International Selection 13:00 - Jan 22nd 2016

Felix Zulauf: «From Buy the Dips to Sell the Rally»

Sandro Rosa und Mark Dittli

According to macro strategist Felix Zulauf, founder and president of Zulauf Asset Management and Vicenda Asset Management in Zug, the almost seven-year-old bull market is over. China is to the current cycle what the US housing market was for the Global Financial Crisis in 2008. It will take years to correct the excesses that were built up in China.

Mr. Zulauf, the markets had a terrible start into the new year. Is the almost seven-year old equity bull market over?
Yes, the bull market came to an end last spring. A new bear market has begun. The coming downturn will be proportional to the excesses that were built up during the boom years. The bull market lasted for a very long time and was primarily fuelled by monetary excesses. And these excesses will now be corrected. And bear in mind, there is no longer any backstop for markets.

What do you mean?
In the past, investors could count on the Fed to bail them out – the Greenspan and Bernanke Put, if you will. Now, however, the US central bank – and it’s still the world’s most important central bank – is keen on raising interest rates. It wants to normalize monetary policy and to end quantitative easing. As a consequence, a sudden about-turn in the Fed’s policy is unlikely.

How big a correction do you expect?
A typical bear market in the US since the Second World War was about 23%. However, this time around I expect a more vicious downdraft. I expect the S&P 500 to drop to a range of 1200 to 1400 – right now the index stands at about 1870. Compared to its all-time high that’s a correction of almost 50%. The German Dax could fall to around 7000, while the Swiss Market Index will see a similar down-leg. There is a real chance of a bigger correction than many investors realize. This is particularly true when there is a weak economy – which I expect.  

Do you think the Fed will continue to raise interest rates?
Hardly. I think that the December rate hike will remain the only increase in this cycle and that there will be no additional moves. Depending on how severe the impact of the falling stock market will be on the economy, the Fed might even reverse their rate hike. That could happen towards the end of this year or at the beginning of 2017. The US economy could cool much more rapidly than many expect.

What makes you think that?
Right now, inventories both in the US but also in many Asian economies are much higher than usual. If sales do not increase materially from current levels – and that is my base case – companies are forced to slash production. As a consequence, data from the manufacturing sector are bound to disappoint in the months ahead. At the same time the Fed balance sheet is shrinking slightly, whereas in China it is falling precipitously, while in Europe we have the situation that Mario Draghi’s verbal interventions might no longer work. We are at the end of an era.

The end of the era of quantitative easing?
Exactly, the era of QE is over or at least nearing its end. Central banks and economists have learned that printing money does not solve any economic problems and does not lead to stronger growth. It did not even help to push inflation higher. The Fed’s interventions during the financial crisis in 2008 were crucial and the right thing to do. Everything that followed, however, was a mistake. In light of the lessons learned over the past years, I do not expect central banks to resort to quantitative easing again anytime soon.

Even though in the past the Fed intervened each time the stock market wobbled? Janet Yellen might start another round of quantitative easing.
For 2016 this is inconceivable, in my view. The Fed is now made up of different members. Granted, former Fed chairman Ben Bernanke, who believes in printing money, would probably administer the same medicine. Janet Yellen, however, has a different philosophy: she is very much focused on labor data. And those look good at the moment. However, labor market data are lagging and not leading. To focus only on employment is like driving by looking in the rearview mirror.  

Would it be positive for markets if the Fed unexpectedly announced QE4?
I believe that in such a scenario we would see a relief rally in equities. The dollar would weaken and commodities and stocks would surge. However, there would not be any impact on the real economy. Any improvement would therefore be built on sand.

How bad is the situation in China?
China is the epicenter of the looming crisis. China in today’s cycle is what US housing was during the financial crisis in 2008. In 2008, China reacted quickly, resorted to fiscal stimulus, which saved the boom and even amplified it. In addition, however, the liquidity from the QE-program in the US flooded into the country, which even accelerated the uptrend – in terms of credit growth and investment, the boom in China grew into the biggest excess in the history of mankind.

