Here is the Barron's interview that Sam mentioned, I hope that the formatting is not too difficult.
FOR PERSONAL USE, copyright BARRONS
Wet Blanket
London strategist still won't touch Asia -- or the U.S.
By Kathryn M. Welling
An Interview With Albert Edwards ~ He sounds veddy British, but don't
mistake the global investment strategist for Dresdner Kleinwort Benson as the
proper sort who wouldn't dream of ruffling feathers. Though an economist by
training, Albert isn't the sort of man who minces words or pulls his punches.
Clearly, he's contrarian to the core. The "Asian miracle," he was saying as
early as '95, was "rubbish." That got him into hot water with political
potentates in the region, but clients who followed his advice and started exiting
Southeast Asia in 1996 and '97 now have good reason to cheer. In fact, all
the dismal news out of the submerging markets got us wondering if Albert,
who last sat still for a Q&A in these pages in December, is getting a mite
tempted to re-enter where others fear to tread. His unequivocal, if cheerful,
retort when we rang him up was a succinct "no." We got him to expand on it
-- and on his growing forebodings about the U.S. market -- in the
conversation reproduced below.
Barron's: Has Southeast Asia taken enough of a beating to tempt you to
buy back into those markets yet, Albert?
Edwards: The bottom line is, no. Notwithstanding the Indonesian political
developments, or a 500-point one-day drop in Hong Kong. Earnings are still
decelerating very rapidly on a fundamental basis all over the Pacific Rim.
When you look at PEG ratios [the one-year forward P/E on IBES earnings
estimates, relative to the long-term growth rate], you can see that you are just
paying far too much for the long-term growth expectations. What I find
shocking is that Hong Kong's PEG ratio shows that market to be basically
more expensive now than it was at the beginning of 1994.
Q: Despite the market's lower P/E?
A: Yes, although the P/E has come down, long-term
growth expectations have also come down-more. So
you are paying an awful lot, not just in Hong Kong, but
in Malaysia and in Singapore, for quite terrible
long-term earnings. On top of that, it's clear that the
one-year forward earnings estimates are still all headed
straight down, if you look at the upgrade/ downgrade
ratios to see what is happening to near-term earnings
momentum. In fact, for the PEG ratio in Hong Kong to
go back to where it was after the peso crisis, which I'd
define as rock-bottom, the market would have to halve
-- from 10,000.
Q: So the Pac Rim's advance earlier this year was
just a bear-market rally?
A: Yes. Actually, it was all driven by U.S. investors. What happened in Asia
in January, February, March was basically what happened in Japan at the end
of 1990, when its P/E had collapsed because the market halved. U.S.
investors thought a 28-times P/E was jolly cheap. So you had this huge wave
of U.S. money coming into Japan; it pushed the Nikkei up from 20,000 to
27,000, or 35%. Investors were taking a punt that the earnings downgrades
would be coming to an end shortly. Well, they didn't. Profits kept unraveling.
Within 18 months you were down to 14,500. That's basically the analysis we
have been hammering away at all through the first quarter. Yes, it's a
liquidity-driven rally. But earnings are still collapsing in Southeast Asia, the
same as in Japan in '90. You're paying too much for sorry profits.
Q: Everybody expects a V-shaped bottom. You gotta buy the dip to be
hip.
A: That's the problem here; there are such competitive pressures to perform
that when you get a bit of money coming in, you get very exaggerated moves.
You've got to recognize that those flows of funds are there. But you also have
to keep one eye on the fundamentals. Recognize that this move is due to
liquidity. Don't get carried away thinking that just because the market is up,
the bad news is over. Put a wet towel over your head and try to be rational.
On May 8, we reduced the Pacific Rim from underweight to heavily
underweight.
Q: Why so glum?
A: One reason is that you just had a price war break out this week among the
real-estate developers in Hong Kong. As we said back in September, when
that market goes, it will make Thailand look like a tea party. It is like watching
a car crash in slow motion. It is quite significant that price deflation in property
in Hong Kong is accelerating. Looks pretty grim. In Singapore, where there
has been a lot of denial, retail sales are down 18% year-on-year now. Hong
Kong retail sales are down 20%. It's looking like a depression out there. A
classic debt deflation in highly indebted economies. With their equities markets
so geared toward financials and the capital flows so tied in with equities, it's all
an uneasy powder keg.
