So what will happen next?
The euro is not the real problem but a trigger and compounder of the structural problems. It could only work if the euro zone entered a fiscal and political union, which won't happen, as Europeans aren't prepared to give up national sovereignty. Politicians therefore will go from one compromise and quick fix to the next, with the crisis deepening until some nations at the periphery won't be able to stand the economic pain anymore. They will want their old national currency back, and devalue to adjust the external accounts.
China won't be able to save us, as it did in 2009. The Chinese will lower interest rates but their actions will be reactive and lag. If my thesis is right, we must assume things will go awfully wrong in the next 12 months and the system will be at risk of collapsing. Most U.S.-focused investors might not understand it as they see corporations doing well.
How bad will things get?
The potential exists for a broad-based nationalization of the credit system, capital controls and dramatic restrictions on financial markets. Some might even be closed for some time.
We are witnessing the biggest financial-market manipulation of all time. The authorities have intervened more and more, and thereby created this monster. They might change the rules when the game goes against their own interests.
We are in a severe credit crunch. It starts when the weakest links in the system can't finance their activities. Then you have a flight to safety into Treasuries and German bunds, compounded by a quasi-shortage of good collateral. That's why bond yields have fallen so low. This isn't an inflationary environment but a deflationary one.
Thank you, Meryl. Felix, you're next.
Zulauf: I assume the world economy is decelerating. China's economy will slow more than expected, but the Chinese government won't do anything dramatic to stimulate it. China will ease somewhat, but in piecemeal fashion. That is why those looking for China to get us out of the doldrums are wrong.
Cohen: What growth rate do you assume for China's economy?
Zulauf: Last year China's GDP grew by 9.1%. This year they will publish something like 7.2%, but the slowdown in reality will be more pronounced, and it will affect those who depend on China. The U.S. economy could grow by 1% or 1.5%. In Europe, I expect the next stage of the crisis -- the ratification of a fiscal agreement -- to be critical. I can't believe all the countries in the euro will ratify it, because it would lock them into a depression for five years. There will be exceptions, and that will trigger the next crisis.
We remain in a deleveraging world, and the deflationary process is intensifying. In the stock market, valuation compression has been at work since 2000. Occasionally we have had bull-market rallies when stimulus has been applied in major quantities. The last fiscal stimulus was in 2009, because all governments have realized they have too much debt. Fiscal stimulus is the only thing that works in this economy, and that will come later. We have to fall into a crisis that triggers a policy response. Equity markets around the world will top out during this quarter and then enter the next down leg in the cyclical bear market that started last spring.
And when will that end?
Zulauf: It could end in the second half of 2012 or in early 2013. The market could drop 20% from the first quarter's high. Therefore we will need ammunition later this year or early next year to buy. My first recommendation is capital preservation, or cash. It doesn't return anything but you'll need it to buy when asset prices become cheap.
Schafer: What's the symbol? [Laughter around the room.]
Zulauf: You figure it out. The U.S. dollar will strengthen against other currencies temporarily, until the policy response comes. We are at the very end of the secular decline in bond yields. Yields on less-safe bonds, such as those issued by Greece and Italy, have already bottomed. Bonds perceived as top-quality will see a low in yields later this year. Ten-year U.S. Treasury yields will hit 1% to 1.20% before ticking up to 2.10% or 2.20%. There will be a horrendous move down triggered by intensifying deflationary pressures as money looks for so-called safe havens. I recommend 10-year Treasuries as a trade. When the yield reaches 1.20%, sell.
Investors should own some gold. But gold also will be subject to deflationary pressure and have a cyclical correction. The first part of the correction was the $400 drop to $1,520 an ounce from $1,920. Gold is now bottoming and could retrace half its losses. Then it could decline again in the second quarter, and you could buy it again in the summer. The low will be lower than $1,520. Then gold will rally in the next two years to a new high.
In what form would you buy gold?
Zulauf: I own physical gold, although you can buy the GLD [SPDR Gold Trust] exchange-traded fund. I hedge my position by selling futures contracts against it, but I closed my hedges recently because a temporary retracement is coming.
Gross: You have more of an emphasis on deflation and I have more of an emphasis on inflation two or three years out. If the 10-year bond yield fell to 1.25% and headline inflation was 2% to 3%, wouldn't that be bullish for gold?
Zulauf: Yes, but some aggressive players are overinvested in gold. If some other assets go wrong for them, they will be forced to create liquidity and sell their gold positions.
Hickey: That's what happened in 2008.
