By Felix Zulauf, via Itau Global Connections.
Since a member of the FOMC had suggested that quantitative easing of current proportions could be terminated sooner than planned, the investment community seems to feel supported in its belief of a normalizing world economy. Moreover, the German IFO index jumped more than expected, raising the hope in Europe that Germany could pull the rest out of recession. IFO is a sentiment and not a production index, however, and it is interesting to note that the IFO index has overestimated German economic performance since the spring of 2011, and it has in particular overstated the true economic picture in the first quarter of the last two years. Hence, I warn against taking that index as a base to project the future economic pace.
We have now gone through several years of monetary stimulation without much success in the industrialized world’s real economies. And while economic growth improved when fiscal stimulus was applied, the same cannot be said about monetary stimulation. Some even think it is counterproductive.
Why is the stimulus not leading to what the expert economists are expecting? It certainly has something to do with balance sheet problems of the average household in many countries and of weakish real household income. But it also has to do with the demographic structure, to which we may not pay enough attention.
Economists and investors assume growth rates of the past 30-40 years are the norm and therefore think once the current “deviation from that norm” terminates, we would return to the world as it was. However, 30-40 years ago the general level of debt in percentage of GDP was decidedly lower than it is today. More importantly, demographics differ very much from those over a generation ago.
We all know what the life cycle of a person looks like, more or less. During childhood and the educational years, the child is, purely economically speaking, primarily a cost factor for its parents. As a young professional, he or she earns little money and cannot save much. Thereafter, marriage and having children follow. At that time, the young family needs a bigger home, clothes and food for the children, but due to rising costs for the children, the family cannot save much or – even more likely – must assume debt to buy a house. Hand-in-hand goes a certain advance in the professional career and rising income, and from the mid-40s onwards, this couple can build more savings. And once their children’s education is concluded, costs go down and savings go up even more, until retirement. At that point, income declines and the retirees begin to draw from their previous savings. By looking at one person’s life cycle, there is a period of rising indebtedness followed by strong savings and thereafter a period of saving withdrawals. Moreover, there is also a period of strong growth in expenditures, which starts on average in the late 20s, levels off in the mid-50s and begins to decline in the mid-60s. Taking the aggregate population and its demography can therefore hint at higher or lower aggregate growth as well as to higher or lower aggregate saving periods ahead.
I recently checked some numbers and was shocked when I learned that the age group of 100 years and older will be the fastest growing group in the world over the next 20 years and is forecast to more than triple (graph 1), followed by the 85 year old plus and finally the 65 year old plus. The age group 0-65 years is only growing around 10% and that comes primarily from the emerging and developing countries, as population growth is stagnating to negative in Europe, almost stagnating in China and declining in Japan. The US has one of the better demographic outlooks and better than virtually all other industrialized countries, with a forecasted growth rate of 0.8%-0.9% p.a. for the total population.
A look at the working age group of a society can tell you a lot about the future, particularly when combined with higher debt levels for the economy as a whole. A rising percentage of the working age potentially leads to rising income and spending, and vice versa. Graph 2 shows how the percentage of the working age group in the industrialized countries has leveled off from 2006 onwards and will be declining quite sharply for the next few decades. At the same time, the percentage for emerging nations is approaching the peak and will begin to level off in about three years’ time for the next 20 years and decline thereafter.
The reason I am showing these charts is that demographics do not point to growth as we had it in the last 40 years. It points rather to stagnation or very low growth in the developed world. While central bankers are trying to force economic growth into higher gear, it won’t be very successful because demographics simply are not right for it to happen. Putting more gasoline in a tank where the gearing is blocked doesn’t get your car moving faster.
Of course, other factors like productivity, innovation or the cost of energy, just to name a few, are also very important, but the investment community usually does look at those factors closely while neglecting demographics.