And this boom is now over?
Not even autocratic China can escape the laws of economics. If you expand capacity to the point at which the return on capital no longer covers the cost of capital, the boom will end and a correction follows. And we have been in this correction since 2012. The rest of the world has not fully grasped this, as it is used to growth rates of 10%. However, China’s growth has been slowing to officially 6 to 7%. In reality, I’d say it is closer to 2% – despite massive stimulus by both the central bank and the government. This cycle will only be completed when the excesses are dealt with. Hence, the downtrend will continue.

Don’t you think Beijing has the situation under control?
Since one and a half years China is doing everything wrong. It started with the government trying to prop up the stock market. China wanted to attract money from abroad in order to stem the capital outflows. However, this was contrary to the fundamentals as company earnings were falling during the entire bull market. That’s why it collapsed under its own weight in the end. These interventions have only worsened the whole situation. The loosening of capital controls too happened at the worst possible time. Even though this move was the right thing to do from a longer-term perspective, it simply exacerbated the liquidity drain. And now again: Beijing is trying to tighten liquidity in the yuan offshore market to deter speculator who bet on a weaker currency. So no, China is definitely not under control. I expect the situation the deteriorate to a point where we will witness a banking crisis in Asia that will hit Singapore and Hong Kong particularly hard.

So the yuan is bound to fall further?
Yes. During the boom all the Chinese made money. Nobody saw the need to diversify their wealth internationally. This changed with the end of the boom, and capital outflows began. Because China boasts a huge current account surplus, this fact went unnoticed in the balance of payments for quite some time. With a loose monetary policy and low interest rates you can only control your currency with capital controls – those, however, were loosened in order for the yuan to qualify for the IMF’s basket of special drawing rights. With less strict capital controls China created a valve for the liquidity to sip out of the country.

At the current rate of $100 bn. per month.
Yes, $100 bn. and counting. This is reflected in the currency reserves that dropped from $4000 bn. to $3300 bn. Out of these, however, only $2000 bn. are really liquid. If the capital outflows continue at the current pace – and experience teaches us that they are more likely to accelerate – liquid reserves will be drained within the next one and a half years. China wants to avoid this.

What would be the solution?
The best course of action would be for China to devalue the currency in one fell swoop. If they did this, they could keep the lion’s share of the capital within the country. When the currency has found a new equilibrium, capital outflows will stop. However, since the Chinese want to save face, the process of devaluation will be gradual. While I cannot predict the exact path, I expect that we will reach a new equilibrium in 2016 at an exchange rate of 8 yuan to the dollar.

That would be a devaluation of a further 20%.
Yes, approximately. By the way, that would be the level of 1994, just before China let its currency fall by 50%. The rise of the yuan over the last several years only brought the currency back to where it stood before that devaluation.

What would be the consequences of a weaker yuan?
The outcome would be disastrous. Asia is the manufacturing hub of the world. If China devalues, all the other countries in the region will follow suit in order not to jeopardize their competiveness. Consequently, export goods from Asia will become significantly cheaper, which will lead to price pressures which will also affect Western competitors. They in turn will also be forced to lower the prices of their products, which will hurt sales and earnings. Then, companies will have to reduce costs which will have second and third round effects on other sectors. A devaluation of the yuan will lead to a global deflationary shock. 

You say the world economy is cooling. The service sector, however, seems robust and the European economy is holding up well.
It is true, the purchasing manager indices for the service sector look good in many countries, while manufacturing often contributes less than 20% to GDP. However, wage cuts and layoffs in the industrial segment will affect services as well. The service sector is dependent on rising asset prices – stocks, real estate, art. Those markets have peaked in many parts of the world. The weakness in the commodity complex is finally being felt. Wealthy Russian, Brazilians and Chinese are no longer aggressively buying up assets. And when asset prices start falling, the yoga teacher, the barkeeper or the office worker will be worse off. That’s the reason why I expect services to follow the industrial sector.

