By Felix Zulauf (via Itau Global Connections).
The consensus is expecting a better world economy later in the year in all regions. That is nothing new. The consensus started the year expecting “normalization” of the world economy during the course of this year. Normalization in the consensus sense meant improving economies, rising inflation and interest rates but also rising corporate profits.
However, so far the incoming data and the corporate sector reports are mostly falling short of expectations. And I seriously doubt we will see conventional developments into next year. In contrast, I worry much more what could go wrong, particularly after four years into a cyclical bull market in equities where aggregate corporate earnings are stagnating or even shrinking instead of expanding and there is widespread optimism in financial markets. While I have expressed some of my concerns here from a structural viewpoint before, my biggest worry over the next two years is the combination of an ever increasing credit bubble in China despite the end of the investment boom and a slower economy combined with the continued targeted yen devaluation and what it could mean for the world. To achieve 2% inflation, Japan will in my view have to devalue its currency 20% each year versus its major trading partners. Japan forcing her currency down will reduce other countries’ competitiveness. It would decrease returns on many investments of recent years in those countries to very low levels, making some even obsolete. Such a development would eventually spread worldwide and have quite deflationary consequences, resulting in recession and declining profit margins despite all the money printing going on.
What could happen if the real global economy does not react to the monetary stimulus and what could happen to equity markets when investors wake up one morning realizing that money printing does not work in the real economy? And how would central banks react in a scenario where markets lose confidence in our central banks’ ability to “create growth”? Will more central banks then buy equities “wholesale style” to “create confidence” by supporting investors’ balance sheets? While we are not there, yet, those will be the questions asked during the next downturn.
As long as structural debt and demographic problems remain untackled, I doubt the industrialized world will get back on the growth track of previous decades. Regarding our debt problem, every borrower has a limited capacity to borrow, even governments. When the borrowing begins, it means the borrower can spend (invest or consume) more than his income. In an aggregate sense, economic growth at that time accelerates. Once the borrower reaches his borrowing capacity, he can spend only what he earns or live off his savings (if he has any). At that time, economic growth in an aggregate sense slows down. If his income decelerates at the same time, the spending or the economy slows even more, bringing to the surface all the structural problems of our Ponzi schemes, from our state health systems to our state pension systems and so forth.
Many Western economies have reached the point of borrowing capacity in an aggregate sense, and that’s why economic growth is slower, although low interest rates and central bank manipulation may extend the point of reckoning somewhat further into the future. In combination with the demographic problem I wrote about a few months ago, the growth capacity of our economies are today most likely far below what policymakers think possible. Hence, stimulating an engine that cannot run faster is worthless, if not even counterproductive. My hunch is that the industrialized world is trapped in such a situation where our economies simply cannot grow more. We could, however, increase our growth capacity by a major supply-side reform, meaning tax and spending cuts and particularly reducing the red tape (bureaucracy and regulation) to free more capacity, but I don’t see anybody among today’s policymakers thinking or moving that way (actually, only China is making some steps in that direction). In fact, the world continues to move in the wrong direction in all these policy aspects.
No Free Lunch
The big debate among economists and policymakers as to whether austerity can be successful or not in reducing public sector debt has started not due to the minor data error in Reinhart & Rogoff’s book, but because policymakers and their constituencies are growing tired of austerity. I don’t want to enter a big debate here, but austerity was never meant to be free of pain. Of course, government debt levels could be reduced if government expenditures are reduced. Some countries in Eastern Europe, the Baltic States in particular, have even demonstrated it in recent years. However, the higher the governments’ share of GDP and the higher the debt burden already is, the more problematic and painful the process. Unfortunately, Western Europe’s government share is relatively high, and the debt burden outstanding is high in most industrialized economies. Continued public sector deficits in a low or no-growth environment lead to higher debt levels. Hence, if we don’t do it now, next time will be even more painful. There simply is no free lunch, even though our alchemists at central banks may make some believe it. In some cases, debt restructuring will be inevitable.
Governments have most of the time worked on the demand-stimulation side for the last few decades, and the result we are faced with today is hardly encouraging. Nobody wants to talk about the supply-side stimulation that is so much needed today, as it is much more difficult to sell painful expenditure cuts. It is politically easier to “tax the rich” more – populism everywhere. Unfortunately, the result of increasing taxes is even lower, not higher, growth.
The authorities’ operating strategy is trying to reduce debt/GDP ratios by creating higher inflation, which they think could grow us out of the debt problem in a painless way. It worked after World War II due to the reconstruction and the high pent-up demand in the system – and after currency reforms (debt restructuring) in many countries. But the framework this time is completely different, and I have serious reservations about this strategy, as it does more harm than good. As an example, it is dismantling retirees’ income from savings and forcing them into risky assets at the wrong time of their life cycle. It also divides our societies in an extreme way into “haves” and “have-nots,” with all its resulting consequences for policy-making. It leads to growing populism and short-sighted, bad decisions threatening the functioning of our system. Most importantly, it removes the pressure on politicians to make the painful necessary adjustments that are only possible in a state of crisis. I seriously doubt our central bankers have thought this through thoroughly. Unfortunately, this ill-guided negative real interest rate policy will stay with us for a long time, whether we like it or not.
