
lend, there is a demand constraint. Nobody
wants to borrow. So you have a market that is
dead on both sides. That is a hallmark of a classic
precursor to a liquidity trap whereupon the
Fed’s actions have no power at all. You can raise
rates, you can lower rates, and it really doesn’t
make a damn bit of difference, because nobody
is trying to borrow anyway. This is the problem.
What you had was a multi-year Ponzi scheme
that created an enormous debt burden. It’s the
unwinding of that credit bubble that is the real
handicap here. And that’s what people aren’t
“getting,” if you like, because we don’t see
these things very often. We don’t see a credit
bubble bursting every day of the week; people
aren’t used to it. And we know that people
aren’t good at looking for change. It’s what we
call “change blindness,” and we see it a lot. So
what people haven’t got a handle on is that the
environment is structurally different. There has
been a bursting of the housing/credit bubble.
And that matters, because it has real economic
impacts, which I’m sure Albert will be able to
talk about far better than me.

That sounds like a challenge—

Albert: No, that was great. What people don’t
generally get is that the credit bubble was the
flip slide to the economic bubble — keeping
growth going at all costs. The process of keeping
growth going involved the U.S. household
sector, and the U.K.’s and Spain’s, as well, piling
up huge debts. That process needed asset
price inflation on the other side of the ledger
for them to borrow against. So you had incredibly
loose monetary policy (however much
Greenspan says he couldn’t do anything about
it). You had double-digit broad money supply
growth for about a decade in the U.S., way outpacing
GDP, to keep asset prices going up. So
sure, asset prices went up. And it’s perfectly
rational for people to borrow against rising
asset prices. But all you have to do is stop the
music with asset prices, and the whole thing
comes tumbling down, because you haven’t got
anything to carry on borrowing against. We’ve
got a measure of household sector savings, not
the normal savings ratio, which everyone knows
is at zero. We deduct household residential
investment from that savings total and what we
find is that there was an enormous ballooning
out, over the Greenspan years, of the total
household savings deficit. It got to a 6% deficit,
as a percentage of GDP. What that meant was
that to keep the level of spending so far above
income, you had to increase debt massively.
Each and every year, you had to increase your
debt income ratio, just to maintain your level of
spending. The level, not the rate of change.

In other words, each dollar of new debt
was less efficient than the last in generating
growth—

Albert: Exactly. As I always say, if a loose monetary
policy and rapid asset price inflation were
the route to economic prosperity, Argentina
would be the richest country in the world by
now. This is a Ponzi scheme, and the U.K. has
been doing the same as the U.S. It’s a bit like
2001, when the corporate sector also borrowed
very heavily on a new paradigm view of the
world. They piled up debt because they thought
profits were going to explode. Then they sat
bolt upright in 2001, realized they’d borrowed
way too much and had to cut back on their borrowing.
The U.S. economy just dropped out of
the sky as they cut back on their investment —
which they had to do, to stop borrowing. Now,
the same thing is happening with the U.S. and
the U.K. consumer: The asset price bubble has
burst, and now there’s nothing there holding up
these extremes of expenditure. Which is why I
expect a deep recession. It surprises me, when
we go around visiting clients, that not more
people are thinking a deep recession is possible.
[Emphasis Added.]

See, you are gloomier than most—

What we tend to hear is that it’ll be only a shallow
recession, or perhaps a prolonged, shallow
recession, if they use the word at all. Even guys
who have been ahead of the curve, like the
Merrill Lynch economists and the Goldman Sachs
economists, who have the right idea of what’s
going on, are still calling for a shallow recession.
There hasn’t been a deep U.S. recession
since 1982, and before that, ’74. Now, I define a
recession by looking at a four-quarter moving
average of GDP. In those recessions, GDP fell
2% year-on-year. If you look at the last recession,
in 2001, on a four-quarter moving average
basis, GDP did not decline, and in 1990-’91, I
think GDP fell by 0.25% on that basis.

And most consumers sailed through those
downturns unscathed.

