January 20, 2013


Felix Zulauf participated in Barron's Roundtable 2013, and he came with a couple of trades. Three of those trades involved Japan. "The moment has arrived where the Bank of Japan needs to bridge the gap and buy more JGBs with newly printed yen," he said. "In other words, the supply of yen will increase dramatically. Japanese inflation will be pushed from slightly below zero to 2%, and the yen will be weakened. This is a major change for Japan, because the yen has been one of the world's strongest currencies for a long time, right behind the Swiss franc." Here are his trades:

• U.S. dollar vs. Japanese yen

• USD/JPY Call Option Strike 95 Exp. 12/31/2014

• WisdomTree Japan Hedged Equity Fund (DXJ)

• iSharesMSCIBrazil Index Fund (EWZ)

• iShares FTSE China 25 Index Fund (FXI)

• iShares MSCI Emerg Mkts Index Fund (EEM)

• Gold

Here are his comments about most of the trades:

Zulauf: This year could turn out to be the opposite of 2012. Last year, we had a potential calamity in Europe that could have led to the breakup of the euro zone, but the European Central Bank stepped in with money to buy up massive amounts of government bonds and prevented a crisis. Many cyclical markets, including emerging markets and commodities, fell in 2011 and the first half of 2012, until the ECB came to the rescue.

Now those markets are rallying, as are the U.S. and Germany, which didn't correct. But the rally is mature. It is late in the cycle. The rally will end sometime between the second and third quarters, and the markets will go down. The problems we have discussed here in recent years are unresolved, and will be back on the table. Hickey: Spain has to fund a record amount of debt. Will problems doing that trigger the next crisis in Europe?

Zulauf: There are several issues in Europe. A monetary union of nations with different economic structures is a strange setup that leads to all sorts of stress. There are huge differences in competitiveness among euro-zone economies. Some observers say Europe's current-account balance is improving, and Europe could have a spectacular recovery, much as Asian countries did in the late 1990s. This is complete baloney.

Asia had a financial crisis in the 1990s, and countries let their currencies drop by 50%, which led to a boom in exports. That is not the case in Europe. Countries on the Continent's periphery don't have an export boom. They have an import contraction. You can't create growth under such circumstances. That is why any hope of Europe's periphery coming out of the doldrums is completely misplaced, and there is a good chance France will be the next problem. Why is that?

Zulauf: Unit labor costs have risen to such a degree that the French economy has become noncompetitive. It is beginning to unravel. The French can't sell their cars anymore. The government isn't reforming the country; it is marching in the wrong direction, toward more socialism. You will see big disappointments in France this year, including rising current-account and budget deficits. Europe's high priests of economic policy have put preservation of the euro above everything else. By doing that, they have destroyed millions of jobs and consigned millions of people to poverty. At some point this will backfire. You can't glue the European Union together forever with central-bank money. Financial markets can't force the issue because the ECB will go against them. It has immense ammunition; it can print money. Eventually, it will be the man in the street who revolts. You can send people into poverty for a while, but there is a limit. Gabelli: How can Europe solve its problems?

Zulauf: Countries could give up national sovereignty and create a federal organization of European states, but that is unlikely and unrealistic. Alternately, some countries could break out of the euro and devalue their currencies. That is the more likely option long-term. Throughout Europe, liabilities are moving from the private sector to the public sector. I don't see the European recovery others are talking about.

They aren't making it up out of thin air. Bond markets in Europe are doing better. Zulauf: Bond markets in Spain and Italy and Greece were priced for calamity. The ECB stepped in and removed that threat. That made bond markets rally and interest rates fall. The decline in interest rates is just about over. Yields in those countries will trade sideways for a few months and then start rising again. Hickey: Felix, is it possible Europe could suppress rates even further, just as the U.S. did, by printing a trillion dollars?

Zulauf: In theory that is possible. The European Central Bank could lower interest rates by a few more basis points before they hit zero. At the moment, the ECB isn't buying large quantities of debt. But if it starts buying in huge quantities, the German public wouldn't greet the move well, as it doesn't want to be on the hook for its less-disciplined neighbors. German Chancellor Angela Merkel is up for re-election in the fall. Debt mutualization [under which creditor countries take on financial responsibility for the debtor countries] ahead of the election is a no-go. It is difficult to time such things, but around the middle of the year, the markets will start to reverse. I don't know whether they will end the year slightly up or slightly down. I expect the first half of 2013 to be friendly to equity markets, and the second half to be unfriendly, with risk rising.

Zulauf: There is huge room for disappointment in the equity market. Zulauf: On top of that, the U.S. has more fiscal drag this year than other countries around the world. GDP could grow by 1.5% to 2%. With 70% of GDP dependent on the consumer, whose real disposal income is growing by 1% a year, and whose savings rate isn't going any lower, it is difficult to put together an outlook for 2.5% to 3% economic growth.