Less Austerity in Europe?
The new Italian government is spreading hopes in Europe that the future will get better. The new prime minister wants to stop “austerity”, pay back some of the new taxes collected and has already made an attempt in a recent visit to convince Germany’s Angela Merkel for less austerity and more growth. It is the same song we have heard when Monti became prime minister. Like then, the new prime minister is establishing an axis with France to increase pressure on Germany to buckle. Merkel won’t – at least not before the German elections of late September – and if Germany eventually does, it will be piecemeal and in lagging fashion and won’t likely solve anything. All we will read and hear will be nice words, but we’ll see no decisive action. The current plans we have seen will not lead to an economic improvement. Nevertheless, markets will like this new melody again, and intermediate-term oversold cyclical segments in global financial markets, from commodities to emerging markets and to European peripheral equities, may rally into summer.
Reform à la Française
The French economic numbers are going from bad to worse, and only Monsieur Hollande and his friends wonder why his highly socialist policy cocktail is not producing the desired results. In fact, they are already backfiring. Hollande was Mitterrand’s economic advisor in the early 1980s when Mitterrand nationalized the banks and was forced a while later to reverse it because the economy was going down the drain. Hollande has learnt nothing since, and I always wonder how such people can get elected to run a large nation. France has missed the opportunity in recent years to reform its labor laws and introduced silly rules such that no entrepreneur is willing to invest again in France. Competitiveness therefore keeps declining, external accounts are slipping further into the red and production and GDP numbers keep weakening. They won’t get any better, and the positive forecast of Hollande and his economic minister is nothing more than empty words. The recently announced “change” is simply a plan to reduce some of the government’s holdings in public companies and use the proceeds for new government controlled investments in infrastructure, health care and the environment. It may sound good to some ears, but in reality there will be a bunch of overpaid bureaucrats sitting around a table in Paris deciding how to spend the money. The outcome is clear: it won’t work and will be a waste of money.
No Bonds to Invest in Anymore
What is the biggest problem for investors today? The fixed-income markets are closed for conservative investors due to the excessively low yield levels thanks to our authorities’ rate manipulation. After 30 years of declining interest rates and central banks buying virtually the counter value of $10 trillions of government paper in a relatively short period of time, bond yields are trading below CPI inflation rates in many countries and are simply the worst value in 60 years. The P/E ratio of the bond markets even beats the excessive valuation of the technology stock bubble in the late 1990s. While central banks remain big buyers – the U.S. Fed, as an example, is buying virtually 75% of the entire Treasury paper issued – and may keep the yields down for longer than most believe possible, buying bonds at these yield levels for the next few years by taxed investors is a sure bet to lose money in real terms and after taxes and therefore hardly an attractive investment idea.
As fixed-income markets simply do not offer any decent yields or risk/reward ratios, investors are forced to buy alternatives, which at this time are equities with decent yields. I hear all strategists singing the same song and also many investors: “We buy equities with decent dividends and solid business models because it is better than bonds or cash.” It is not untrue and does make sense – until it doesn’t anymore. The legendary market strategist Bob Farrell once said “when all the experts agree, something else is going to happen.” The question here is WHEN?
Entering Euphoria in Equity Markets
The problem with currently rising equity markets is not rising prices but the lack of fundamental improvement. Stock prices are driven primarily by this lack of alternative investment opportunities and the growing belief that central banks’ money printing can and will generate attractive investment returns for equity investors for a long time despite the lack of supporting fundamentals in the real economy. That is a risky assumption, but as long as rising trends remain intact, nobody worries. In fact, the momentum of the leading equity market indices (Japan, the U.S., Germany and Switzerland to name some) is very powerful and has the potential to carry further, potentially even into a buying climax. Similarities to the gold price in spring 2011 come to mind. At that time, the conviction that gold could only go one way because inflation will eventually rise was as extreme as is now the case for equities.
Once equity markets discover the emperor has no clothes, they could face a quick and painful adjustment to bring markets in line again with fundamentals. For the gold market it was when investors realized there was no rise in CPI inflation or the assumption that systemic risks are declining. It is true that equities look attractive relative to fixed-income alternatives from a valuation point of view, when depressed fixed-income yields are compared to dividend yields or earnings yields (reciprocal of P/E ratios). Those comparisons are all fine as long as economies do not fall back into a recession and earnings stay at least stable. As investors are not expecting a recession, they still believe equities are by far the best place to be, and they act accordingly. That’s why we might see an end to this cycle with a bang (buying climax) and not a whimper (conventional broadening cycle top).
Currency manipulation is the game of the day for central banks, although they deny it. Several central banks have cut their rate recently, with Korea being the latest. Sweden will most likely be next. With central banks in the U.S. and Japan extremely expansive and the ECB most likely joining soon to “help the economy,” there is plenty of liquidity in the system to nourish a continuation of the stock market rally. Moreover, with the world economy sloppy and CPI-inflation rather soft, there is still more room for central banks around the world to further loosen monetary policy.
