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http://financecapitalinvestors.com/business-financials/felix-zulauf-sees-markets-falling-further/
Felix Zulauf Sees Markets Falling Further
Aug. 29, 2015 1:23 a.m. ET
Felix Zulauf has long trained his considerable wisdom on understanding and profiting from the investment implications of macroeconomic trends. As anyone with a pulse and a brokerage account now knows, the trends are pretty awful. Felix, a longtime member of the Barron’s Roundtable, is convinced the implications could be worse.
It is hard to argue with his track record of late as a prognosticator, since much of what he forecast in our midyear Roundtable, published on June 15, has come to pass. Major stock indexes around the world indeed have corrected by roughly 10% or more—and in China’s case, by 18%—since the Chinese government suddenly devalued the nation’s currency three weeks ago. The devaluation is another thing Felix predicted, although it happened a bit sooner than he expected.
Felix wears several hats these days: He’s president of Zulauf Asset Management and co-chief investment officer and partner at Vicenda Asset Management, both based in Zug, Switzerland. He thinks the world and the markets could be roiled further in coming months as China continues to adjust to decelerating growth, taking steps that will export deflation around the globe. He shared his bracing insights and current outlook in a conversation last week.
Barron’s: Is the recent selloff in stocks a so-called buying opportunity or the prologue to a bear market?
Zulauf: Technical indicators—of volume, breadth, volatility, and so forth—hit an extreme on Monday. After a selling climax like that, the market usually tries to recover. Such recoveries tend to last from a few days to a few weeks. Then the market retests its lows. My hunch is that U.S. stocks, and other stocks, will undercut this month’s lows in the next wave of selling.
On what do you base that hunch?
You have to look at the markets’ underlying fundamentals. Every market cycle has a dominant theme. The U.S. housing market was at the epicenter of the financial crisis of 2008-09. China is at the epicenter of the current crisis, and its problems will have an impact on the rest of the world. China experienced the biggest investment and credit-creation boom that mankind has ever seen, and the downturn probably will last for a few more years. China’s economic growth decelerated from more than 10% to about 2%, although the targeted figure is 7%, but that’s baloney. The industrial complex in China is in a recession. The currency is overvalued by 20%, at least, and the capital account has fallen into deficit.
The key to this crisis is a balance-of-payments problem, which many analysts and economists don’t seem to understand. China has experienced capital outflows for the past 12 months on the order of $500 billion or more. The country doesn’t have a completely open capital account, so you need to get the government’s permission to move money abroad, or find ways to cheat via fake billings and things like that. Under free-market circumstances, capital outflows would depress the value of the currency. But China was running down its foreign-exchange reserves to support its currency. The government concluded that a currency regime change was needed to prevent the loss of further foreign-exchange reserves.
China’s foreign-exchange reserves aren’t exactly puny.
According to the latest figures, China has $3.5 trillion in foreign-exchange reserves, of which about $1 trillion is illiquid. The authorities spent about $150 billion to support the currency, or smooth its decline, in the past two weeks. China was buying the currency with the country’s foreign-exchange reserves. In a sense, that meant it was withdrawing liquidity from the domestic credit market. It cut interest rates this week to try to calm the market, and reduced the bank reserve-requirement ratio, allowing Chinese banks to be more generous in lending.
Nice try. The Shanghai index has continued to fall.
In prior balance-of-payment crises, such as Latin America in the early 1980s, Mexico in 1994, Asia in 1997, and Russia in 1998, the currencies involved typically declined by 40% to 70%. I’m not saying the Chinese renminbi must decline by 40% to 70%, but it probably will decline against the dollar by 30%, in all. It is down 10% already.
What are the likely repercussions of a devaluation of that magnitude?
China is the world’s largest exporter, and has the world’s second-largest economy after the U.S. If the Chinese currency falls 30%, Chinese products will get 30% cheaper in the market. The price of all globally traded goods will come under pressure. That is terrible news for China’s direct competitors, and bad news for other producers. Price deflation would translate into declining sales, shrinking profit margins, and lower profits for the corporate sector worldwide. What do companies do when profits come under pressure?
That’s easy: They cut costs and fire employees.
Exactly. They cut the incomes of others. Consumers start saving more and spending less, which leads to a weaker world economy. The offset is that consumers get some relief from lower prices.
