Felix Zulauf of Zulauf Asset Management sat down with the Barrons Roundtable to update his outlook on the global economy. Zulauf made some fairly prescient remarks earlier this year when he said QE would fail and that markets would decline when they began to recognize this:
“Zulauf: The market will range between 10% up and 10% down. I don’t know where it will end the year. The U.S. central bank will be forced to quit quantitative easing by the middle of the year as political pressure increases, but it won’t shrink its balance sheet. The ending of QE will take some excitement out of the stock market. Then there is room for unpleasant surprises. From time to time, the Chinese could shock the markets by acting more serious about tightening. I don’t like the widespread optimism right now, and I can’t join the bandwagon. The crisis in Europe is continuing. We don’t know where it will lead and how it will affect the U.S. Corporate profit margins can’t stay at such high levels. They will probably revert to the mean, which historically was 5.5% or so, not today’s 7%.”
In short, Zulauf sees the world in much the same way that I do with a few differing conclusions. Structural imbalances have resulted in severe global problems and central bankers are largely mishandling the situation. Unlike Zulauf, however, I see a bifurcation in the global economy. He sees global inflation whereas I see emerging markets battling inflation and developed markets remaining at a risk of deflation as they fend off debt woes. You can read his views and many more from the Roundtable at Barrons.com:
“Barron’s: How’s the view from Europe, Felix?
Zulauf: I am in a good mood but I feel sorry for the world. The global economy’s structural problems haven’t gone away, and the authorities continue to kick the can down the road. They go from one quick fix to the next. Quick fixes have worked well in the past two years, and might work a bit longer. But at some point we will have to face reality, and that will be a very sour moment.
In the medium term, it is much more a trading market than an investment market. Expectations for earnings growth are too optimistic. Professional investors are fully invested because they have no choice. Individuals have come back to the market, but not like in previous cycles. There just isn’t much firepower left to push stocks higher, and there have been some important changes in fundamentals.
The biggest challenge has been greater inflation, particularly in emerging economies. These economies are operating at full capacity. With inflation rates rising, the authorities moved away from ultra-expansive policies, and in China they started to tighten credit. That will slow these economies over time, although they are structurally sound.
The problem is in the developed world. In the U.S., quantitative easing is ending due to tremendous criticism. The hurdle for launching QE3 will be very high. Europe is a special situation. The ECB [European Central Bank] is trying to reduce its balance sheet for the third time since the financial crisis of 2009. The first time they tried it triggered the Greek crisis. The second time it triggered the Irish crisis. The third time there could be problems in Italy.
What will happen if Greece defaults on its debt?
Greece is bust but it isn’t allowed to default. If it does so you could see a bank run throughout the European and the global banking system. The ECB and Germany are trying to force a Teutonic fiscal program on Europe. They are on a collision course with economic reality. If Greece defaults, the ECB probably will lose 30 billion to 50 billion euros. The bank’s equity capital is €10 billion. The Irish and probably Portugal and Spain would default. Germany’s Bundesbank owns more than €300 billion of European debt. A default would be worse than the collapse of Lehman Brothers.
If you ran the ECB, how would you deal with Greece?
There is no painless solution. We have to let entities, even governments, default. But we have to make sure first that the banking system can handle its clients’ defaults. That is the problem. In the European banking system, equity capital is only 3% of assets. In the U.S. it is 4.5%. Raising banks’ equity-capital ratios is the only way to solve the problem in the long run.
We missed the chance during the financial crisis. I would have handled the whole crisis differently. I would have nationalized the banks and not allowed them to pay any dividends or big bonuses. First they would have to improve their equity-capital positions. This would go hand in hand with extremely low growth.
You would have been very unpopular.
The fiscal authorities have to support the system. But instead of wasting money to boost consumption, they should be spending on investments that will bear fruit long term. By the middle of the decade at the latest, we will have a major crisis, bigger than 2008. Several countries will default, particularly in Europe. Quasi-fixed exchange rates between the U.S. and China will start to unravel, which will force the U.S. dollar down tremendously. It will push bond yields up and stocks down.
What do you see in the near term?
From Asia to Europe to the U.S., all the important economic indicators are rolling over. Some blame the Japanese tragedy; others, the weather. It is more than that. It is the result of policy decisions. Economic growth could slow to a crawl well into early next year. The stock market isn’t priced for that. Analysts will cut their earnings estimates. There is 20% downside risk from the market’s intraday May high. Once the economic news turns decisively disappointing, the authorities will come to the rescue and try to stimulate again. That is when a trader can move in on the long side for a rally at year end.
Those who have to own stocks should buy pharmaceuticals, health care and consumer staples rather than cyclicals. In the near term, through the summer and fall, I would short the XME [ SPDR S&P Metals and Mining exchange-traded fund], the XLI [Industrial Select Sector SPDR], the XLK [ Technology Select Sector SPDR] and the XLF [ Financial Select Sector SPDR]. If you have to own something, go with theConsumer Staples Select Sector SPDR [XLP] and the Utilities Select Sector SPDR [XLU].
What form will stimulation take this time?
The U.S. central bank is doing the opposite of what Paul Volcker did from the late 1970s until the mid-’80s. He tried to break inflation by limiting the money supply. In so doing, he created extremely high real interest rates. It took the bond market about five years to understand it. [Federal Reserve Chairman Ben] Bernanke’s monetary policy creates deeply negative real interest rates. It will take the bond market several more years to realize this will lead to inflation. Bonds can’t be recommended to long-term investors for the next 10 years. Gold will beat stocks in the next few years, even if gold corrects by more than 10%.”
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.
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