Unlike at the beginning of '96, the first quarter's capital inflows into the region
weren't big enough to turn around the property markets in Hong Kong and
elsewhere. This time the deflationary pressures were too severe for the capital
inflows to turn the tide. You didn't move back into the virtuous circle, as you
had in early 1996. So you're left with the capital inflows drying up again --
and the awful reality of horrendous deflation out there. Thus, one of the most
important developments in the region generally in the last couple of weeks was
a failed property auction in Singapore. A real shock. We believe the highest
level of complacency in the region has been in Singapore. But it is all catching
up with it now.
Q: But hasn't Hong Kong real estate already taken
quite a hit?
A: You've had a lot of investors nibbling on Hong
Kong. Property prices have fallen 40%, and people
are saying, "They are going to bottom out after 50%,
so we are almost there." But the real-estate price war
means their cozy cartel has blown up. It's suddenly
dog-eat-dog out there. There's no reason those prices
can't drop another 40%-50%, like in Japan. And
here's a most amazing statistic: Over half of all private
residential mortgages in Hong Kong have been taken
out in the last year and half.
Q: Over half?
A: It's a phenomenal number. We may have already gotten to this point
already, with the price war, but in mid-April, another 10% drop in property
prices, meant we'd see 40% of purchasers sitting on losses from their
purchase price. We've been through that in the U.K., and it's pretty
horrendous. Geoffrey Barker, our regional economist, has just cut his Hong
Kong growth forecast. Until Hong Kong's chief executive used the "R" word
on Wednesday and sparked that 500-point selloff, I think Geoffrey was the
only one out there forecasting a full-blown recession for this year, down 1 1/4
%. What is significant is that his background is in Japan. He knows about
deflation. He is forecasting down 2% next year. A deeper recession than this
year.
Q: How much of a deceleration is that?
A: All we've had are fourth-quarter data, when Hong Kong was up 2.6%
year-on-year. But that was when retail sales were still growing. [Hong Kong's
GDP fell 2% in the first quarter, it was announced Friday.] The real question
is, what is going to turn it around?
Q: What's the answer?
A: Nothing can turn it around because with their currency peg, the more
property prices go down, the higher their interest rates have to go. The more
damage there is in Hong Kong, the higher the interest-rate-risk premium
investors will demand for holding Hong Kong dollars, as protection against the
risk of the whole thing imploding. The once-virtuous circle has turned vicious.
Q: When will China have to pull the plug on the peg?
A: No idea -- even if they will. We think they've done a deal with the U.S.
Administration not to devalue the renminbi, so that's off the agenda, at least
for six months or so -- and so, too, is any Hong Kong devaluation they might
link to it. If the Chinese economy got really awful six months out, they might
reconsider. But until then, the Hong Kong Monetary Authority will just stick
with the peg.
Q: What would get you back into Asia?
A: The question is, What will forward earnings be? Those economies are
more like the U.K. in '88 than like anything the U.S. has seen -- at least since
the 'Thirties. It's like what the next U.S. recession will be. There was just a
feeling in the 'Eighties in the U.K. that everything was marvelous. There had
been a Thatcher miracle, a property price boom. People borrowed a lot.
Stock prices were going up. Then you had the collapse in the property market
in the U.K. The Reichmann brothers went bust. The feeling was awful; we'd
had these expectations and then the bubble burst, and they were shown to be
rubbish. There was a total collapse in confidence, which went beyond just the
pure cyclical. It was structural. It takes people years to start borrowing again.
When I was chatting about this with our Mexican economist, he said, "Sure,
look at what's happened with Mexican bank borrowing. Since the peso crisis,
in real terms there has not been any. Confidence is shot to pieces." We're
seeing that same level of structural event in Asia. People just climb into their
bunkers -- and cocoon. Even when things finally bottom out, you are not
going to see 5%-8% growth rates. You are going to see 3%-4%, if you are
lucky. It's also like Japan. The total incompetence of policymakers has
shattered confidence -- and people just won't borrow in Japan. Ultimately, it
will probably happen in the U.S. U.S. corporations, which are levered up to
eyeballs, will suffer a loss of confidence as well.
Q: Hold on -- corporate debt levels were a lot worse here during the
junk-bond craze in the 'Eighties.
A: True, but there are other sorts of leverage. You have been seeing around 1
1/2 % of the share float swallowed up each year by corporations -- on
borrowed money. There has also been a lot of investment in machinery out
there -- much of it high-tech, which everyone thinks is great. But when a
company has invested a lot in productive assets, its operational gearing is
higher. Come a downturn, a lot of people will be shocked by what drops out
of the woodwork -- even in a normal cyclical recession. And it will happen,
because the business cycle hasn't been abolished.