Albert: Kind to consumers, unkind to corporates.
The high-yield corporate default rate
went to 12%. Now, Moody’s did a scenario
analysis recently and they said in their most
pessimistic scenario the default rate would go back
up to where it was in the last two recessions. But
those were mild recessions. And that may be
what happens. But if you’re going to pencil in a
pessimistic scenario, why don’t you pencil in a
deep recession where default rates won’t stop at
where they went to in the last two recessions,
around 12% for the speculative grade, but go to
20% or higher, which is what will happen if
there’s a deep recession? So Moody’s hasn’t
learned. You know, the lesson from the AAA
ratings of CDOs was its mistake in not factoring
in the possibility of a deep housing downturn.
Yet they’re making the same sort of mistake
again, by not factoring in the fact that there
could be a deep recession. Well, why not? Why
not simulate what would happen and warn people
that the AAA stuff that is not CDO-related
will come under incredible pressure if there’s a
deep recession?

You are a party pooper.
Albert: Yes, it seems quite impolitic to express
a view like that. But deep recessions happen.
Luckily for the U.K., its housing market and
the household sector have gone through a deep
recession more recently than the U.S. After the
excesses at the end of the ’80s, we actually had a
deep recession in the early ’90s. So at least we
have had more recent experience. In the U.S., it
has been so long that people just are not even
thinking. I am not saying they have to make a
deep recession their central case, but they
should at least concede there’s a 20%-30%
chance of one. Granted, it is my central case,
but it amuses me that people just aren’t even
considering the possibility.

Not to worry. The Fed fixes all.
Albert: That’s just it! It’s beyond the potency of
the Fed. They aren’t in control of it. Paul Volcker
actually said recently that maybe the Fed lost
control. There are so many people saying, quite
rightly, that this is the most serious downturn
since the Great Depression. Yet almost every
forecast calls for a mild downturn.

…

Just how ugly are you expecting the
recession to get?

Albert: Well, U.K. core inflation is 1.4%.
Headline inflation is 3%. In a year’s time, if we
get a deep recession and the oil price buckles its
way back to $60, even with food inflation still
where it is, I calculate that produces zero headline
inflation in the U.K. And it would work out
about the same in the U.S. Now, what no one
else really is saying is, “Hang on, if all this is a
bubble and the bubble has burst, we could get a
real flip over back to deflation worries if headline
inflation collapses. Again, we’ve got a
minority view on that, but markets do flip flop.

No argument. But oil back down at $60?

Albert: Yes. Think what the oil price might be
in a deep recession in which the emerging markets
go down. Emerging markets earnings optimism
is crumbling just as quickly as the developed
markets. There’s no decoupling at all, so if
you’ve got a sharp slowdown in growth in China
and in emerging markets generally, I think perceptions
will be totally transformed in six
months’ time. But all you can do is sort of warn
of these things. And obviously people want to
go with the flow. So stagflation is trendy again.
I mean, if unit labor costs were picking up quite
briskly the inflation bulls would have a very
good case, but they are going in reverse.

Okay, but inflation expectations are soaring,
and they’re supposed to lead—

Inflation expectations can go up — and they are.
But you go and ask for a pay raise and see what
happens. Very little. I mean if these statistics
are right, and I think they are because they survey
the wage data, wage inflation is falling. Real
incomes have just been absolutely clobbered.
Which makes a consumption recession much
more likely, which means that the emerging
markets will see their current account surpluses
shrink, which means the emerging markets are
more likely to feel the double-whammy I mentioned
earlier. And the inflows into their sovereign
wealth funds will slow dramatically,
because their foreign exchange reserves will
stop growing. So we’re saying with a slowdown
in the emerging economies, that money is far
more likely to stay at home and be put to use on
infrastructure projects than to come back here
to bailout Western banks.

What would that mean for the dollar?

Albert: The surprising thing could be that as
the economy slips into deeper recession over
the next six to 12 months, the dollar actually
rallies. For two reasons: 1) Because interest rate
expectations start to fall elsewhere quite rapidly,
and that’s already starting to happen. 2) If we
do get the sharp fall I expect in the U.S. current
account deficit, it’s quite likely that the markets
will focus on that and we’ll have the dollar showing
surprising strength in a period where the U.S.
doesn’t really want the dollar to be strong.

How much improvement are you talking
about in the U.S. current account deficit?

Oh, it was 6% of GDP. It’s 4%-5% now, I’d say
that if it drops to around 1%-2% in the next 12
months, it could have a big impact on the dollar.
Japan has had that problem repeatedly, and
often has had to intervene very heavily to stop
the yen from going up when the economy was in
trouble. To the extent the dollar does rally, the
less intervention the emerging economies will
have to do to stop their currencies going up —
and that will squeeze their reserves and money
supplies even more. A bull in the china shop is
unwelcome, as they say, and that would be a
most unwelcome dollar rally from the point of
view of the U.S., really turning off what has
been a global liquidity pump. The lesson from
Japan is these things can happen, especially if
your economy is heading towards the rocks.

