Felix Zulauf's Market Prognosis

Karen Maley Business Spectator February 14, 2012

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Karen Maley

Published 7:12 AM, 13 Feb 2012 Last update 7:12 AM, 13 Feb 2012

Legendary Swiss investor Felix Zulauf believes that the current rally in risk assets is likely to last until at least the end of March, but that global sharemarkets will again succumb to downward pressure in the second half of the year.

In a wide-ranging interview with Business Spectator, Zulauf, who is president of Zulauf Asset Management and who has been a member of Barron’s Roundtable for more than 20 years, paints a gloomy picture of debt-laden industrialised countries, where central banks have no choice but to print money in an attempt to stave off dire deflationary pressures.

He also predicts that dwindling demand from the West will force China to redouble its efforts to boost domestic consumption, but that this will reduce China’s rate of economic growth.

First of all, investors are becoming increasingly nervous as negotiations over the latest €130 billion Greek bailout drag on. What do you think will happen to the country?

The situation is hopeless, of course. We all know that – Greece is bust. But politicians, not only in Europe but also in the United States, camouflage the reality and present an unreal picture.

There is no hope for Greece if Greece stays inside the eurozone. Giving Greece more money is not actually helping Greece, but it is helping others, particularly the banks, and also the European Central Bank.

Eventually I believe a Greek prime minister will decide to take the country out of the eurozone, and go back to their local currency, which will decline by at least 50 per cent against the euro. The financial system would be bust, as would many other parts of the economy. Greek enterprises – both government and private – would default on the debts they owe to the outside world. The Greek national bank and the Greek government would refinance the financial system in drachma.

The thing is, Greece doesn’t make a lot of products. It makes feta cheese and olive oil, and it has tourism. If Greece became 50 per cent cheaper than Spain, Italy and Portugal, after a year or so, the economy would recover. After four years, Greece could come back to capital markets and after seven, eight or 10 years, it could re-enter the eurozone in a much-improved position. It’s a much healthier way of proceeding than what the European politicians are doing.

Portugal is bust too. Their bond yields are in default territory, clearly. So after Greece comes Portugal.

