An excerpt from a recent note that legendary Swiss investor Felix Zulauf wrote to Itau Global Connections newsletter.
A short while ago the VIPs and aspiring VIPs of world politics and business met at the World Economic Forum in Davos, a resort in the Swiss Alps famous for great ski slopes, and discussed the state of the world economy and what lies ahead. In contrast to the meetings of the last few years, doubters have disappeared and the general mood was upbeat. Leading politicians pointed to their great achievements in overcoming the great financial crisis and the positive results, although in my view the “improvements” are primarily a result of more money printing by leading central banks due to a disturbing inability to make progress via politics.
However, economic indicators seem to confirm the general mood of an improving world economy, and according to my analysis this may remain so in the first half of the year. Recent numbers released in China, the US, Germany, and even the euro zone as a whole are welcomed good news. The question is whether this improvement will continue for the whole year or not. I will address this question in another report in coming months, as I think it is not relevant now, because coming months should see at the very least acceptable economic numbers. The main exception is Europe, where I see total credit growth now falling into deep negative territory, which makes a sustainable improvement virtually impossible. Spanish retail sales down more than 10% year over year are a shocking reminder that problems in the real economy remain unresolved.
Nonetheless, the investment industry is getting euphoric. I just glanced through an e-mail I received from a German portfolio manager, and his bottom line expectation is 50% upside in European markets from current levels! While he was wise enough to not put a time on his forecast, I felt moved back to 1999 when reading his message. Indeed, sentiment surveys are showing the most optimism in many years in the US as well as in Europe. Anecdotal evidence also shows investors who did not want to touch equities near the lows in 2009 cannot get enough of them now. The rationalization is simple. They don’t get enough yield from fixed-income investments, and dividend yields are much more compelling. However, most investors buy equities for price performance, not for the dividend, as the dividend yield of one year can be lost in one day of trading. But there is nothing more persuasive than rising prices. Price performance should have something to do with earnings. So far earnings have done all right, not the least due to cost cutting by managements, particularly for large companies. This process, however, has its limits. Cutting costs means cutting somebody’s income, which forces the government to bridge the problem, and the government eventually is the taxpayer who will have to pay the bill. But the game may continue for a while longer. In fact, dividend yields of German equities are at the highest level in 90 years compared with German Bunds. That argument seems compelling enough for many.
Bond yields are distorted on the downside, of course. Central banks have bought more than 10 trillion dollars counter-value of government and other fixed-income paper in recent years. They have thereby facilitated the financing of continued large public sector deficits and sharply rising debt burdens – and made governments avoid the necessary steps to adjust their budgets, unfortunately. Moreover, they have distorted corporate earnings to a large extent on the positive side due to lower interest costs. It is also punishing savers whose income has melted away. If the world economy normalized, as some of the optimists are suggesting, what will happen to interest rates and all these variables? Long bond yields in the major currencies and for “perceived high quality borrowers” are very distorted on the downside and show price/earnings equivalents that are more excessive than the NASDAQ’s P/E ratio in 2000. While central banks will continue to intervene – excuse me, help facilitating all the madness of indebtedness – and try to depress yields and interest rates for quite some time longer, I have no doubt this is the secular and cyclical bottoming process in bond yields around the world.
Equity markets agree with the optimists, as breadth in some markets (but not all) have confirmed the highs achieved. Moreover, 70% of the 45 global market indices show rising 200-day moving averages and over 90% of the indices are trading above this average. This confirms the uptrend in force, and the recent rise to over 90% is extending the life of this bull cycle. At the market top, we usually see many non-confirmations, 200-day moving averages worldwide flattening out and indices breaking below that average. The time to turn defensive is when we see both of these readings breaking below 50%. While there is no such thing as one indicator to forecast successfully, other breadth and momentum statistics should also not confirm the final rise and point to markets losing upside momentum. We are not there yet, and in my view, it will require at least another 3-4 months to get there, if not more.
Several markets have developed a pattern that looks like a rising wedge since mid-2010 or late 2011. Rising wedges reflect a coiling sentiment by investors and a breakout of the wedge is usually accompanied by a sudden shift in sentiment and price. The Chinese equity market showed a declining wedge recently, and the Japanese Yen showed a rising wedge against the US dollar and the euro. Wedges usually show weakening underlying demand when rising or weakening underlying supply when falling. Hence, shifts after breakouts are sudden. The current wedges in the US equity market (S&P, DJIA), as an example, show strong breadth, which doesn’t fit the picture (the NASDAQ, however, appears to be a weak wedge). Hence, we have to be alert to the idea that this “wedge” could see a breakout in the direction of the wedge and turn into an acceleration on the upside.
The recent rise, momentum and sentiment could therefore lead to a buying panic before this rise is over. If a buying panic evolves, the peak will come sooner, and my guess would be in the second quarter. If it is a step-by-step rise with continued loss of momentum, markets may rather move in an up-down-up sequence into the third quarter, whereby the second up would most likely be unconfirmed by all sorts of breadth and momentum indicators. If my thesis is right that the world economy will not regain the sustainable momentum that the optimists expect, at some point, probably from late spring/early summer onwards we could approach a large discrepancy between economic reality and market expectations.