While global equity markets show some minor divergences here, they are not serious yet and are counterbalanced by important positive confirmations in the technical picture of the market. Usually we see the deterioration and non-confirmations with a lead of a few months before markets begin a bear cycle in earnest. Those signs are not yet present, today. But this is not a cycle that can be compared with previous ones, and therefore we have to monitor the health of the market very closely for any sign of trend deterioration to avoid a more serious and painful downside adjustment.
Global equity markets have bifurcated, with multinational growth stocks performing strongly this year and cyclical stocks performing less well until about two weeks ago. Commodities and emerging equity markets performed more in line with the latter category. Recently, however, this latter segment became quite oversold on a medium-term basis and is beginning to show life, while the former category is overbought and beginning to slip in relative performance. A certain change of leadership is obvious, but we do not know how sustainable it will be. In the next short-term correction, which could be close, we would like to see the cyclical segment holding up better in relative terms for a sustainable change of leadership. Such a development would be encouraging for a further rally by that segment into a summer high. The caveat is that buying laggards is usually a losing portfolio strategy, while staying with leaders is more successful.
After Draghi recently announced the ECB’s intention to buy asset-backed securities, the ECB will most likely soon join the Fed in the quantitative easing strategy. The ECB’s goal obviously is to help clean up bank balance sheets by buying bad assets to make room for loans to the private sector. However, even lower interest rates have not attracted new borrowers due to severe structural constraints. Hence, I doubt those expectations will be fulfilled, but markets can look forward to more liquidity added to the system, which may be used by professional operators to play the risk assets on the long side. And investors who are not fully invested will read it as an incentive to also buy more stocks. Hence, all these cyclical segments could firm up well into summer despite possible short-term setbacks.
The strong rally in the Japanese Nikkei Index has broken the downtrend line from 1990 and 2007 highs and is approaching major trend resistance between 15,000 and 16,000. While it is conceivable for the Japanese stock market to stall and congest for a while, the cyclical trend is bullish and remains so, and the downside risk of a correction is relatively limited in magnitude.
Don’t Underestimate the U.S. Dollar
I don’t see much change in the major currencies and expect them to remain within relatively small ranges. However, I repeat again that the world’s view of a continued weak U.S. dollar is most likely wrong. Today, the U.S. is not alone in aggressive money printing. All major central banks are doing it. And although the U.S. has a debt problem similar to Europe’s if not even worse, the protection of individual property is less under attack than in Europe, where socialist trends to make everybody equal by taxing the rich excessively is much more pronounced. My hunch is that serious big money in Europe is rather willing to move to the U.S. for these reasons than the other way around.
USD/JPY had a great run in recent months and now even broke above 100. It may now need a rest for a while and congest around this level. But the fundamental forces continue to weaken the yen, and the cyclical and structural decline of the yen is only in its early stage and will continue on a major trend basis, most likely for several more years.
The Norwegian krone has been a favorite currency during the euro crisis due to Norway’s strong external accounts and its wealth of natural resources. Moreover, Norway runs a budget surplus of 10% of GDP and the economy is expected to grow 2.6% this year with a 3% unemployment rate. There are upcoming elections in September, and the party in power fears losing them and has therefore decided to take over 3% from the oil fund and invest it in the economy to prop it up for the elections. This will certainly lead to a firmer krone over the next few months, which has corrected over the last 12 months versus other European currencies.
On the other hand, the Swiss franc is weakening in the crosses and has a bit more to go. I would rather favor the U.S. dollar versus the Swiss franc than any other currency.
Several of the Asian currencies favored by investors are bouncing back against the U.S. unit after the weakness of previous months. I don’t see this as the beginning of a major new rise but rather as a medium-term improvement within a long-term top against the U.S. dollar. Moreover, the same goes for natural resource currencies, where the Australian dollar in particular is vulnerable to more weakness over the next few quarters.
Medium-Term Low in the Works for Gold
Physical demand is increasing again for gold as rising imports by China and anecdotal evidence from coin and bullion dealers indicate. After the selling climax in mid-April, gold bounced back slightly to below the breakdown point and has now rolled over again. So far, the decline is on low volume and promises to become a successful test. The medium-term trend, momentum and sentiment indicators are all lined up for a good medium-term bottom from where a more sustainable rally should follow. However, in the context of my biggest worry (mentioned in the first few lines of this report), the resumption of the secular bull market will only start once the world economy enters its next crisis, sometime within the next two years. We therefore have to expect a lot of trading within the range of the highs and lows of the last two years for a while longer.
Felix W. Zulauf is president and founder of Zulauf Asset Management AG. He has worked in the financial markets and asset management for almost 40 years, working with leading investment banks in New York, Zurich and Paris. He joined Union Bank of Switzerland (UBS) in 1977 and held several positions there over the years, including managing global mutual funds, heading the institutional portfolio management unit and acting as global strategist for the UBS Group. In 1990 he founded Zulauf Asset Management AG to pursue his own individual investment philosophy. He focuses on managing a conservative global macro fund and provides advisory services to selected individuals and institutions. He has been a member of Barron’s Roundtable for over 20 years.