Always worthwhile to hear Zulauf’s views on the economy and investment markets. Member of Barron’s Roundtable for more than 20 years, legendary Swiss investor Felix Zulauf paints a gloomy picture in this recent interview with Barron’s. Besides his usual bearish calls on China and Europe, he says the US will perform relatively better than others and recommends holding US$ cash and shorting Emerging Markets.
Here is an excerpt:
Barron’s: Is there a good word from Europe?
Zulauf: Adjusted for inflation, Italy trades at levels last seen in Mussolini’s era. Greece trades at 1.5 times the Shiller P/E ratio [the market’s current price divided by the past 10 years’ inflation-adjusted earnings]. Most European markets are good value but that doesn’t make you any money. The structural framework is wrong and cyclical dynamics are still pointing down.
Barron’s: Structural? Cyclical? Please explain.
Zulauf: There is too much debt in the industrialized world and the financial system is virtually bust. Real disposable personal income is stagnating or declining. Employment participation keeps heading south. This produces a chain reaction: Weaker consumer demand in the West weakens manufacturing in places like Asia, which weakens natural-resource producers such as Australia or Brazil.
As for the euro, it is a misconstruction. As I said in January, I expect the disintegration to begin in the second half of this year. That should lead the world into financial and economic chaos. My two major themes into 2013 are euro disintegration and China weakness, due to the bursting of a real-estate boom.
Barron’s: Sounds like a fun year.
Zulauf: The global economy is weakening cyclically on top of a highly fragile credit system. It is an explosive cocktail. The tower of debt is compounded by the gigantic over-the-counter derivatives market. In the past 10 years the notional value of derivatives worldwide has grown from $100 trillion to almost $800 trillion. The numbers are mind-boggling. If something goes wrong in the real economy, it could shake the whole credit system dramatically. It is a dangerous situation.
Barron’s: How will policymakers react?
Zulauf: They have exhausted a big part of their resources. Governments around the world have realized they carry too much debt and need to tighten fiscal policies. Even the U.S. will wake up to this after the election. Monetary policy, or so-called quantitative easing, doesn’t produce economic growth, given current systemic circumstances. But it may prevent the credit system from imploding, if provided in massive quantities.
Barron:s So what will happen next?
Zulauf: The euro is not the real problem but a trigger and compounder of the structural problems. It could only work if the euro zone entered a fiscal and political union, which won’t happen, as Europeans aren’t prepared to give up national sovereignty. Politicians therefore will go from one compromise and quick fix to the next, with the crisis deepening until some nations at the periphery won’t be able to stand the economic pain anymore. They will want their old national currency back, and devalue to adjust the external accounts.
China won’t be able to save us, as it did in 2009. The Chinese will lower interest rates but their actions will be reactive and lag. If my thesis is right, we must assume things will go awfully wrong in the next 12 months and the system will be at risk of collapsing. Most U.S.-focused investors might not understand it as they see corporations doing well.
Barron’s: How bad will things get?
Zulauf: The potential exists for a broad-based nationalization of the credit system, capital controls and dramatic restrictions on financial markets. Some might even be closed for some time.
Barron’s: Good heavens!
Zulauf: We are witnessing the biggest financial-market manipulation of all time. The authorities have intervened more and more, and thereby created this monster. They might change the rules when the game goes against their own interests.
We are in a severe credit crunch. It starts when the weakest links in the system can’t finance their activities. Then you have a flight to safety into Treasuries and German bunds, compounded by a quasi-shortage of good collateral. That’s why bond yields have fallen so low. This isn’t an inflationary environment but a deflationary one.
Barron’s: How will the U.S do in your scenario?
Zulauf: On a relative basis, the U.S. could do best. It has more of an affinity for freedom than socialist-minded Europe, and if the U.S. is clever, it could become energy self-sufficient by developing natural gas and shale oil.
Barron’s: What is an investor to do in the face of this unpleasant news?
Zulauf: I am sticking with my January recommendations. In the short-term, equity and commodity markets are making a low. They are oversold. The euro zone will come up with new quick fixes later this month and markets will attempt to rally. But I see a cyclical bear market continuing well into 2013.
I would hold lots of cash, preferably in U.S. dollars. While I expected Treasury yields to hit bottom in the fall, I would take some profits and not buy new bonds. Sell the rest in the fall, and use a stop-loss order to protect profits if you bought the 10-year when it was yielding 2.20% in January, as I recommended. Stick with Australian three-year government bond futures. This is a direct bet on China’s weakening, and short-term rates could fall further. I also continue to recommend buying gold if it breaks below $1500. That could lead to a quick shakeout into the $1300s, but gold will offer protection in coming years because it is true money.
Barron’s: Do you see any opportunity in equities?
Zulauf: Only on the short side. I would continue to short the EEM, or iShares MSCI Emerging Markets index fund, which is a bearish play on stocks as well as currencies.
Source: Barron’s (“Caution: Sharp Turns Head”)