A cyclical bull market moves from fear at the lows through doubts to conviction and finally complacency. Risk indicators like quality spreads in the bond market or volatility indices are currently hitting multi-year lows. Seasoned investors, however, know when these risk indicators show perceived high risk, as in the spring of 2009, when the risk in fact is low, and vice versa. Hence, the current state of conviction and low-risk indices is rather an early warning sign and no reason to lie back.
Short-term pullbacks followed by further advances
The very short-term condition of markets points to some setback, as we are already seeing in selected emerging markets. If my thesis is right, this setback will be short-lived and should be followed by higher highs. Such developments reflect strong markets, and markets always look strongest at the surface when corrections are short and limited in size. We have to get concerned as soon as the demand/supply indications underneath the surface begin to deteriorate. Aside from sentiment, it is too early, and that’s why an approaching pullback will most likely be short lived.
The US, euro zone and Japan are the most powerful markets, together with a few selected emerging markets. I have most faith in Japan as the investment community is not there yet, and the macro change is gigantic. Defensive stocks and groups in general are underperforming, while cyclicals, industrials and even financials are performing better than the market.
Strange forex markets
Sometimes what I don’t understand is more important than what I do understand in the markets. I understand the current strength of the euro because the euro is a current account surplus zone, and since the market believes the ECB prevents a breakup, that risk has disappeared. Current account surplus currencies may strengthen, particularly because the ECB is currently not expanding its balance sheet while the US and Japan do so, and not in timid fashion.
I also understand the weakness of the Japanese yen, which I have described here before, and I also understand the weakness of sterling, as the UK is in recession and keeps a tight fiscal policy while the new Canadian head of the BoE has outlined his plan to continue printing money at a rapid pace against very weak external accounts. These three currencies are playing to my fundamental understanding.
What I don’t fully understand yet is the incipient weakening of Asian emerging market currencies (see the charts below showing the USD against those currencies). The Korean won, the Taiwan dollar and even the Singapore dollar have begun to weaken against the US unit and also against the euro, of course. Even the Chinese renminbi is in my view in a precarious technical position with reversal potential, and in combination with the flattening of Chinese forex reserves and the deteriorating capital account (see my last report), the risk of a more serious selloff is increasing. My hunch is Asian exporters are adapting to the weakening yen in a certain way to protect their own mercantilist interests. Perhaps there is even more behind these emerging moves, which I don’t understand yet.
The problem with this development, of course, is the bond market in emerging countries. Over the last 10 years, emerging market bond funds have increased tenfold in size and have attracted a lot of hot money that is now invested there. As conventional borrowers’ yield became unattractive, investors are rotating to the next big thing to get more yield. And that’s how a lot of capital was attracted to these markets over the last few years. If those currencies begin to weaken, money may flow back again and trigger much more instability in global financial markets than many believe. External accounts of selected emerging market countries like India or Brazil are deteriorating sharply, and I expect such an outcome to become more widespread sometimes in the second half of this year and am surprised we are already seeing emerging signs of a turn in selected currencies now, when the world economy, according to the consensus view, should be accelerating. Something is iffy.
If selected emerging market currencies weaken against the US dollar and natural resource currencies like AUD and CAD are also weakening and the US dollar weakens against the euro, European economies may get hurt much more due to the strong euro than most imagine. This contrasts sharply with the rising optimism for Europe we are hearing about from all corners. It may also show that the rising euro is entering a more risky environment, as its own strength will eventually cannibalize any potential export improvement.
Rising commodity prices
I think the big secular bull market in commodities ended in 2008, and the current rise is simply a recovery towards previous old highs from the previous slump’s lows for a few selected commodities and less for many others. Once this cyclical recovery off the 2009 lows is over, I do expect a lengthy correction to unfold.
However, we are not there yet, and the current uptick in leading economic indicators in several regions, and Asia in particular, are supporting rising commodity trends for another few months. This is particularly true, as the Fed and some other major central banks are nourishing inflationary and “growth” hopes by their quite expansive monetary policy. Energy looks particularly strong, while grain and soybeans should also have another rally.
Gold, however, has been pushed to the background, as investors now want to benefit from the economic recovery and are less interested in crisis protection. In my view, gold’s fundamentals are very well intact for the secular bull market to continue, but investors are now running after equities and gold has temporarily lost its glitter. Sentiment is accordingly quite depressed but reflects a bottoming sequence, in my opinion. Once the world discovers the economy is not healing the way the majority believes, at present, interest in gold will revive. Real interest rates are now 0% or negative in almost 40 countries, and fixed-income markets are distorted by trillions of manipulations by central banks. Most importantly, it must continue, as the world will hardly get back to satisfactory growth by itself in a sustained way as the optimists assume.
Bond yields are bottoming for the cycle
I agree with those expecting rising bond yields on a cyclical and secular basis. However, very short-term, bond yields may soften when stocks pull back. On a longer-term basis, however, bonds remain unattractive. The cyclical risk may be limited due to continued market interventions by central banks, but German Bunds or 10-year US Treasury yields may still carry a risk of 50-75-bp yield rise over the next 12 months. Investors must be aware that from now on, the next 30 years will be an uphill battle in global bond markets.
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.