Q: Okay, tell us what happened to the flood of cheap Asian imports that
were supposed to be swamping these shores?
A: One of the interesting things is that everyone is saying, "Asian exports
aren't picking up." If you look at the U.S. trade data, exports to Asia have
collapsed. But imports from Asia, for instance, from Korea, are only up about
7% year-on-year in dollar terms.
Q: But that's because prices -- and those currencies -- have cratered.
A: Exactly my whole point. People are showing these charts and saying, "This
means Asia is not having an impact." But if I did the same chart in won terms,
it would be up 60%-70%, year-on-year. Actually, both charts are slightly
misleading. The U.S. data showing a 7% value increase could be because
volume is up 30% and the dollar price is down 20%, which they can do
because the won has collapsed. To get a better look at what is going on in
terms of the volume of Asia's exports, we've charted Baltic freight rates from
the Pacific Rim to Europe versus the Baltic Freight Index. As you can see [in
the nearby chart], freight rates from the Pacific Rim to Europe, which
collapsed last fall, have rocketed up just recently.
Q: Your chart divides those transatlantic rates by the overall Baltic
Index?
A: Yes, because there is general deflation in all the rates -- like everything
else, global containers are in overcapacity. I wanted to strip out the secular
downtrend to see what was going on in those particular rates between the
Pacific Rim and Europe.
Q: Which tells you --
A: The sharp rebound in freight rates is only very recent and is specific to the
Far East routes. People have been saying Asian exporters can't get their
shipments financed. Well, clearly they can get financed now, because they
want to export. Now they can't get containers to ship their exports in, because
there's no shipping into Asia, which isn't importing. This means that Asian
exporters are having to import empty containers -- which is what they are
doing. As the chart shows, their demand is such that if you look at the price of
a round-trip for a container to Asia, it's almost the same price [about
80%-85%] as a one-way trip from Asia. That's interesting, because usually
it's about half the cost of a round-trip. So you are getting virtually a free trip to
Asia. Clearly, people want to export from Asia and are bidding up the price
of containers to ship in. The problem isn't lack of finance.
Q: What of the U.S.?
A: I don't feel that bearish within myself, it's just that this froth has built up.
And given the liquidity, it's not reassuring that the mutual-fund cash is now
down to 4.2%, the lowest since '72. Our essential case, as you know, is that
with a 45% decline in the market, we'd be very happy. I actually feel more
comfortable with our U.S. view than I ever was with our Pacific Rim view,
before last fall. But it's a case of when will the penny drop.
Q: So when will it?
A: Well, we're coming up to the second quarter reporting round. Even if it
turns out to be another zero, the market could just shrug that off, like the first
quarter. But I think profits are going to start getting so poor that ultimately this
will catch up with the market. I'm not too worried when. IBES, which is
always bullish, wrote recently that "the 12-month forward P/E moves to new
all-time high. Valuations further stretched. We remain fully invested. We are
also petrified."
Q: "Petrified"?
A: Yes, and they are always real cheerleaders. I can understand why. Based
on their data, each pre-announcement season is getting worse. Each reporting
season is seeing fewer positive surprises. Ultimately, we'll end up with falling
profits -- soon. The margin cycle is alive and kicking. To have 2% profits
growth when you just reported 4% GDP growth is pretty stunning. What will
happen to profits when the economy slows down? That's where the imports
from Asia come in. The latest trade data show import volume growth, quarter
on quarter, annualized at 22%, while import prices are falling very rapidly.
That's a sign that Asia is crushing margins. Still, I don't feel it's terminal. It's a
cycle, excess bullishness and froth on the way up mean excess bearishness on
the way down. It used to be that people didn't think much of 30%-40% drops
in the market. They happened, were regarded as quite healthy. The problem
is, we haven't had one for so long, when it happens, it will be a shattering
blow to many people. Retail investors get paralyzed. I know that from my
own experience. If things go down far enough, you don't step in and buy; look
at Japan. Maybe you do if they go 10%, maybe 15%; but at a certain level,
it's different. So if this is a new era, then fine; the market is fine, as Warren
Buffett and Alan Greenspan have said. It could even be cheap, if you do get
15% long-term earnings growth. If you don't, it's not. Simple, but those "ifs"
don't register with most people. And nobody wants to spoil the party. The
recently released minutes of the last FOMC [Federal Open Market
Committee] meeting were quite funny. People were worried about putting up
rates because of the market's reaction. Everyone is paralyzed by fear of
upsetting retail investors -- the biggest potential lynch mob in history.
