January 11, 2013
Zulauf: The new government in China wants to maintain 7-8% growth, and wants to take steps to ensure this. They may increase public spending and relax monetary policy. This won’t come anywhere close to the stimulus of 2008, as China is still suffering the negative side effects. You might see a temporary improvement in economic indicators, but that’s it. The real level of growth in China is probably only 3-4%. That said, there is still perhaps 20-30% upside in Chinese equities, particularly in the first half, although you won’t see the sort of sustained move we saw off the 2008 low there.
Fusion: How does Japan look right now? We note you called for shorting the Yen at a Barron’s conference in October – again, a very prescient call.
Zulauf: Japan’s economy is not doing well and still suffers from deflation. The pronounced deterioration of Japan’s current account and the disappearing ability to finance her own large budget deficits are forcing some important changes. The new government in Japan, led by the LDP and Prime Minister Abe, has a 2/3 majority in parliament and can push through their own will without any problem. Abe wants some increased deficit spending, on top of a budget deficit that is already near 10% of GDP. He wants the Bank of Japan to finance a big part of it by printing new money and thereby weakening the Yen and targeting 2% inflation. If the BOJ doesn’t comply, they have basically been told they will lose their independence as a central bank. The spending will increase deficits further and weaken the currency, which should improve exports. I see Dollar/Yen going to 120 within the next 2 years, and the Yen weakening decidedly against all major currencies.
Fusion: So you’re clearly still constructive on China and Japan …
Zulauf: China’s market rebound should at least last during the first half of this year. There is still another 20% to go. After a consolidation and pullback, you can buy FXI here to play it. As for Japan, I am much more bullish as nobody owns Japanese stocks. The total market cap of the market there is one quarter of what is was 23 years ago. If the currency continues to decline against all the others, there will be a tremendous lift to Japanese equities. The Nikkei has at least another 20% upside in 2013 and could do more and last longer, all in local currency terms.
Fusion: What impact will this policy have on their trading partners? How will they respond?
Zulauf: This will put tremendous competitive pressure on emerging Asia and may weaken their exports. This should impact their balance of payment and if they try to stimulate domestic demand more by cutting rates, it may weaken their currencies versus the US-Dollar. As there is simply not enough global growth, competitive devaluations will become more common and could create political anger. The Fed started this. You then saw the Bank of England joining and last year the ECB under Mario Draghi when he said he would do “whatever it takes” to maintain the Eurozone. Now the BoJ, and soon emerging Asia. Everyone is trying to stimulate more on the monetary side, which should help propel world equity markets higher in the first half. It does nothing, however, to help global growth and markets will get disappointed in the second half.
Fusion: Does all this easing start to get reflected in commodity prices? And if so, doesn’t this lay the seeds for demand destruction and economic slowing?
Zulauf: Yes, you will see rising commodity prices. Oil and copper are two we would look at. They could also have a nice rally into mid-year, yet at some point, markets will start to realize the entire stimulus did nothing to help overall global growth, at which point markets will react quite negatively.
Fusion: How does Europe look now?
Zulauf: In Europe, the prevailing policy goal is to keep the Eurozone together. Draghi has told us as much. The austerity policies may not be sustainable in the peripheral countries as people begin to revolt due to the painful and long lasting recession. Mario Monti lost support because the highly fragmented Italian parliaments withdrew its support. Angela Merkel faces an election in September, and may agree on diluting austerity programs as she doesn’t want any trouble. I see no growth at all in the peripheral countries. Germany may be forced into some debt mutualization on a small scale. It will be the ECB that has to carry Europe through by financing rotten financial institutions and rotten governments. The euro could see 1.40 into the second quarter before going to 1.00 next year, when the markets see more trouble and yields rise again on the sovereign debt of the peripheral countries.
Fusion: How are the European banks doing?
Fusion: European banks are still in a terrible situation in terms of their balance-sheet. But Basle 3 is getting more and more diluted and the ECB is carrying all through. It is far from a solid situation but stocks are recovering still a bit further. In my view, this is not a place to invest.
Fusion: How does this play out?
Zulauf: As the market starts to understand there will be no meaningful recovery in the periphery and the fundamental problems remain and grow even bigger, the ECB will have to step in. That should in the second half lead to a resumption of the capital outflow from these countries. At that time, Germany may make more compromises, which will then mean capital doesn’t flow to Germany but out of the Eurozone, which will weaken the Euro. In essence, the ECB may create more liquidity, yet the liquidity will find its way out of Europe. Up until now, the liquidity created has stayed in the Eurozone. When this reverses, the Euro will have a big drop.
