Felix Zulauf's market prognosis

The legendary Swiss investor explains why Greece is likely to exit the eurozone and QE3 won't come anytime soon, and canvasses the outlook for commodity prices and the Australian economy.

Legendary Swiss investor Felix Zulauf believes that the current rally in risk assets is likely to last until at least the end of March, but that global sharemarkets will again succumb to downward pressure in the second half of the year.

In a wide-ranging interview with Business Spectator, Zulauf, who is president of Zulauf Asset Management and who has been a member of Barron’s Roundtable for more than 20 years, paints a gloomy picture of debt-laden industrialised countries, where central banks have no choice but to print money in an attempt to stave off dire deflationary pressures.

He also predicts that dwindling demand from the West will force China to redouble its efforts to boost domestic consumption, but that this will reduce China’s rate of economic growth.

First of all, investors are becoming increasingly nervous as negotiations over the latest €130 billion Greek bailout drag on. What do you think will happen to the country?

The situation is hopeless, of course. We all know that – Greece is bust. But politicians, not only in Europe but also in the United States, camouflage the reality and present an unreal picture.

There is no hope for Greece if Greece stays inside the eurozone. Giving Greece more money is not actually helping Greece, but it is helping others, particularly the banks, and also the European Central Bank.

Eventually I believe a Greek prime minister will decide to take the country out of the eurozone, and go back to their local currency, which will decline by at least 50 per cent against the euro. The financial system would be bust, as would many other parts of the economy. Greek enterprises – both government and private – would default on the debts they owe to the outside world. The Greek national bank and the Greek government would refinance the financial system in drachma.

The thing is, Greece doesn’t make a lot of products. It makes feta cheese and olive oil, and it has tourism. If Greece became 50 per cent cheaper than Spain, Italy and Portugal, after a year or so, the economy would recover. After four years, Greece could come back to capital markets and after seven, eight or 10 years, it could re-enter the eurozone in a much-improved position. It’s a much healthier way of proceeding than what the European politicians are doing.

Portugal is bust too. Their bond yields are in default territory, clearly. So after Greece comes Portugal.

Is there any chance that Europe will be able to escape its debt crisis?

It’s really getting ugly. Germany is trying to force everyone onto an austerity course, but that’s only reinforcing the downward spiral of the periphery. Cutting government spending and raising taxes will cause the periphery to slip into recession or to stay in recession. They have all this downward pressure in their economies as a result of tightening fiscal policy.

The trouble is that when you have an over-indebted economy, you can’t use monetary policy to offset this because monetary policy doesn’t work anymore, only fiscal policy does.

But they’re trying the austerity course. In Italy, [Italian prime minister] Mario Monti is noticing that these policies aren’t working to improve the situation, that’s why he’s calling for growth programs. But how you can have austerity programs and growth programs at the same time, I don’t know.

What’s the outlook for global sharemarkets this year?

The move by the European Central Bank to provide banks with a €500 billion long-term bridging facility will reduce systemic risk for a while. And there are now reports that the second tranche later this month could be €1 trillion. So the balance sheet of the ECB is exploding; it’s rising faster than when the US Federal Reserve did its QE1 and QE2.

Obviously monetarists believe that when the central bank’s balance sheet explodes, it raises final demand in the economy. I don’t believe that will happen, because the transmission mechanism is broken. But what it is doing is that it’s reducing systemic risk, so that risk assets can recover. That’s all about the rally that we’ve seen since last October.

I think the rally will continue into the end of the first quarter, or maybe a little bit further. And this flood of money means my original scenario could be pushed out further in time. I had been expecting that problems would start in the second quarter of this year, and there would be a correction. But now this cyclical rolling-over could be pushed out. From this summer to fall of 2013 seems to me the most vulnerable period for markets.

The very big picture is that markets in the United States and Europe are in a long, sideways value compression period, similar to what we saw from the mid 1960s to the early 1980s. This current one started in 2000, and will probably last into the second half of this decade. And it’s very similar to what you saw in Japan, with cyclical run ups and cyclical corrections. And these cyclical moves are usually triggered by government programs – both monetary and fiscal.

Speaking of monetary policy, when is the US central bank likely to announce a third round of bond buying (or QE3)?

I don’t think we’ll see QE3 very soon, because economic trends right now don’t justify it. The published numbers are somewhat better than everybody expected, so there’s no need to do a QE3.

Right now, we’re seeing relatively good production numbers, but we’re also seeing rising inventories – in the United States, Europe and Asia. In some cases, we’re seeing inventory-to-sales ratios at similar levels to early 2007. If final demand doesn’t pick up the way producers are expecting, they’ll reduce production, which will change the sentiment in the marketplace. So we need to watch that very carefully.