And Europe?
Europe has indeed been surprisingly resilient – to a large degree thanks to a significantly weaker currency. Another supporting factor was the reduction in many austerity programs. This, however, has led to increasing fiscal deficits. Particularly in countries such as Spain where elections took place. Those two drivers will no longer be in place going forward. In addition, due to the refugee crisis, many countries will face enormous additional costs. This money will not be available for other projects.

What should investors do in such an environment?
Investors need to position as defensively as possible. A high allocation to cash is important. In Switzerland this can be a problem given negative interest rates. Bonds are another option – but not in Switzerland. I buy 30-year US Treasuries that yield 2,8% and manage the dollar risk.

Instead of buying the dip, investors should start selling the rallies?
Absolutely. In addition to the excesses in China and many emerging markets we have demographic headwinds. The positive impact of the past – the entry of the baby boomers into the labor force, Eastern Europe and China opening to global markets – are running out. Also, since the 1980ies, growth was fuelled by a massive increase in debt. Unfortunately, a lot of this debt was used to increase consumption instead of investing for the long term. Now, however, many countries and companies have reached a kind of debt ceiling and can no longer increase their leverage. Globally, there is now more debt outstanding than in 2007. And finally, regulation has mushroomed over the last several years. More regulation, however, in general leads to less growth and prosperity. And it does not look like this will change anytime soon. That’s why we will be trapped in this secular stagnation.

What’s your view on commodities?
I would still avoid commodities. Even though I do expect a relief rally sometime this year, as we have already seen a massive correction. From a fundamental point of view, however, there is nothing that would support higher prices.

What could trigger a rebound?
If the Fed admits that the US economy is less robust than expected and announces that it will stop raising rates, the dollar will correct. At the same time, commodities will then see a rally. This, however, will only be a technical rebound, because most market participants are short and because commodities are traded in dollars. The secular bear market in commodities is not over and will last for several years. But even in such an environment gold could rise by 30%. However, I don’t expect this to be the start of a sustainable bull market.

So commodity-related stocks are still no buy?
Only for traders. These stocks could exhibit violent swings, but these are unlikely to be sustainable. It will take years before the commodity sector will shine again. The boom in China was unique and will not be repeated anytime soon. In the uptrend the sector has built huge overcapacity, whose correction will take years to complete.

When is it time to buy?
I expect the stock market to form a bottom in the second half of the year, at which point there will be buying opportunities in sectors that offer growth opportunities, such as health care or digitization. If you have to be invested, you should stick do defensive segments such as food companies, health care and the like. These stocks will fall as well, but less so than the overall market.

Would you recommend gold miners? The look cheaper and cheaper.
Gold miners have indeed been beaten down and are attractively valued. However, in general, they are badly managed and of low quality. If the gold price recovers, gold miners will benefit as well. Right now, we witness a positive divergence with new lows for gold miners, that are not confirmed by the gold price. As a trader, I would currently buy into weakness.

Only as a trader?
For a longer-term investment I need better visibility – which I do not have at the moment. Currently, I don’t see any new highs for the gold price.

Despite all the problems?
All those problems are of a deflationary and not an inflationary nature. In deflationary times gold is not a good investment. I cannot tell the future, but it is possible that our paper currencies will be destroyed. As soon as systemic risk flare up again – a banking crisis in Asia seems probable – gold should be part of any portfolio. I expect a substantial move in the gold price in 2016. But I don’t think that this will be the start of a new, long-term bull market. However, I am willing to change my mind if the facts change. At present, I expect a rally towards 1400 $. After that, we’ll see.

Read also:

Juli 27th 2016 International Selection Comment

Unburdening the Facebook Generation

 
Juli 20th 2016 International Selection

J.P. Morgan: «Chinese buyers offer good prices»

lock-status
 
Juli 20th 2016 Comment

The Problem with Politicians as Historians

 
Juli 15th 2016 Comment

Is China the Next Japan?

 
Juli 13th 2016 Comment

Putin’s Illusion of Reform