In our guest blog, Odey Asset Management's Crispin Odey gives an overview of the market for investors.
The developed world averted a recession in 2008 by cutting rates to 0%, then embarking on Quantitative Easing or QE. We expected healing, then growth, then inflation, then rising rates. But we have experienced the distortions of QE without generating enough growth or inflation. Central banks have ended up with the safe assets and driven pensions and savers into everything else. We haven’t achieved inflation, so we haven’t worked through our debt and the solution may have to come from default.
We have become increasingly concerned by China’s five critical challenges; the economic slowdown, lack of competitiveness as wages rise, an overvalued currency, debt at 300% of Gross National Product (GNP) and a stock market bust. All this while trying to keep the Communist Party and the people happy and managing a migration from capex-led to service-biased growth, a virtually impossible task. In 2007-8, US housing indebtedness and lack of visibility was the problem but now it is China, with huge debt and true affordability being hidden. In 2007-8 the interbank markets started the recession, now that risk comes from China. And if confidence in the system fails, the current RMB outflow will turn into a flood.
As Emerging Market (EM) economies suffer in the fallout, currency wars will lead to trade disputes, rising tariffs and trade block formation. This threatens world trade which, in the last 25 years, has gone from 12% to 35% of GNP. The chief beneficiary, China, will turn from customer to competitor as it tries to move up the value chain to protect its industries from a domestic and export slowdown. We are already in a deflationary downdraft amidst currency wars, yet China, the most bellicose country with the biggest army, has just fired the first shot.
Elsewhere, we see the replacement cycle weakening - commodity capex is falling, the oil price is killing new aircraft demand, cars have already been replaced using cheap credit. We risk being on peak multiples of peak margins, but everyone is trapped in equities by QE. We are not guaranteed a Developed Market recession, but neither are we priced for any risk of one. Workaday stocks like Kellogg are on 18-20x earnings after a seven-year QE-fuelled market up cycle. Valuations are so extended that they will need to fall 30-40% to be compelling.
So for investors, after a tumultuous August, the question is whether these shocks and adjustments are largely complete. Our overriding conviction is that we are nearer the beginning of this process than the end. Our pension fund clients need to protect themselves from the de-rating and be asking, how much insurance should we have?
In our view the cycle has no more been abolished now than it was in 2007, when Bear Stearns and Northern Rock were seen as containable. As Bank of England Chief Economist Andy Haldane says, there is a recession every decade. We are now due ours. It is too late to chase the QE happy trade, but not to protect against the deflationary bust. At Odey, we can have periods of mediocre performance whilst we position for a change in the climate. But when that change comes, we can make strong returns at a time when others are confused and fearful.