Not all demographic factors look bad, however, as graph 3 shows on the next page. The net savings influence that has been a drag on Japanese stocks for example should have a positive impact on equities in the land of the rising sun, although only for a few years. And in the US, demographic factors should become a positive factor again from approximately the middle of this decade onwards. Moreover, the echo of the echo-baby boomers may have a temporary positive influence on our economies, but it will be much weaker than the echo-baby boom effect. Hence, while demographic trends may lead to mounting problems for the real economies – just think of healthcare costs and the state pension systems – the savings cycle may show up sometimes in coming years in a positive way in the markets for a limited period of time.
Bella Italia Opens the Next Euro Chapter
Italian elections have really not surprised me, as I expected at best a weak government that lacks the broad support of parliament. Monti’s weak performance was also no surprise, as the Italian people are simply fed up with fiscal austerity without seeing any benefits. Moreover, having a technocrat implanted as a leader by Brussels bureaucrats is beyond what a democracy can swallow. Prosperity in Italy has declined, jobs are either gone or less secure, unemployment is rising and GDP is 8% below the level of six years ago and still declining, with no improvement in sight. Moreover, personal freedom is declining, as for example, cash transactions are limited to €1000. It is simply ridiculous when a government doesn’t allow its own money to be accepted in free trade but only where it has control. It is the worst signal a government can send and a further step towards more totalitarian regimes, which never brought more but always less prosperity.
Comments about the Italian election outcome in leading German newspapers were simply shocking to me, as those journalists are generally in line with German politics and big business and very pro-euro. They cannot understand that this “great project” can be put at risk by other countries. Merkel’s contender for the upcoming election even remarked that he was shocked that not only one but two clowns won the election, and Italy’s President Napolitano immediately cancelled a planned meeting with him. The “Eurocrats” still don’t get it that what would be good for Germany, IF it really worked, is not acceptable to other nations at the costs imposed. And turning all nations into German clones is not what European history and culture are all about.
Many may think Italy has always been a badly functioning economy, but actually that is not true. We have had a competitive north and an uncompetitive south, with a social contract to transfer money from north to south. True, Italy has devalued its currency many times before entering the euro, which was okay, as the exporting industries received strong foreign currencies and sent the weaker domestic money south. Although I am not trying to portray Italy of the old days as an ideal situation, I simply want to stress that it was working much better for everybody until the bureaucrats decided they wanted a big European currency empire and everybody had to become the same to make it work and to give the bureaucrats the power they wanted. What may have excited the shortsighted was a dumb idea from the beginning. In a democracy, the people want to elect their own government even if it is a bad one, and they will change it when they think someone can do better. But no nation wants a government imposed by foreign bureaucrats, and Italians just got rid of one, which I applaud.
Italy is not Spain, as most of its debt is held domestically and it can finance it from domestic savings. Moreover, Italy is running a primary surplus, while Spain, as an example, is far from it. Italy did not have a real estate boom like Spain, which built more houses every year from the mid-1990s to the great financial crisis than Germany, France and the UK together. And while the economy is weak, it is definitely not as bad as Spain, where nominal retail volume is off by over 10% over the last 12 months.
While I doubt the Italian election will trigger another crisis in the short term, I do believe it is a game-changer in the medium term, as this message from Italy makes clear that debtor countries cannot and will not push the reforms through as dictated by Brussels and as the German political leadership has sold it to its own public. The confrontation that will eventually come will be between the bureaucracy in Brussels and the national government/parliament in Italy. You can be assured that Spain, Portugal, Greece and also France will side with the Italians, as they also feel the pressure from their own people. In the short run, everybody will play down the importance of the upcoming differences of opinion, but it will be inescapable. My view remains that the euro will not survive without a political union, which is unlikely for at least another generation, but that easy money and breaking all rules of sound fiscal and monetary policy will extend the drama for many more years but will make the euro a weak currency.
While some believe the euro-zone economy is close to recovery – that at least is what all the reports I read are pointing to – I wonder whether they have looked at the latest auto sales, which were down 14.2% in January from a year ago. In fact, they have slumped way below the lows of 2009 and even the much lower lows of the mid-1990s. It is simply beyond my comprehension how the euro-zone economy should recover under current circumstances. Interestingly, the luxury brands Mercedes, BMW and even Landrover increased their sales, which simply confirms how much our society is dividing into haves and have-nots.
