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.