Is there any chance that Europe will be able to escape its debt crisis? It’s really getting ugly. Germany is trying to force everyone onto an austerity course, but that’s only reinforcing the downward spiral of the periphery. Cutting government spending and raising taxes will cause the periphery to slip into recession or to stay in recession. They have all this downward pressure in their economies as a result of tightening fiscal policy. The trouble is that when you have an over-indebted economy, you can’t use monetary policy to offset this because monetary policy doesn’t work anymore, only fiscal policy does. But they’re trying the austerity course. In Italy, [Italian prime minister] Mario Monti is noticing that these policies aren’t working to improve the situation, that’s why he’s calling for growth programs. But how you can have austerity programs and growth programs at the same time, I don’t know. What’s the outlook for global sharemarkets this year? The move by the European Central Bank to provide banks with a €500 billion long-term bridging facility will reduce systemic risk for a while. And there are now reports that the second tranche later this month could be €1 trillion. So the balance sheet of the ECB is exploding; it’s rising faster than when the US Federal Reserve did its QE1 and QE2. Obviously monetarists believe that when the central bank’s balance sheet explodes, it raises final demand in the economy. I don’t believe that will happen, because the transmission mechanism is broken. But what it is doing is that it’s reducing systemic risk, so that risk assets can recover. That’s all about the rally that we’ve seen since last October. I think the rally will continue into the end of the first quarter, or maybe a little bit further. And this flood of money means my original scenario could be pushed out further in time. I had been expecting that problems would start in the second quarter of this year, and there would be a correction. But now this cyclical rolling-over could be pushed out. From this summer to fall of 2013 seems to me the most vulnerable period for markets. The very big picture is that markets in the United States and Europe are in a long, sideways value compression period, similar to what we saw from the mid 1960s to the early 1980s. This current one started in 2000, and will probably last into the second half of this decade. And it’s very similar to what you saw in Japan, with cyclical run ups and cyclical corrections. And these cyclical moves are usually triggered by government programs – both monetary and fiscal. Speaking of monetary policy, when is the US central bank likely to announce a third round of bond buying (or QE3)? I don’t think we’ll see QE3 very soon, because economic trends right now don’t justify it. The published numbers are somewhat better than everybody expected, so there’s no need to do a QE3. Right now, we’re seeing relatively good production numbers, but we’re also seeing rising inventories – in the United States, Europe and Asia. In some cases, we’re seeing inventory-to-sales ratios at similar levels to early 2007. If final demand doesn’t pick up the way producers are expecting, they’ll reduce production, which will change the sentiment in the marketplace. So we need to watch that very carefully. If there is a big change in sentiment, the Fed might do QE3, but it would be very counter-productive. Printing money doesn’t lead to a rise in final demand, it only leads to rising prices for risk assets. QE3 pushes oil prices higher, and punishes the average citizen who doesn’t have a balance sheet with risk assets. But the US Federal Reserve will try that gimmick when the economic numbers deteriorate, because central banks are in a hopeless situation. Everyone thinks they’re the ones that can save the system. But by printing money, you don’t make the world wealthy, you make a few people wealthy, and you increase the disparity in society. You push the top 20 per cent further up, and you push the other 80 per cent further down in prosperity. And eventually that will lead to a social backlash, which could be very bad. What’s the outlook for commodity prices? Commodity prices have been pushed in the last decade by the rise of China – that’s been the main factor by far. I don’t expect China’s rise will stop, but the country is now at a critical crossroads. China’s economic model has been to be the cheapest manufacturer for the world, so they’ve invested heavily in plant and equipment and in infrastructure, in order to support a thriving export industry. That’s been the driving mechanism, to feed consumption in the world via the Chinese export industries. But I think we are now dealing with a structural weakness in consumption in the industrial world due to declining prosperity. Real disposable personal income in most industrialised countries is stagnating, or even declining. And that means China has to change its model. Its export industries won’t be as vigorous as they used to be, both as a result of the weakness in demand outside China, and also because Chinese labour costs have risen sharply in recent years. So China has to change and put more focus on domestic consumption. But this has important implications for Chinese growth because domestic consumption doesn’t have the same multiplier effect on the economy as investment. So what we’re likely to see is that China’s growth rate will decline from around 9-10 per cent per annum, to around the 6-7 per cent level. And it also means that demand for commodities will slow. It won’t collapse, but it will slow. Commodity prices will tend to underperform equity prices during periods of “risk on” trading. But I would make an exception for two commodities – oil and gold. Oil, because the oil price is driven by geopolitics, and the geopolitical situation is very fragile. And gold because, in my view, gold is a currency. Central banks – in the United States and Europe – have no choice. They have to continue printing money to prevent their systems from collapsing, and this will debase their currencies. Will US politicians ever find a way to tackle the yawning US budget deficit? If the US government did decide overnight to cut the deficit from 10 per cent of GDP to zero, 10 per cent of final demand would disappear from the economy overnight, and this would lead to a very severe recession, if not a depression. I’ve calculated that over the last 10 years, if the US government had not run budget deficits, then US GDP would be 25 per cent lower than it is right now. It’s very difficult. Because there is no way of growing out of the problems, we are destined to keep building up government debt in future. At some point, markets will have to be the arbitrator and then you could see bond yields rising sharply, like we’ve seen in some European countries. So bond yields could rise dramatically, and break the system. The other alternative, which I think is actually more likely, is that central banks will step in and take over the financing role that creditors used to perform. That’s already happening. In the United States, the central bank is buying Treasury bonds. In the United Kingdom, the Bank of England is the largest holder of government bonds. In history, whenever we’ve seen a central bank finance more than 30 per cent of government expenditure, we’ve always had a highly inflationary period four to five years later. So, at the moment, you have two countervailing forces. On the one hand, you have a high level of debt, which is a highly deflationary force, which results in lower economic growth and a decline in prosperity for the masses. If you let this run unchecked, it leads to depression and the collapse of the system. In order to counter these deflationary forces, governments and central banks adopt policies aimed at fiscal and monetary reflation. At the moment, we’re weaving between these two forces, and at any moment, it’s a question of which force is stronger, and whether it’s risk on, and risk assets go up, or risk off and risk assets going down. Eventually there will be a conclusion, either a systemic collapse or a rise in inflation which will lead in some countries to hyper-inflation. And hyper-inflation itself always leads to systemic collapse. It’s an ugly situation, no question. But what’s the outlook for emerging economies? Emerging economies are in a much better structural position. Most of them have relatively low debts, they don’t have welfare systems they can’t finance, and they have much better demographics, so they have a built-in natural growth rate in their economies. They are the place to be in the long run. The only problem is they are intertwined with our world, and when our world suffers systemic problems, they will have a cyclical correction. But that’s where the money should flow. Finally, what is the outlook for the Australian economy? You are blessed. You’re far away from all these problems. Australia is the major beneficiary from the rise of China, as rising commodity prices have helped your economy and led to prosperity. The only issue is that if China has a cyclical correction, you will probably have a recession. I think that if China’s cyclical downturn comes in the second half of this year, or next year, Australia will fall into recession.