Zulauf: I don't deny it is a benefit, but becoming a net importer will account for only a $2 billion improvement in a monthly trade deficit of $40 billion. Zulauf: Because U.S. energy costs are half those in the rest of the industrialized world, the U.S. is the only country building new energy and chemicals plants. That is a positive.

Zulauf: At some point this year, I expect to see the consumer-price index rise by more than 3%. In the first half of the year, oil prices could have upside of $10 to $20 a barrel. Food prices could rise by 15% to 20%. That would hurt consumers.

Zulauf: The forecast for demand is stable to slightly down in the developed world. But demand is rising elsewhere. Even if China's economy grows only 3% or 4%, the country's energy bill is going up as more motor vehicles are added to the national fleet. That is going to make a difference in the price of oil.

Almost every country is trying to devalue its currency. The world economy isn't growing enough to keep structural problems under control, much less fix them. Therefore, nations are trying to grab more of the pie by devaluing their currencies. The U.S. started this nonsense, and the Fed's money-printing has made the dollar a weak currency.

Zulauf: This will end in national confrontations. It is a very dangerous game. The Japanese have entered the game, and the Europeans will be next. Just because earnings might be up by 5% or whatever doesn't mean the financial system isn't fragile. We could have a shock at any time, and possibly this year. If you want to fix the situation, you can't expect to have a high level of economic growth. The outlook for growth is less and less attractive. That is why a decline in the stock market's valuation would be justified.

Zulauf: Switzerland had a similar problem on a much smaller scale. About 10 years ago we introduced a debt-limit law that prevents the government from spending more in any given year than it spent in the previous year. It has worked, but it takes political will. We have had balanced budgets for the past 10 years. We have even run surpluses.

Zulauf: The Swiss National Bank is playing a dangerous game and knows it. When the next euro crisis hits and the market is flooded with euros, it won't be able to continue to protect the franc. The next step could be capital-control measures that prevent foreigners from buying unlimited quantities of Swiss francs.

Zulauf: Thirty-eight countries are pursuing a zero- or negative-real-interest-rate policy. I have never seen anything like it. Isn't that a comment on globalization?

Zulauf: No. It is a comment on irresponsible central bankers and irresponsible political leadership.

Zulauf: Actually, things get worse, spurring social debates about whether to tax people who made smart investment decisions and take away the benefits of their intelligence.

Zulauf: We have talked today about structural problems in the global economy and financial system. Policy makers dreamed a dream that they could take volatility out of the economy. They tried to fine-tune it, and instead have led us into a miserable situation. People believe the risk in the market is low, because volatility indexes are low. Perceived risk in March 2009 was very high, but market risk was low. Right now, it is just the opposite, and that mismatch could persist. But we should be aware that we are operating in a high-risk environment. We are well aware.

Zulauf: I made two recommendations atBarron's Art of Successful Investing conference in New York in October. One was to buy the U.S. dollar versus the Japanese yen. At that time, the exchange rate was 79 yen to the dollar. Now a dollar buys ¥89. Within two years, the exchange rate could go to ¥120. The Japanese government is in a difficult position, with the country's debt running at 230% of GDP. Japan is in a recession. The budget deficit exceeds 8% of GDP, and could top 10% this year and next. The deficit was easy to finance as long as Japan was running a structural current-account surplus and the domestic pool of savings was large enough to do so. In recent times the country's external accounts have deteriorated, and that could continue.

Japanese institutions have always been the largest and steadiest buyers of Japanese government bonds, or JGBs. They recently announced they lack the funding sources to keep buying on the same scale. Japan Post Bank is an example. It formerly was a government institution in which individuals held savings of more than $2 trillion. It was a big buyer of government debt, as were pension funds and life insurers. All said recently they can't keep buying. The moment has arrived where the Bank of Japan needs to bridge the gap and buy more JGBs with newly printed yen. In other words, the supply of yen will increase dramatically. Japanese inflation will be pushed from slightly below zero to 2%, and the yen will be weakened. This is a major change for Japan, because the yen has been one of the world's strongest currencies for a long time, right behind the Swiss franc.

There is definitely a trend here.

Zulauf: Japan's big life insurers are pension-fund-style entities for the Japanese public. They are big investors overseas, and because of the yen's strength, have hedged part of their exposure to the currency. What would happen if they unwound 10% of their hedges? The four largest life insurers would have to buy $25 billion worth of dollars and sell yen. Many pension funds and industrial companies are in a similar position. The potential purchase of dollars and sale of yen is gigantic. Of course, Japanese bond yields would rise under this scenario, which is another problem, as Japanese banks have 900% of their Tier 1 equity capital in JGBs. To prevent the bond yield from rising, the Bank of Japan will have to buy even more bonds, and print more yen. They will keep things under control for a while, but eventually this plan will fail.