Q: Not to nitpick, but you admit that you turned negative on U.S.
equities too early. And even rotten earnings lately have seemed to only
momentarily daze the blue chips.
A: We've been bearish on the Dow for over a year now. All last year we said
P/Es were going up not because of lower bond yields, but because of rising
long-term earnings expectations that were just ludicrous. We were warning
that at some point, the day of reckoning would come. But it wasn't going to
come last year, with profits doing reasonably well. As long as they were going
up 10%-15%, the market could engage in its fantasy that it would last forever.
It's only been over the last three months that what we assumed would be
Judgment Day has arrived. But still, the market is pursuing its fantasy. I was
quite shocked, as we went into the first quarter's pre-reporting round, which
was horrendous, that the market was still rallying. Earnings were just falling
apart in analysts' hands in the first quarter, yet the market still charged ahead
-- because long-term earnings expectations were still going up. The market
certainly wasn't rallying in the first quarter because interest rates were
dropping -- it wasn't as if the bond market was rallying particularly strongly.
So it was only in the February-March time frame that I really started
scratching my head, trying to figure out what the heck is going on. Considering
such a poor pre-reporting round, I could no longer attribute the market's
strength to misperceptions of the fundamentals. Something very odd is going
on now.
Q: Don't keep us hanging.
A: I've now decided that it is straight leveraging-up speculation. So perhaps
the market has moved into a final liquidity-driven blow-off phase, totally
devoid of rationality.
Q: Why now?
A: I know, some people have been saying that for the last two years -- and,
frankly, I've always suspected that liquidity arguments are what people wheel
out when they're at a loss to explain what's going on by fundamentals
anymore. But what's been going on this year in the money supply -- while no
one has been watching -- is amazing and, I think, vindicates my conclusion
that tremendous leverage is now being employed just to keep the bubble from
deflating. The [accompanying] chart, which will probably shock a lot of
people, shows that the real money supply, in its broadest terms [which is
referred to as "L," defined as M3 plus liquid assets], is up 12 1/2 %
year-over-year through April. And by "real" I mean that I divided L by core
CPI to get to its inflation-adjusted growth rate-which is clearly pretty robust.
Q: So what? No one watches the
money supply anymore. Especially
not the Fed.
A: That's just it. No one looks at
money supply anymore; the Fed is
not targeting it. I cheerfully concede
that I am an economist by training,
but even economists have tended to
move away from monetarism. And
I'm certainly not a monetarist.
Nonetheless, as a strategist, I know
that if there's excess liquidity, and it's
not going into the economy, it inflates
assets prices. Now, because I'm
fairly eclectic, the way I normally look at the money supply is by looking at the
broadest data series I possibly can, which means that I look at L, not M2 or
M3. And if you look at a chart of that broadest money supply measure, it's
quite clear that it's taken off -- a lot of money's sloshing around somewhere.
Most of the time, though, instead of looking at money-supply data, which
quantify deposits and which I have a hard time getting my mind around, I tend
to look at the flip side of money supply growth, which is bank lending. Well,
guess what? The bank-lending numbers have taken off just recently, too. But
not because banks are lending to consumers or to companies. What has taken
off is bank lending to directly purchase bonds and bank lending to securities
dealers -- which is up 50%, year-on-year, in the U.S.
Q: Did you say 50%?
A: Yes. It's just ludicrous. I only spotted it because the Bundesbank
explained their own stronger-than-expected money-supply growth by blaming
German bank purchases of equities, which have been phenomenal. In fact, this
isn't just a U.S. problem. The only place where banks aren't buying securities
hand over fist is Japan. They've had their fill there, already. Anyway, when I
did the analysis, I found U.S. bank lending to finance financial activities roaring
through the roof. Which explains the huge growth in the broad money supply.
And that's inflation to me -- the sort no one minds, though. Asset price
inflation is generally seen as a good thing. Until banks leverage up to do it and
go bust -- and taxpayers have to bail them out again.
Q: An all-too-familiar pattern:
Bank lending officers developing
an unerring nose for the next
disaster.