Today’s environment is deflationary because the indebtedness of too many economic subjects has reached capacity. The borrowing can’t continue. Central banks can’t solve the problem by providing more liquidity because liquidity isn’t the issue. We have plenty of liquidity; we don’t have enough borrowing capacity. Also, inventories are high around the world, in Asia and elsewhere. This virtually guarantees lower prices in the future. Inflation rates will be lower, and interest rates will stay low. The stock market will have to adjust to this new reality.
Among institutional investors and private households in the U.S., the asset allocation to equities is similar to the level in 2007. Liquidation pressure is building. It is going to be an extremely difficult environment.
How much lower, then, do you expect the Standard & Poor’s 500 index to fall?
I was targeting the low-1800s for the S&P, and 9000 for Germany’s DAX index. Both indexes fell to the vicinity of those levels on Monday and we closed our short positions. As the rebound unfolds, we will short them again as we think both markets will fall further. But the easiest bet is to short the Chinese currency, although that is a trade only for professional currency traders.
Is it time to buy gold?
Gold has begun a medium-term rally that could carry the price from a recent $1,125 an ounce to about $1,300. But I wouldn’t call it bullish for commodities in general; the commodity complex remains in a secular bear market.
The crisis in Asia will do a lot of harm to the banking systems in China, Hong Kong, and Singapore. The balance sheets of the region’s banks have more than doubled in the past six years relative to gross domestic product. Big and unexpected moves in currencies can hurt carry trades [borrowing at low interest rates to invest in potentially higher-earning assets], and nonperforming loans could jump dramatically at these institutions. It wouldn’t surprise me if one or another bank disclosed one of these days that nonperforming loans had climbed to 15% or 20% or 25% of its loan book. That might cause systemic risk, as the banks in these countries are linked to our banking system. People buying gold now are doing so for that reason.
Do you foresee another crisis along the lines of 2008?
No, because the process is different. There most likely won’t be a waterfall decline in the value of financial assets, but a gradual erosion. The Chinese are trying to slow the process, which will make it even uglier over time. They aren’t letting market forces adjust to the economic situation. They are preserving the belief that the authorities have it under control. That is also baloney.
Speaking of the authorities, what are the odds that the Federal Reserve will lift its short-term interest-rate target in September?
If the Fed hikes rates next month, it will probably send the wrong signal to the market, and at the wrong time. I said in January that the Fed wouldn’t lift rates this year, and I still believe that. I simply don’t see how the financial authorities are going to prop up the world economy again. Look at the European Union: Its members knew Greece was bust but lent the country another 90 billion euros ($100 billion) to repay its old debt. They are the United Gang of Can-Kickers. As long as the authorities try to fix the global economy by increasing government control and manipulating markets, it can’t heal.
Europeans are proud of the recent uptick in their economy, but I expect Europe to disappoint again this year. The euro zone has benefited from the one-time effects of lower oil prices and a cheaper euro. Also, some economies, such as Spain, relaxed austerity measures in advance of national elections. But the recovery isn’t sustainable. Germany will eventually suffer on the export side as Japan eats into its markets. Developments in China and Russia are bad for the Europeans. That said, Greece isn’t an issue for the world. It is a symptom of the state of the world.
The recent selloff in global markets has hurt the portfolios of the superrich as well as the rest of us. Does this spell trouble for other highly valued assets, including luxury real estate and art?
Deflationary forces eventually bring prices down and lead to corrections. But the capital flowing out of China is being invested in the Western world, particularly in real estate in the U.S. and London. While things might look bleak in China, such investment creates the impression that everything is fine here.
The fact is, investors have no place to go. You can’t buy low-yielding bonds for a long-term investment, and the Chinese, by selling dollars to support their economy, are also selling U.S. Treasury bonds. That is a negative for the Treasury market.
Surely, there must be someplace to hide.
Stay defensive. The S&P 500 could bounce up to 1980 but then fall to 1800, or lower. Stick to quality in equities and bonds. Buy companies with low cyclicality and strong balance sheets. A U.S. investor should stick with the U.S. dollar and avoid trading other currencies. And, don’t try to bottom-fish emerging-market stocks, bonds, and currencies.