Zulauf: My next idea is how to play the slowdown in China. It will dampen prices for commodities, natural resources and Australian exports. China's boom was the main driver for the Australian economy in the past 10 years. Australia's last recession was in 1991. Despite rising exports to China, Australia runs a current-account deficit of more than 2% of GDP. GDP was up almost 2% last year. There is a budget deficit of around 3%. The current-account deficit was easy to balance because there was tremendous investment in the Aussie dollar. It was the so-called high yielder among currencies. Carry traders [who borrow in cheap currencies to buy higher-yielding ones] have bought it, along with individuals and even central banks. Holdings of Australian dollars are widespread, but now the Aussie dollar will suffer.
Why is that?
Zulauf: The strong investment inflow led to credit growth when interest rates already were too low. That led to a tremendous real-estate boom, with prices tripling. If China slows as dramatically, Australia will be hurt. The Australian central bank started raising interest rates in the fall of 2009. They went from 3% to 4.75% in November 2010. Last November they cut them to 4.5%. Now Australia is tightening fiscal policy because it has a growing deficit. The government cut spending, and as we have discussed, fiscal policy works much better in this environment than monetary policy. Short-term interest rates have declined to 3.2% and could fall another percentage point.
There are Australian government-bond futures with a three-year maturity. The yield is the difference between 100 Australian dollars and the futures price, which is currently A$96.84. That means the yield in the futures market is 3.16%, and it could rise by another percentage point in the next 12 months. This is a conservative play and you can lever it. It is a liquid market. The Reserve Bank of Australia will have to cut rates a lot more. Therefore, I would short the Aussie dollar against the U.S. dollar. The Aussie dollar has nearly doubled in the past three years against the U.S. dollar, from 60 cents to $1.02. It could correct by 20%.
Hickey: Do you have a view on the New Zealand dollar?
Zulauf: No, but I have one on Turkey. The global economic slowdown and the shrinking of bank balance sheets, particularly in Europe, will affect economies that depend on foreign capital flows. Turkey has huge external deficits. There will be a balance-of-payments crisis in Turkey, and one can profit by shorting the Turkish lira against the U.S. dollar. Turkey has been a booming economy for many years. Its leader, Recep Tayyip Erdogan, wanted to bring it into the European Union. The French didn't like that, and the Germans probably were happy the French blocked it. When Turkey's bid failed, Erdogan sought to boost its appeal as the leader of the Middle East.
To do that Turkey needed high economic growth, which required an aggressive and loose monetary policy. That created a credit boom, strong domestic demand and way too low interest rates for way too long. Economic growth was approximately 8% last year. Consumer price inflation is about 9.5%. The current account deficit is 10% of GDP. The budget deficit, despite the boom, is 2% of GDP. Ten-year government bonds yield 9.7%, around the inflation rate. Short-term rates were hiked to 11% from 8%. The 10% current account deficit won't be easy to finance.
So, what will happen?
Zulauf: Turkey is trying to cool its economy by hiking interest rates. They are trying to support the currency because they believe it is essential to have a strong currency to get continued capital flows to finance the current-account deficit. That is a dangerous strategy and will push the economy into a severe slump. At some point this year the government will have to change its focus from supporting the currency to supporting the economy. When that happens, the lira will go down. The dollar ranged from 1.80 Turkish lira to TRL1.15 for 10 years, and only recently broke out of that range. The dollar is trading at TRL1.88. Short term, it might rise, but long term it will drop.
Schafer: Don't high interest rates attract capital to Turkey?
Zulauf: Some investors are attracted, but when the currency falls there will be a new dynamic.
Finally, I am bearish on equities this year. It is best to short the EEM [iShares MSCI Emerging Markets Index exchange-traded fund] rather than individual stocks because it is dollar-denominated. Emerging-market currencies will decline against the U.S. dollar, and emerging-market equities will decline as much as developed markets, if not more. The EEM peaked at $55 in the fall of 2007. It is currently at $38.23 and could fall at least 20% later this year. Next January I hope to arrive with a more bullish message.
Faber: I don't disagree with you, but when would you reverse your position if you are wrong?
Zulauf: A 20% decline is my minimum expectation. If the Standard & Poor's 500 managed to rise above 1370, that would be a sign I am wrong.
Faber: Then you would buy?
Zulauf: Then I would close my short positions. On that note, thanks.
Felix Zulauf was born 1950, and is the owner and president of Zulauf Asset Management, a Zug, Switzerland-based hedge fund. Felix has worked in the financial markets and asset management for almost 40 years. Mr. Zulauf has been a regular member of the Barron's Roundtable for more than 20 years.