Surely you know the U.S. is just is not like
Japan in very many ways.

James: Yes, but Peter Tasker, the Japan specialist
we used to work with at DrKW, always used
to say that the U.S. will eventually start to suffer
something similar to Japan’s malaise, only
worse because it’s a more flexible economy.

Did you say worse?

James: Yes. At least in Japan companies didn’t
cut jobs, because there was no social security
net. Companies hoarded labor in the downturn,
which meant margins totally collapsed, and
profits. But whole economy consumption never
really collapsed because there weren’t big drops
in employment. In contrast, he said, the U.S.
economy’s greater flexibility will actually hurt

…

You two are conjuring up what have to be
chilling prospects for central bankers — no
wonder you call it the Ice Age.

Albert: What I’ve been saying all along is that
in a low inflation world, equities should be
cheaply priced relative to bonds. All we say to
our clients is, if there is a recession, even a mild
one, profits will fall 30%- 40% maybe. But people
are counting on multiple expansion as bond
yields come down to offset the lower earnings.
What we’re pointing out is that investors will
really be surprised if we get a repeat of 2001-
2003, where you get a recession and bond yields
come clattering down, and you also get a forward
P/E contraction from 13 times say, to 9
times. Plus, you get that on top of the profits
recession. We still think we’re in a secular bear
market for valuations. And equities are still, as
James says, hideously expensive on cyclically
adjusted measures.

That’s what happened, I dimly recall, back
in the mid-’70s and early ’80s.

Albert: Yes. And if you go back to the ’50s and
’60s, the whole market used to yield a lot more
than bonds, not just a few stocks. I think that’s
what we’re going back to. But mine is very
much a minority view. So what we’re saying to
clients is to just hang on. Don’t expect a bear
market in a recession to be just 20% or 30%
because of multiple expansion. You could get,
in a deep downturn, market declines on the
order of 50% to 75%, because you get the fall in
profits and you get P/Es coming down. That’s
how, mathematically, you can get to a seismic
fall in the markets in the event of a decent
recession. Nothing I’ve seen yet disproves that
theory. Sure, the bulls also could still be right;
maybe P/Es will expand to 18 times if bond
yields come down to 2.5%. But that’s just their
postulation. They argue multiples won’t contract
again like they did in 2000-2003, because
equities were ridiculously expensive then and
the decoupling between bonds and equities was
a one-off event. We’re just saying that maybe it
wasn’t. And if so, watch out.

Wouldn’t it be behaviorally, well, natural
for multiples to contract in a nasty downturn,
as people turn cautious?

James: Absolutely classic. That’s what you saw
in Japan as the Ice Age played out there:
Multiple contraction with each subsequent
downswing. I think that will be a feature of a
post-bubble environment. Markets do become
quite economically driven, if you like. The earnings
cycle tends to matter much more. And
we’ve barely begun an earnings downswing
here. So I would fully envision a much sharper
earnings decline that will make people that
much more cautious. Now, after they lose faith
repeatedly over the course of these ongoing
cycles, eventually you do end up at the bubble
process’ end, which is revulsion. But it’s slow
getting there. It doesn’t happen in the course of
one market correction of 20% or 30%.

It almost sounds like you’re saying it’s
“fate.”

James: No. As I wrote a few months ago, the
events unfolding in the U.S. aren’t a black swan
but an example of a predictable surprise. To claim
otherwise is to abdicate all responsibility for
what’s happening — and I believe bubbles are a byproduct
of human behavior— which is (sadly) all
too predictable. Of course, the details are different
in every instance, but the general model was
laid out long ago by Charles Kindleberger and Hyman
Minsky: Bubble rise and fall in 5 stages — displacement,
or the birth of the boom, then credit creation,
euphoria, then crisis/financial distress and
finally revulsion. We’re not close to that last stage
yet — and the path to it is never straight; always
includes plenty of sucker rallies, as the quotations
we talked about earlier so amply demonstrate.

There’s more here. Every word is worth reading several times.

My thanks to Investment Postcards from Cape Town for reprinting this article.