No Foreign Exchange Manipulations?
Despite all the denial by officials and former officials, currencies are more manipulated than ever, and I rather see an intensification of this trend than normalization. As long as the structural economic problems remain in our world and technocrats believe they have to manage it the way they think is right, the more manipulation we will get. No doubt, this will not be good for the world, but we have to live with it as it is.
The first decline of the Japanese yen against virtually all currencies is most likely over. The move was driven by changing expectations of an advertised forthcoming aggressive monetary policy in Japan as requested by the new prime minister. Now, the Bank of Japan has to deliver, and until we see it coming through as decisively as announced, the yen will most likely congest as traders are taking profits. Any correction will, in my view, however, be only temporary and counter to the cyclical and most likely even secular decline of the Japanese unit. Even so, a correction is due. Stay short the yen as a main strategic position, as the fundamental change driven by its decisive structural deterioration of its balance of payment will last for a long time.
The other currency that is in a sharp decline is sterling. The current mix of tight fiscal policy combined with easy monetary policy will continue, and now the Bank of England has assigned a Canadian as its head. He is one of those technocrats who believe they know how to improve the economic situation. He even beats Bernanke in his future attempt to print money based on what he outlined as the most likely way to go. Sterling will certainly continue to be a major casualty. GBP has already declined from over 1.62 against the USD to below 1.52 and is now terribly oversold, which is a sign of weakness. It could therefore bounce somewhat over coming weeks, but I don’t think this decline is anywhere near a major bottom yet.
The most important foreign exchange ratio is EUR/USD. While the euro zone represents a chronic current account surplus region due to Germany, the US is exactly the opposite – but improving. The problem of the euro lies within the growing imbalances among the creditor and debtor nations. France has just recently undershot its growth and overshot its deficit target, and president Hollande requested the ECB to weaken the euro, which immediately triggered a bold response by the head of the Bundesbank. Many have been surprised by the euro’s rally from 1.20 to 1.37 recently, triggered by Draghi’s backstop in late summer. My hunch is the recent 1.37 was probably the high for the year. The stress within the euro zone will grow as the year goes on and the political confrontation will be on the rise again between debtor and creditor nations. It is conceivable that EUR/USD will take more time to top out and could bounce in the near term. However, my view is that the primary trend is down for the euro, as the ECB will eventually turn more dovish due to rising dissatisfaction with the economy. Moreover, the fundamental problems of the misconstruction remain unresolved, and therefore imbalances will grow over time. By default, the US dollar will become the least dirty shirt in the laundry and therefore the strongest currency over the next 12-18 months.
The Controversial Message of Bonds
Bonds are behaving incredibly well in view of all the talk about economic normalization. Obviously, bonds seem to look more toward commodities that do not send as strong a message as equities. From a multi-year perspective, bonds are not only unattractive but outright dangerous; however, we don’t see signs yet among the major currency-denominated bonds of immediate major risks. In fact, we cannot even exclude another yield decline in coming months within the yield ranges of the last 18 months or so.
A different story is European peripheral bonds, where the cyclical decline in yields from the Draghi intervention level is most likely over. Italy’s election may just have been a wake-up call to speculators, and European banks in particular, who have bought these bonds in large quantities over the last nine months as one of the biggest moral hazard trades ever! Spreads to Bunds are rising again.
Commodities Hardly Signal a Strong World Economy
The economy bulls may be somewhat disappointed by the performance of commodities, as most major indices have fallen back to the lowest level since last summer. While base metals and the energy complex had a decent rally since the Draghi lows last summer, they have lost momentum and are weakening again. This is hardly representative of a robust world economy. While in China the credit aggregates have been quite strong over this period, their momentum will most likely peak very soon, pointing to a slower growth pace for the second half of the year.