Thanks for your time, Felix.
E-mail: [email protected]
Felix Zulauf Sees Markets Falling Further
Aug. 29, 2015 1:23 a.m. ET
Felix Zulauf has long trained his considerable wisdom on understanding and profiting from the investment implications of macroeconomic trends. As anyone with a pulse and a brokerage account now knows, the trends are pretty awful. Felix, a longtime member of the Barron’s Roundtable, is convinced the implications could be worse.
It is hard to argue with his track record of late as a prognosticator, since much of what he forecast in our midyear Roundtable, published on June 15, has come to pass. Major stock indexes around the world indeed have corrected by roughly 10% or more—and in China’s case, by 18%—since the Chinese government suddenly devalued the nation’s currency three weeks ago. The devaluation is another thing Felix predicted, although it happened a bit sooner than he expected.
Felix wears several hats these days: He’s president of Zulauf Asset Management and co-chief investment officer and partner at Vicenda Asset Management, both based in Zug, Switzerland. He thinks the world and the markets could be roiled further in coming months as China continues to adjust to decelerating growth, taking steps that will export deflation around the globe. He shared his bracing insights and current outlook in a conversation last week.
Barron’s: Is the recent selloff in stocks a so-called buying opportunity or the prologue to a bear market?
Zulauf: Technical indicators—of volume, breadth, volatility, and so forth—hit an extreme on Monday. After a selling climax like that, the market usually tries to recover. Such recoveries tend to last from a few days to a few weeks. Then the market retests its lows. My hunch is that U.S. stocks, and other stocks, will undercut this month’s lows in the next wave of selling.
On what do you base that hunch?
You have to look at the markets’ underlying fundamentals. Every market cycle has a dominant theme. The U.S. housing market was at the epicenter of the financial crisis of 2008-09. China is at the epicenter of the current crisis, and its problems will have an impact on the rest of the world. China experienced the biggest investment and credit-creation boom that mankind has ever seen, and the downturn probably will last for a few more years. China’s economic growth decelerated from more than 10% to about 2%, although the targeted figure is 7%, but that’s baloney. The industrial complex in China is in a recession. The currency is overvalued by 20%, at least, and the capital account has fallen into deficit.
The key to this crisis is a balance-of-payments problem, which many analysts and economists don’t seem to understand. China has experienced capital outflows for the past 12 months on the order of $500 billion or more. The country doesn’t have a completely open capital account, so you need to get the government’s permission to move money abroad, or find ways to cheat via fake billings and things like that. Under free-market circumstances, capital outflows would depress the value of the currency. But China was running down its foreign-exchange reserves to support its currency. The government concluded that a currency regime change was needed to prevent the loss of further foreign-exchange reserves.
China’s foreign-exchange reserves aren’t exactly puny.
According to the latest figures, China has $3.5 trillion in foreign-exchange reserves, of which about $1 trillion is illiquid. The authorities spent about $150 billion to support the currency, or smooth its decline, in the past two weeks. China was buying the currency with the country’s foreign-exchange reserves. In a sense, that meant it was withdrawing liquidity from the domestic credit market. It cut interest rates this week to try to calm the market, and reduced the bank reserve-requirement ratio, allowing Chinese banks to be more generous in lending.
Nice try. The Shanghai index has continued to fall.
In prior balance-of-payment crises, such as Latin America in the early 1980s, Mexico in 1994, Asia in 1997, and Russia in 1998, the currencies involved typically declined by 40% to 70%. I’m not saying the Chinese renminbi must decline by 40% to 70%, but it probably will decline against the dollar by 30%, in all. It is down 10% already.
What are the likely repercussions of a devaluation of that magnitude?
China is the world’s largest exporter, and has the world’s second-largest economy after the U.S. If the Chinese currency falls 30%, Chinese products will get 30% cheaper in the market. The price of all globally traded goods will come under pressure. That is terrible news for China’s direct competitors, and bad news for other producers. Price deflation would translate into declining sales, shrinking profit margins, and lower profits for the corporate sector worldwide. What do companies do when profits come under pressure?
That’s easy: They cut costs and fire employees.
Exactly. They cut the incomes of others. Consumers start saving more and spending less, which leads to a weaker world economy. The offset is that consumers get some relief from lower prices.
