Is The Market Rebound Over?

In a strategy piece released yesterday, Albert Edwards of Societe Generale points out that, despite all the bullish chatter in the equity markets, nominal GDP is now shrinking in the US and Japan. His conclusion? “In the US and elsewhere, debt deflation is climbing the ramparts and putting the brave but under-armed defenders to the sword.”
If you need evidence to support a deflationary view, here are some of the statistics that Edwards quotes: US wages and salaries are falling at an annual rate of nearly 5%; total pre-tax household income fell 3.4% in the year to June; and even after recent US tax cuts, household income was down 1.3%.

US capacity utilisation is falling at a double-digit annual rate and since this series leads core inflation rates by about a year, expect the core producer price index series (which was up 3.3% in the year to June) to start heading towards negative territory soon.

Edwards points out that in the nineteenth century prices used to move from inflationary to deflationary territory and back again with regularity. The difference between then and now is that economies are currently carrying an unprecedented debt burden, whose size will increase in real terms if we enter into a period of deflation, making it less and less likely that these debts will ever be repaid.

The UK government’s surprise decision yesterday to extend and expand the size of its quantitative easing programme must therefore be seen as another attempt to ward off the deflationary bogeyman. Whether the expansion of the programme will reassure people is another matter. After all, it could just as easily be taken as a sign of panic amongst the policymakers.

Because no one (including the government and the Bank of England) seems to know if the quantitative easing programme is working or not, or how to measure its success if it is, passing judgement on the matter is difficult. When I wrote on the subject a few months ago in a feature for this site, I took it that QE was a way of ensuring some devaluation of your currency without proclaiming this as your goal (given that G8 and G5 members are officially committed to a “no competitive devaluations” policy).

If that’s the idea behind the strategy, it hasn’t worked in the UK – sterling has risen against both the euro and the US dollar since the programme was initiated in March. Gilt (UK government bond) yields haven’t changed much at all since then, so if the idea was to push yields down that doesn’t seem to have worked either.

What does seem clear is that fiscal measures have had some effect in boosting, or at least front-loading demand in both the US and the UK. A report on the UK’s Channel 4 news last night highlighted that the government’s car scrappage scheme is giving a temporary boost to demand for certain models.

The question is what happens when these “temporary” schemes come to an end or fail to be added to. If fiscal programmes and government rhetoric aim to convince people that a recovery and price rises are just around the corner then any disappointment at the actual outcome could lead to a real hardening of deflationary expectations.

If this occurs then we would face an abrupt end to the equity rally, a reversal of the recent easing in credit market conditions, a probable secondary peak in commodity prices, and a renewed flight to safety in government bonds and precious metals.

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