If there is a big change in sentiment, the Fed might do QE3, but it would be very counter-productive. Printing money doesn’t lead to a rise in final demand, it only leads to rising prices for risk assets.

QE3 pushes oil prices higher, and punishes the average citizen who doesn’t have a balance sheet with risk assets. But the US Federal Reserve will try that gimmick when the economic numbers deteriorate, because central banks are in a hopeless situation. Everyone thinks they’re the ones that can save the system. But by printing money, you don’t make the world wealthy, you make a few people wealthy, and you increase the disparity in society. You push the top 20 per cent further up, and you push the other 80 per cent further down in prosperity. And eventually that will lead to a social backlash, which could be very bad.

What’s the outlook for commodity prices?

Commodity prices have been pushed in the last decade by the rise of China – that’s been the main factor by far. I don’t expect China’s rise will stop, but the country is now at a critical crossroads.

China’s economic model has been to be the cheapest manufacturer for the world, so they’ve invested heavily in plant and equipment and in infrastructure, in order to support a thriving export industry. That’s been the driving mechanism, to feed consumption in the world via the Chinese export industries.

But I think we are now dealing with a structural weakness in consumption in the industrial world due to declining prosperity. Real disposable personal income in most industrialised countries is stagnating, or even declining. And that means China has to change its model. Its export industries won’t be as vigorous as they used to be, both as a result of the weakness in demand outside China, and also because Chinese labour costs have risen sharply in recent years.

So China has to change and put more focus on domestic consumption. But this has important implications for Chinese growth because domestic consumption doesn’t have the same multiplier effect on the economy as investment. So what we’re likely to see is that China’s growth rate will decline from around 9-10 per cent per annum, to around the 6-7 per cent level.

And it also means that demand for commodities will slow. It won’t collapse, but it will slow. Commodity prices will tend to underperform equity prices during periods of "risk on” trading.

But I would make an exception for two commodities – oil and gold. Oil, because the oil price is driven by geopolitics, and the geopolitical situation is very fragile. And gold because, in my view, gold is a currency. Central banks – in the United States and Europe – have no choice. They have to continue printing money to prevent their systems from collapsing, and this will debase their currencies.

Will US politicians ever find a way to tackle the yawning US budget deficit?

If the US government did decide overnight to cut the deficit from 10 per cent of GDP to zero, 10 per cent of final demand would disappear from the economy overnight, and this would lead to a very severe recession, if not a depression.

I’ve calculated that over the last 10 years, if the US government had not run budget deficits, then US GDP would be 25 per cent lower than it is right now.

It’s very difficult. Because there is no way of growing out of the problems, we are destined to keep building up government debt in future. At some point, markets will have to be the arbitrator and then you could see bond yields rising sharply, like we’ve seen in some European countries. So bond yields could rise dramatically, and break the system.

The other alternative, which I think is actually more likely, is that central banks will step in and take over the financing role that creditors used to perform. That’s already happening. In the United States, the central bank is buying Treasury bonds. In the United Kingdom, the Bank of England is the largest holder of government bonds. In history, whenever we’ve seen a central bank finance more than 30 per cent of government expenditure, we’ve always had a highly inflationary period four to five years later.

So, at the moment, you have two countervailing forces. On the one hand, you have a high level of debt, which is a highly deflationary force, which results in lower economic growth and a decline in prosperity for the masses. If you let this run unchecked, it leads to depression and the collapse of the system.

In order to counter these deflationary forces, governments and central banks adopt policies aimed at fiscal and monetary reflation. At the moment, we’re weaving between these two forces, and at any moment, it’s a question of which force is stronger, and whether it’s risk on, and risk assets go up, or risk off and risk assets going down.

Eventually there will be a conclusion, either a systemic collapse or a rise in inflation which will lead in some countries to hyper-inflation. And hyper-inflation itself always leads to systemic collapse. It’s an ugly situation, no question.

But what’s the outlook for emerging economies?

Emerging economies are in a much better structural position. Most of them have relatively low debts, they don’t have welfare systems they can’t finance, and they have much better demographics, so they have a built-in natural growth rate in their economies.

They are the place to be in the long run. The only problem is they are intertwined with our world, and when our world suffers systemic problems, they will have a cyclical correction. But that’s where the money should flow.

Finally, what is the outlook for the Australian economy?

You are blessed. You’re far away from all these problems. Australia is the major beneficiary from the rise of China, as rising commodity prices have helped your economy and led to prosperity.

The only issue is that if China has a cyclical correction, you will probably have a recession. I think that if China’s cyclical downturn comes in the second half of this year, or next year, Australia will fall into recession.

Want access to our latest research and new buy ideas?

Start a free 15 day trial and gain access to our research, recommendations and market-beating model portfolios.

Sign up for free

Related Articles