The dollar/yen trade could have a mild correction, dropping back to the €86 area. I would buy on that correction. Professional investors could employ an options strategy, buying $1 million of yen futures with a strike price of ¥95 at the end of 2014, for $35,000. Break-even would be ¥98.30. At ¥120, you quintuple your money. Gross: The critical question for all central banks is, can they generate real economic growth and solve a debt crisis at the same time? Japan is attempting to devalue the most to get a head start on growing at the expense of other countries. Can they do it?

Zulauf: They will be partially successful for a few years. But can they push the dollar/yen to ¥160 to help things further? That is probably unrealistic. Does a lower yen benefit Japanese stocks?

Zulauf: If the yen weakens as I expect, I would feel sorry for German exporters of cars, machinery, and such, and South Korean car manufacturers. But this is bullish for Japanese stocks. I'm not saying the Japanese economy will heal, but reflation is bullish for equities. The last time I discussed Japanese stocks was at the 1990 Roundtable, when Paul Tudor Jones and I recommended selling the Nikkei at 40,000. We said it would be cut in half. The Nikkei hit a low of 7,000 in 2009 and since then has traded in a range of 7,000 to 11,000. Japan has one of the cheapest equity markets in the world, as it has disappointed for years. The market trades for 20 times earnings, but the price/earnings multiple isn't relevant because earnings are so depressed. Price-to-book is one. Seventy percent of all Japanese stocks trade below book. Price-to-sales is 0.5, compared to 1.5 times in the U.S. Fiscal and monetary stimulus are the keys to change.

Gross: Can the Japanese government generate nominal GDP? Can it produce inflation of a positive sort that will generate corporate profits?

Zulauf: GDP has been stagnant in nominal [noninflation-adjusted] terms for 20 years. The price for generating growth is higher indebtedness. In the past 22 years, the market capitalization of Japanese stocks has fallen by 75%. The capitalization of the bond market has risen by four times. A major reallocation from bonds to stocks is beginning. I would be surprised if the Japanese stock market didn't rally 50% in the next two years. The best instrument to play this trend is a currency-hedged exchange-traded fund listed in the U.S. It is the WisdomTree Japan Hedged Equity fund, or DXJ. It trades for $38.53.

Emerging-market equities will have the wind at their backs in the year's first half. The U.S. dollar is weakening because of the Fed's moves. But emerging markets don't want their currencies to rise because they need more trade and growth. They will try to lean against the Fed with some monetary stimulation of their own. Whether this will help their economies is a question, but it will help their stock markets, which will do well in the first half of the year. I would buy Brazil because it is a commodity producer, and commodities traded in dollars will benefit. I would buy the EWZ, or iShares MSCI Brazil Index ETF, which is trading at $56. I would also buy the iShares FTSE China 25 Index, or FXI, which I recommended at the October conference. China's market has been disappointing and could probably rally a little longer. The Chinese market is trading where it did in 2001. It is not a market for widows and orphans. The iShares MSCI Emerging MarketsIndex, or EEM, is another pick, as the whole emerging-markets complex will outperform the U.S. I reserve the right to take all these trading recommendations off the table at the midyear Roundtable in June. Black: Felix, the Brazilian government is pursuing a socialist path. This has stymied the economy's growth rate. What gives you confidence in Brazil?

Zulauf: That is why it is only a trade, and not an investment.

Oil prices could rise. What do you think about Russia?

Zulauf: Russia is part of the emerging-markets complex, and it is a beneficiary of higher oil prices. I expect oil prices to rise in dollar terms in the year's first half but retreat in the second half, because the world economy won't revive to the extent the optimists believe. They are using recently positive data out of China to justify a more optimistic view of the world. I don't see it. Nor do I trust Russia as a country. Putin [Russian President Vladimir Putin] blew it. He had the chance to democratize Russia and create free-market structures. Instead he went the other way and helped the oligarchs. This is bad for Russia, and the country's demographics are awful.

We are living in a world of money-printing. Almost 40 countries are pursuing a policy of zero or negative real interest rates to spur more economic growth. We have never seen anything like this in modern history. The people will try to protect themselves against this monetary baloney. It is accelerating the debasement of paper currencies around the world. That is why I have to recommend gold again. Gold's fundamentals are strong; although some technical indicators of sentiment and momentum turned down in the summer of 2011, gold is at the very end of a cyclical correction and the gold price will be up and running again soon. Once gold surpasses $1,800 an ounce, it will run to the low- to mid-$2,000s.


January 11, 2013

Felix Zulauf interview with Fusion IQ

Fusion: Looking at China, Felix, you were bearish at the start of 2012, and then very presciently called a bottom in September. Both the Shanghai Composite and Hang Sang have rallied very strongly since that call. What is your current outlook on China?

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.

Zulauf: Yes.

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.