A: What's more, if you take those
two categories of financial lending
out to produce a chart line showing
bank lending to the private sector,
which isn't spinning around in the
markets, fed funds track that series
exactly. I was quite shocked when I
realized that. I mean, what the Fed is
looking at is that bank lending for buying goods isn't going up, so it doesn't
need to tighten rates. They're saying, "We are going to tolerate an explosion of
bank lending generally, even though it's financing inflation in asset prices." But
even if I were sort of sitting on the fence on the markets or on the economy, if
I were a Fed policymaker and I saw all this leveraged activity going on into
the equity market -- which has just started this year, explaining why, despite
the earnings slowdown, the market took off in the first quarter -- I'd be a little
concerned. I'd say, "A quarter-point rise in rates isn't going to do much harm
to the economy, but just might knock this on the head. And maybe, if we put
rates up 1/4 %, we might have to cut them 2% if the Dow collapses. But if we
don't do this now ... " I mean, people like to say, "One of the lessons of the
'Twenties is the Fed shouldn't raise interest rates to stop a bubble." But the
real lesson of the 'Twenties is that if you are going to do it, do it bloody early.
Don't hang around until the thing is going to collapse 80%. Do it early and, if
necessary, then reverse monetary policy to act as a cushion on the way down.
Q: All this monetary stimulus has
seemed to lose some of its wallop
over the last month. The Dow has
only stalled out, but much of the
rest of the list has done
considerably worse.
A: And the second-quarter
pre-announcement season, which
even Abby Cohen would expect to
be seasonally weak, hasn't even
started yet. It gives one pause,
doesn't it? Especially if you are the sort of nasty person I am and juxtapose a
chart of the liquidity ratio for equity mutual funds with my chart of broad
money-supply growth. I did that just on the suspicion that the two would be
quite closely related. After all, at the top in a bull market, there's basically no
liquidity in mutual funds. It's interesting now that this broadest measure of
money supply is just belting along, as people plow into the equity market
through mutual funds. But when it all goes horribly wrong, and they try to cash
them out -- look at the implications of those charts.
Q: Let's consider something more upbeat -- like your outlook for Europe.
A: A lot of people are suggesting that investors back off from European
stocks. Obviously, since there have been such tremendous gains there, it's
quite a normal reaction to ask why buy Spain at 24 times one-year-forward
earnings -- it has bubbled up from 15 times. That is something to think about.
We're saying that in a low-inflation environment, with bond yields of 4 3/4
%-5%, these sorts of multiples are fine. We don't see much further multiple
expansion in Europe. But what you have now is earnings momentum in the
bubble economies. Germany, France and even the U.K. are okay, growing at
between 2 1/2 % and 2 3/4 %. But in these Euro bubble economies, profits
are exploding. Growth is so strong in there, their deficits are disappearing and
they are going into a budget surplus, a bit like the U.S. is, a bit like Malaysia,
Hong Kong, and Thailand were. Now the European Commission has just
figured this out and is saying that those countries with surpluses really have an
obligation to tighten fiscal policy. But anyone who believes politicians sitting on
a budget surplus will engage in a countercyclical fiscal policy stringency is just
in la-la land. It is like the Asian bubble phenomenon. These economies are
accelerating out of control very nicely. These are bubble conditions. There are
even serious inflation pressures starting to emerge in Holland and Ireland.
Q: That sounds ominous.
A: Long-term, sure. But for the equity investor, the proper strategy now is to
buy that leveraged rubbish. You buy the banks, the property developers, just
as you did in Asia. The key is that the markets now follow earnings. The
multiples don't keep expanding, the market is earnings-driven. The Euroland
markets are now in the earnings-momentum phase. A good example is a U.K.
stock, CRH, predominantly based in Ireland. We've got the No. 1-rated team
of building analysts at Dresdner Kleinwort and they are bullish on this stock.
They know the story. But they are consistently having to move their earnings
estimate higher because the cycle is so strong. That stock epitomizes what will
happen with all Euro bubble stocks, as they're dragged up by earnings
surprises and inflation.
Q: The virtuous circle is alive and well and living in Europe?
A: It is. And it will attract capital in a world where equities are being hit by
creeping deflation. That will start pushing up the euro, which will hit Germany.
Her interest rates will tend to stay lower and that will just reinforce the boom.
Ultimately, of course, three or four years down the road, this might all turn into
a disaster waiting to happen. But it ain't any time soon. And I'm sick of being
too early. So, to anyone thinking of investing in emerging markets, we're
saying "don't bother, go into the Euro bubble markets. You'll get faster
growth, more inflation in a fixed-exchange-rate regime -- far better
emerging-market returns."
Q: On that happier note, we'll bid you adieu. Thanks, Albert.
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