Today’s environment is deflationary because the indebtedness of too many economic subjects has reached capacity. The borrowing can’t continue. Central banks can’t solve the problem by providing more liquidity because liquidity isn’t the issue. We have plenty of liquidity; we don’t have enough borrowing capacity. Also, inventories are high around the world, in Asia and elsewhere. This virtually guarantees lower prices in the future. Inflation rates will be lower, and interest rates will stay low. The stock market will have to adjust to this new reality.
Among institutional investors and private households in the U.S., the asset allocation to equities is similar to the level in 2007. Liquidation pressure is building. It is going to be an extremely difficult environment.
How much lower, then, do you expect the Standard & Poor’s 500 index to fall?
I was targeting the low-1800s for the S&P, and 9000 for Germany’s DAX index. Both indexes fell to the vicinity of those levels on Monday and we closed our short positions. As the rebound unfolds, we will short them again as we think both markets will fall further. But the easiest bet is to short the Chinese currency, although that is a trade only for professional currency traders.
Is it time to buy gold?
Gold has begun a medium-term rally that could carry the price from a recent $1,125 an ounce to about $1,300. But I wouldn’t call it bullish for commodities in general; the commodity complex remains in a secular bear market.
The crisis in Asia will do a lot of harm to the banking systems in China, Hong Kong, and Singapore. The balance sheets of the region’s banks have more than doubled in the past six years relative to gross domestic product. Big and unexpected moves in currencies can hurt carry trades [borrowing at low interest rates to invest in potentially higher-earning assets], and nonperforming loans could jump dramatically at these institutions. It wouldn’t surprise me if one or another bank disclosed one of these days that nonperforming loans had climbed to 15% or 20% or 25% of its loan book. That might cause systemic risk, as the banks in these countries are linked to our banking system. People buying gold now are doing so for that reason.
Do you foresee another crisis along the lines of 2008?
No, because the process is different. There most likely won’t be a waterfall decline in the value of financial assets, but a gradual erosion. The Chinese are trying to slow the process, which will make it even uglier over time. They aren’t letting market forces adjust to the economic situation. They are preserving the belief that the authorities have it under control. That is also baloney.
Speaking of the authorities, what are the odds that the Federal Reserve will lift its short-term interest-rate target in September?
If the Fed hikes rates next month, it will probably send the wrong signal to the market, and at the wrong time. I said in January that the Fed wouldn’t lift rates this year, and I still believe that. I simply don’t see how the financial authorities are going to prop up the world economy again. Look at the European Union: Its members knew Greece was bust but lent the country another 90 billion euros ($100 billion) to repay its old debt. They are the United Gang of Can-Kickers. As long as the authorities try to fix the global economy by increasing government control and manipulating markets, it can’t heal.
Europeans are proud of the recent uptick in their economy, but I expect Europe to disappoint again this year. The euro zone has benefited from the one-time effects of lower oil prices and a cheaper euro. Also, some economies, such as Spain, relaxed austerity measures in advance of national elections. But the recovery isn’t sustainable. Germany will eventually suffer on the export side as Japan eats into its markets. Developments in China and Russia are bad for the Europeans. That said, Greece isn’t an issue for the world. It is a symptom of the state of the world.
The recent selloff in global markets has hurt the portfolios of the superrich as well as the rest of us. Does this spell trouble for other highly valued assets, including luxury real estate and art?
Deflationary forces eventually bring prices down and lead to corrections. But the capital flowing out of China is being invested in the Western world, particularly in real estate in the U.S. and London. While things might look bleak in China, such investment creates the impression that everything is fine here.
The fact is, investors have no place to go. You can’t buy low-yielding bonds for a long-term investment, and the Chinese, by selling dollars to support their economy, are also selling U.S. Treasury bonds. That is a negative for the Treasury market.
Surely, there must be someplace to hide.
Stay defensive. The S&P 500 could bounce up to 1980 but then fall to 1800, or lower. Stick to quality in equities and bonds. Buy companies with low cyclicality and strong balance sheets. A U.S. investor should stick with the U.S. dollar and avoid trading other currencies. And, don’t try to bottom-fish emerging-market stocks, bonds, and currencies.
Thanks for your time, Felix.
E-mail: [email protected]