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Don Gilbert wrote:

Good article Karen. This is well thought out and runs logically (Felix Zulauf's market prognosis, February 13).

David Murray points out that the federal government, together with the states (mainly Labor governments), have $500 billion in debt. I do not think we will get off lightly, as you say. Queensland Labor (seeking re-election; the cheek) has bankrupted us.

13 Feb 2012 7:31 AM

Michael Linnett wrote:

Thank you for presenting this Karen – it is by far the best short summary of how things really are that I have read in a long time (Felix Zulauf's market prognosis, February 13). I think I shall frame it and hang it on the wall to provide an investing sanity check in the years to come.

13 Feb 2012 7:54 AM

Tony Holland wrote:

He's not at the top of his game, right now here in Switzerland he would know from figures just published that tourism in Greece is almost non-existent (Felix Zulauf's market prognosis, February 13).

Greeks aren't making money from tourism because folks are scared of violence and cost pressures on holiday packages.

The general feeling here is Greece has been contained either way and and markets will lift in the second half.

13 Feb 2012 11:20 AM

John Whelan wrote:

Tony Holland (February 13, 11.20am) seems to have missed the critical point that Felix Zulauf said that Greek tourism would return when the drachma replaced the euro at 50 per cent of its value (Felix Zulauf's market prognosis, February 13). That would make Greece a very cheap destination and by then, Greece would be cut loose to run their economy internally how they liked. That would also stop the rioting which in turn would make tourism attractive again.

13 Feb 2012 12:40 PM

Brian Hill wrote:

Thanks Karen! (Felix Zulauf's market prognosis, February 13). Mr Zulauf is a new name to me but he seems to see the big picture clearly.

I have received other warnings which gives September 2012 as a critical time economically for Australia and I should get ready to sell my "risk assets".

13 Feb 2012 12:57 PM

JJ Brits wrote:

I think Tony Holland's criticism (February 13, 11.20am) is a misrepresentation of what Felix Zulauf really said. (Felix Zulauf's market prognosis, February 13). It seems to me Felix was merely making the point that tourism is structurally and traditionally the backbone of the Greek economy (which is one of the many reasons why their growth prospects are almost non-existent now).

In addition, I would certainly not place too much value on the "general feeling" in any country. I think Felix is much closer to the mark than the "general feeling" Tony talks about. Excellent analysis by Felix and one of the great articles on Business Spectator, Karen.

13 Feb 2012 1:12 PM

Tony Holland wrote:

It's late here and Im jet lagged watching the Australian market and reading the good ole Business Spectator (which is about the best reading currently available to me). But, I can only say the guys I had dinner with, including my son and his team look at more money daily than Felix can throw a stick at. Indeed some of these guys are the guns of major banks here, so I repeat, I'd back that general feeling anytime....cos, not only do I love my son, but, I know he runs with a top pack of guys and chics....not from one bank, but I think all (Felix Zulauf's market prognosis, February 13).

13 Feb 2012 2:30 PM

Gilson Bick wrote:

Thanks for such a well put together overview (Felix Zulauf's market prognosis, February 13). Without the broadest gist of the real time overall picture, then any component understanding thereof is no better than a glib guess.

Truth in things political, financial, and commercial, have been disguised and euphamised for far too long. Wherever this game has been allowed to flourish there is now, or soon will be in the immediate future, a full value and unforgiven price extracted to obtain a balancing of the books.

