You say markets will march to a very different drumbeat next year. What do you mean?
They’re marching to the drumbeat of the mistakes of the past. You can generate massive shortterm recoveries both in the economy and the markets, based on massive fiscal and monetary stimulus. Japan did so many times in the past decade. But inevitably you get sucked back down into the recessionary gloom. People forget that in Japan, equity markets used to rally 40%-50% and then they’d collapse again. It’s like the grand old Duke of York: we’ll be marching all the way up the hill and all the way down again.
So where will the FTSE be next year?
I think that sometime in 2010 it will fall back below the lows of March 2009. Ironically, that will be very good news for private investors.
Why’s that?
In the rapid inflation period of the late 1960s, 1970s and early 1980s, equities were a very poor investment. They did nothing in nominal terms and in real terms (ie, adjusted for inflation), they were significantly lower. They weren’t seen as an inflation hedge. The reason for this was that when inflation took off, equities started off with a very high p/e ratio.
But if we start an inflationary period with equities on a very low p/e, then stocks will be a much better inflationary hedge because they’ll go up more with earnings. If my forecast for next year is right and we get a sort of capitulation phase in the equity markets and they begin looking much, much cheaper than they were in March, then on a ten to 20 year view, equities will be more than simply a huge investment opportunity. In addition, they’ll be an inflation hedge over and above gold and index-linked bonds.
So you’re worried about inflation?
If you are a long-term investor, I think you really have to be concerned about higher inflation. We’re in the middle of a massive economic experiment in quantitative easing. We’re going to struggle for years with these excess debt loads we’ve got. And it’s not just the private sector – now it’s the government sector too. So I would worry about inflation and look at ways to insure yourself against it. It comes down to gold and index-linked bonds.
Gold will give you no return. It’s not a proper investment where you can work out net cash flow, and unlike silver or platinum it is useless, regardless of the economic cycle. You are relying on it going up in price to make a return. In that sense, it is dead money. But people should accept that dead money because it gives you a good insurance policy.
How bad will inflation get?
We’re not talking about inflation going up from 2% to 5%. We’re talking more like 10% to 20%. Most pensions have an inflation cap of 2.5%, or if it’s deferred, 5%. If we have inflation of 10%, you’re wrecked. So you need some sort of insurance. And even if gold doesn’t go up in price but just stays where it is, that’s fine. You’re only using it as a hedge, or insurance policy.
Look at the unsustainability of government finances, not just in Britain but elsewhere. It’s not just the 100% debt-to-GDP ratios. When you add in the unfunded liabilities, you’re looking at liabilities of about 500% of GDP. There’s no way they can meet those. So some sort of default has to be part of the equation here. And default through inflation is effectively a default. Milton Friedman’s notion that “inflation is everywhere and always a monetary phenomenon” is right. So often, the reason for monetary debauchery is fiscal un-sustainability.
You are bearish on China. Why?
The biggest single predictor of economic collapse is credit growth, which is off the scale in China. The Chinese are doing what the Americans did in 2003-2005. They didn’t want a deep recession so they pumped it all back up again. There was massive credit growth and asset inflation. They thought they were in control and then they tapped the brakes and the economy collapsed.
So I’m worried about the economic collapse in China. But I’m more worried that the markets will be totally blindsided by it. People believe the growth story will carry on forever. But I think China is more cyclical than people expect. And often when you get these growth stories the problem is that people overpay for them. In effect, there is no connection between equity returns and whether the economy grows rapidly or not. Because people overpay for it.
Who is Albert Edwards?
An economics graduate from Bristol University and an economist at the Bank of England, Edwards has a history of going against the grain. He forecast the 1997-1998 Asian crisis in a January 1996 note; his castigation of Malaysia’s policies as ‘Noddynomics’ created political trouble for his then-employer, Dresdner Kleinwort. For over ten years, Edwards has been bearish on stocks. His argument is that most markets are in an ‘Ice Age’ of declining valuations. Edwards is regularly ranked as the top strategist in surveys. In 2007, Edwards became co-head of global strategy at Société Générale.