Gold is disappointing its fans, too. It is indeed somewhat strange for gold to perform relatively poorly in view of all the money printing going on in the world. Its performance would be logical if the world economy was normalizing, as the consensus believes, as systemic risks would decline while inflation remains moderate, at least as measured by the official statistics. It appears that the “normalization camp” is reallocating more money from gold into equities, and this may have triggered some forced selling by gold funds. Forced selling usually shows up in the latter stages of a decline, when margin liquidation sets in. The sharp decline in open interests to the lowest level in several quarters does reflect deep pessimism, confirming the rising bears by several well-known investor surveys. In the physical market, it may have been the merchandise coming out of Turkey via Iran and the dampening effect of the hike of Indian import taxes on gold to reduce gold imports and help prevent a further deterioration of the Indian balance of payment.
Are Equities in a Crack-Up Boom?
Ludwig von Mises, an economist of the Austrian school, called a rising stock market primarily driven by central banks’ money printing and not by economic performance, a “crack-up boom.” The French called it “hausse de misère”, which is probably a more appropriate term. Once a system moves away from free markets, capitalism and freedom and governments and their central banks choose to create artificial prosperity via money printing, and it will eventually lead to inflation, hyperinflation and collapse. Crack-up booms develop when too much money is chasing not enough equities, in other words what one would describe as inflation. Investors flee out of paper money into real assets like equities, selective art or real estate, etc. to protect their wealth against the debasing value of money due to unlimited money printed by central bankers who do so on the theory that rising asset prices will improve balance sheets and that in turn will improve purchasing power, which will in turn lead to increasing expenditures. If you open your mind and look around, that is what our authorities are working on. At its ultimate end, no one wants any paper money anymore, and that is when a system collapses.
I don’t think we have a true crack-up boom situation worldwide yet, but we certainly see signs that fit the picture. For instance, economic growth is lagging stock market performance in many countries, and the side effects of this policy, namely the division of our society, is obvious in all industrialized countries. But most rising equities still have supporting corporate developments, and if those disappoint, they do sell off hard. Hence, I don’t think we are in a true classic crack-up boom yet, but we are probably near the threshold of entering one in coming years.
Crack-up booms are dangerous because they are not supported by sustainable economic and corporate performance but rather by aggressively expansive monetary policy that forces investors out of nominal assets and paper money into real assets. No question, monetary policy around the world is very expansive without the beneficial impact of true economic improvement or self-sustainable growth. Unfortunately, excessive money printing is unsustainable in the long run and leads to extreme economic, social and political imbalances and is therefore most likely to be an even bigger crisis than the one our authorities are trying to overcome. Hence, crack-up booms in equities have a limited life span and usually lead to systemic chaos.
If Japan will do what the prime minister is requesting, it has the potential to lead to a crack-up boom, and investors will be best served to be long Japanese stocks but short or hedged the Japanese currency, at least for the next few quarters.
A Medium-Term Top in the Making
I am mentioning the crack-up boom because global equity markets have performed somewhat stronger than what one would see at a top, and investors are rationalizing their purchases of equities by a lack of alternatives and the decline of cash’s value. While the rally off the November lows is showing many divergences, they are not yet of a nature that one usually sees near a top. If this is part of a topping process, more time will be required. My working hypothesis remains of a medium-term peak in spring, probably late this quarter with a medium-term correction to follow. Thereafter we will most likely see another rally attempt as part of a broader distribution process, which should in my view be followed by a deeper correction. In my expectations that second rally should show weak technicals and rising non-confirmations, which would then lead to a bigger decline.
Markets are not homogenous any longer, and investors should therefore become step-by-step more defensive and weed out relative weak performers and concentrate on strong relative performers. The strongest market I still find is Japan, although some complex correction would be normal after the good rally. In the US, I see many relative changes in favor of more defensive groups and stocks and against more cyclical segments, including consumer discretionary. Some selective manufacturing names, however, remain good performers. Europe is again slipping, and the relative performance of cyclical groups is clearly deteriorating, even more so than in the US. European automobile stocks are a case in point, and basic resources are weakening in synch with base commodities. Emerging markets as a group are underperforming, and some like Brazil or Malaysia are quite disappointing. I still believe China is one of the more attractive markets in that segment. But even China may enter some choppy water after the good run since early December.
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.