In Australia may it not be, yet again, the honest and toiling Aussie battler who pays this price.

13 Feb 2012 2:45 PM

Wayne Cant wrote:

Lovely analysis (Felix Zulauf's market prognosis, February 13). The system's on the verge of collapse, its just a matter of how and when. "The transmission mechanism is broken" translated means the banks are just keeping the liquidity (money) that's being injected into the system and that game has now arrived in Australia. How long does anyone think it's going to last before the lid gets blown off the whole shooting match? The Germans pushing the austerity barrow is a clear indication of how short Europe's political and economic memory really is.

13 Feb 2012 11:14 PM

Geoff Croker wrote:

The US Federal Reserve is and will continue to purchase government bonds (Felix Zulauf's market prognosis, February 13). This is QE3 on a $1T/year scale. So no official QE3 just a constant hum from the printer.

BoE is and will continue to purchase government bonds. BoJ is and will continue to purchase government bonds. ECB is and will continue to swap printed euros for inflated bank assets. BoC is and will continue to print yuan to keep parity with the US dollar. A new printer, Canada, has entered the market in an effort to keep parity with the US dollar. The Swiss continue to print to keep parity with the euro. Greece will default, then Portugal, then Spain, then Italy.

A war may interrupt the death spiral of fiat money. It always has before. This time we have nuclear weapons.

14 Feb 2012 10:02 AM

M K wrote:

The comments have been very instructive. I think we have been lulled by the relative calm in the last few decades into thinking everything will always be OK. History actually shows otherwise (Felix Zulauf's market prognosis, February 14).

Countries like Australia still have the luxury to be able to cut government waste which in countries like UK, US and Europe is difficult as they are already deleveraging. These countries can cut the government waste but use these funds for useful national infrastructure projects.

What waste? Please compare government spending in Australia or another developed country with a developing or semi-developing country – or ourselves 50 years ago.

The baby boomers are going to absorb large amounts of money in medical and pension costs – not largely provided for. Many other government programmes are probably unsustainable. Private household debt is huge in Australia compared with 120 years of data. Prepare.

Lastly we need national and international leaders of great stature, who look to their reelection second, and look to the longer term with their decisions. This will bring benefits later. Otherwise, there is lots of pain in store for most of us, without much gain down the track.

The political effects of the economic crises in Greece, Spain, Portugal, Ireland actually haven't been seen yet.

14 Feb 2012 2:12 PM

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Don Gilbert wrote:

Good article Karen. This is well thought out and runs logically (Felix Zulauf's market prognosis, February 13).

13 Feb 2012 7:31 AM

Michael Linnett wrote:

13 Feb 2012 7:54 AM

Tony Holland wrote:

He's not at the top of his game, right now here in Switzerland he would know from figures just published that tourism in Greece is almost non-existent (Felix Zulauf's market prognosis, February 13).

Greeks aren't making money from tourism because folks are scared of violence and cost pressures on holiday packages.

The general feeling here is Greece has been contained either way and and markets will lift in the second half.

13 Feb 2012 11:20 AM

John Whelan wrote:

13 Feb 2012 12:40 PM

Brian Hill wrote:

Thanks Karen! (Felix Zulauf's market prognosis, February 13). Mr Zulauf is a new name to me but he seems to see the big picture clearly.

I have received other warnings which gives September 2012 as a critical time economically for Australia and I should get ready to sell my "risk assets".

13 Feb 2012 12:57 PM

JJ Brits wrote:

13 Feb 2012 1:12 PM

Tony Holland wrote:

13 Feb 2012 2:30 PM

Gilson Bick wrote:

In Australia may it not be, yet again, the honest and toiling Aussie battler who pays this price.

13 Feb 2012 2:45 PM

Wayne Cant wrote:

13 Feb 2012 11:14 PM

Geoff Croker wrote:

A war may interrupt the death spiral of fiat money. It always has before. This time we have nuclear weapons.

14 Feb 2012 10:02 AM

M K wrote:

What waste? Please compare government spending in Australia or another developed country with a developing or semi-developing country – or ourselves 50 years ago.

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Felix Zulauf's Market Prognosis

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