Fusion: What will be the signposts the markets understand the game is over? Simple signs of global growth faltering?
Zulauf: The first few months of 2013 will look like things are gradually getting better, or at least stabilizing. A Honeymoon, in short. Then markets will begin to realize that the improving fundamentals they have discounted will not be there and markets will react negatively. It’s hard to pinpoint exactly when this occurs. My best guess is sometime in mid-2013 or even 2014, as it will all depend on how market internals and indicators are behaving.
Fusion: Let’s move to the U.S. How do things look in the wake of this week’s legislative settlement averting the fiscal cliff ? You had said a few years back that the world needs new leaders that are willing to make the tough decisions. That doesn’t seem to be happening. Will they fumble the ball in March, too ?
Zulauf: There will most likely be another crisis as we approach the debt ceiling problem. So far, the fiscal compromise was all about revenues. This upcoming battle will be about spending cuts and the GOP will fight hard for entitlement cuts. Whatever policy measures coming out of this negotiation will ensure the U.S. economy won’t take off, which means 2013 earnings estimates are too optimistic. In fact, at the margin, the US will be joining Europe by adopting some austerity – but by far not enough to solve the problem.
Fusion: So Bernanke’s program will ultimately not be successful, in terms of ushering in a period of sustainable growth?
Zulauf: Sustainable growth requires several things: a good savings rate, strong level of investments, an educated workforce, and strong consumer balance sheets and rising real incomes. Greenspan started a process of inflating the balance sheet of consumers so they feel richer and spend more, which has weakened the whole system. Bernanke is following the same policies, and other central bankers are doing the same.
Fusion: Does the Fed have any bullets left ?
Zulauf: The Fed can buy stocks, or buy commodities … they can buy anything. Yet once you get to the point where central banks are financing 30-40% of government expenditures and the interest carry on that government debt increases, then you have a huge crisis. At that time, we will be forced to either clean out the debt, restructure or we end up like the Weimar Republic. But we are not there yet and it may take many more years until that point is hit.
Fusion: Which brings up rates and the fixed income market. How does this look right now ?
Zulauf: Bond yields have more or less hit bottom on a secular and cyclical basis. The 10-year US Treasury will be range bound, between 1.5 and 2.5%, probably for longer than most can imagine – I mean a few years. Central banks want to prevent a breakout above 2.5%, to keep carrying costs on all the debt as low as possible. Eventually rates will rise much more aggressively.
Fusion: So in the short term, rising commodity prices and yields. Does that in itself stunt the recovery ?
Zulauf: Interest rates will not rise enough to break the economy but rising commodities, energy in particular, and a lack of rising real income would do.
Fusion: Let’s turn to strategy going forward. Let’s start with gold.
Zulauf: The de-basing of currencies is fundamentally bullish for gold, long term. As long as real interest rates remain negative, the fundamentals for gold remain supportive. Right now, gold isn’t trading well, as it’s consolidating. Iran is selling oil for gold, which in turn is dumped on the market. It should be range-bound, $1,500-1800. It needs to break $1,800, and then it will run to $2,200, and new highs. The first positive sign will come once we break above $ 1750.
Fusion: How about commodities ?
Zulauf: Oil and copper will move together and rise in the first half but the big commodity boom that really topped in 2008 is over. The current move is temporary and more for traders, not investors, responding to government and central bank actions and is not sustainable global growth.
Fusion: Thus we still have the China and Japan trade going, and the currency bet we just talked about.
Fusion: As they say the apple doesn’t fall too far from the tree. That said, we hear another Zulauf will so be carrying on the family Global Macro legacy. Can you give us some details about your son Roman and his new fund? Will it be available to US investors and will you be involved in the fund ?
Felix Zulauf: My son will start his own company together with some colleagues this spring and will offer a fund as well as managed accounts to investors from around the world, including American. His style is similar to mine, as we have been exchanging views about markets on a daily basis for over 10 years. But I never wanted him to work for me but do his own thing. And after his studies in banking and finance, he has seen research, prop trading, commodity trading and in recent years was part of a global macro team with another hedge fund group. Now, he will start in my offices and I will certainly help him and his colleagues, who bring a good expertise and understanding of markets, and look over his shoulders.
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.