Last May, at the 64th CFA Institute Annual Conference in Edinburgh, Scotland, veteran investor Felix Zulauf laid out a number of bearish predictions that have largely proved to be on the money. Now that six months have passed — and with so much happening in the world — we thought it was a good time to review his predictions and get a fresh update on his outlook for the economy and financial markets. Zulauf, who has been investing professionally since 1971, did not disappoint.
CFA Institute: Felix, when we last met with you in Edinburgh, Scotland, you had stated that the euro itself was a misconstruction because you can’t have a monetary union without a fiscal union and a political union. As a result, the very structure of the euro creates a balance of payments problem among the eurozone Nations. Consequently, Europe has now broached the inevitable crisis, and you had predicted that the peripheral nations (the so-called PIIGS) would enter recession in late 2011. Have these countries entered recession, and where does Europe go from here?
Felix Zulauf: Yes, I believe the peripheral nations have entered recession territory, and I believe it will get worse. The fundamental problem in Europe is indeed a balance of payments problem due to the large gap of competitiveness between the periphery, including France and Germany. If the eurozone was a political and fiscal union, this would not matter. But as all of them are independent sovereign nations, it leads to a structural balance of payment crisis. As the people of Europe are not ready to enter a political union and thereby give up their own sovereignty, a fiscal union is difficult to achieve, as it basically means a transfer from the successful north to the not competitive south. It is also important to understand that the European nations comprising the eurozone are very different from each other.
Given the dynamics within Europe, many people are looking to Germany to bail out the rest of Europe in some way. What do you see as Germany’s interest in maintaining the euro, and what do you believe Germany will do?
Many people also think that Germany benefited the most from the euro. Nonsense! True they were able to export more, and other eurozone countries could no longer devalue their currencies against the deutschmark. However, while Germany’s export model drove growth in its export sector, it also sacrificed domestic demand and investments to some degree. Actually, before the crisis broke out, Germany had the lowest growth since the euro was introduced. In purely economic terms, it makes more sense for Germany to exit the euro. Nevertheless, Europe’s history of war is an overarching concern for Germany (as well as Europe). Germany’s interest in the euro is primarily to forge an alliance with France. Given that Germany’s economy has much inherent strength, the question for Germany is whether or not they can balance their domination of the European economy with cooperation among the European nations.
Before we can think about all of that, you must remember that the German culture is very different from that of the rest of the Anglo world. Whereas other Anglo nations see a problem and try to fix it with whatever tools are available, Germans are more regimented in their thinking and believe that a fiscal problem must be solved with fiscal tools. While both approaches have their strengths and weaknesses, the German approach virtually assures that Germany will demand fiscal austerity — which also ensures that the eurozone remains in a state of crisis.
So, the situation in Europe will get worse before it gets better. Moreover, the ECB, which has its roots in the German Bundesbank, will see to it that the ECB does not become the lender of last resort until they are absolutely forced into it by the market. For investors, this is very important to understand. The new leader Mr. Draghi may leave Trichet’s conservative path, however, as since he is in power he has talked one way and acted in another way. This is delicate as the credibility of the ECB could be lost quickly.
Obviously, Greece has been a hot topic for some time. However, the situations in both Italy and Spain have flared up in the markets in the past six months. How do you view the situations in Italy and Spain?
Italy is overindebted and very uncompetitive. In contrast to Spain, it did not have a real estate bubble. It simply has too much debt and an uncompetitive economy. Politically speaking, the recent departure of Prime Minister Silvio Berlusconi ended a relatively long period of political stability in Italy, but one that was not used to reform, unfortunately. Since World War II, the average government in Italy has lasted only nine months, sort of a pregnancy cycle.
With respect to Spain, it had a real estate bubble that was even worse than the United States. Real estate prices should drop another 20–30%, and of course this will add additional burden to the banking system. Consequently, Spanish banks will have to be nationalized, and the sovereign debt burden in Spain will be even greater than it already is. Both Italy and Spain are caught up in a deflationary process that will exacerbate the crisis in Europe. As these economies are stuck with a 30% overvalued currency and high real interest rates, it is impossible to truly improve the economy. Austerity will make it even worse. So, the question really is: How long will the people tolerate this downward spiral, or when will they revolt and force their governments to exit the euro?
When we last spoke, you had mentioned that the commodity complex will decline, equities will react favorably at first, and then recession will hit. Industrial commodities have certainly declined, but oil has remained stubbornly high. Where do you see commodities going from here, and how much does this depend on your views of China?
The economic slowdown will continue for some time, which will reduce commodity prices. China will continue to slow mostly because construction in China will slow as sales of real estate are substantially less than production. Oil is a bit of a different animal as it also has substantial political influence, particularly from events in the Middle East. Presently, I think that investors should remain very defensive and wait until the headlines can’t be any worse before they start buying. Consequently, I believe government bond markets may have one more decline in yields left in response to the coming economic weakness that should finally terminate the 30-year decline in yields.
Lastly, I think the gold price has had its first correction and should retrace part of it during the first quarter, but a second correction may follow if the deflationary forces get stronger, as I expect. Afterwards gold will most likely resume its upward trajectory as central banks, including the ECB belatedly, will have no other choice but to print money. In general I assume the first quarter will still see a friendly undertone, but underneath the surface the world economy keeps deteriorating. That could hit risk assets again thereafter. We may see a great buying opportunity for equities and commodities sometime in the second half.
Do you still believe that emerging market economies will have to break the back of high inflation and end up in recession (in about 2014)?
As growth slows in the world economy, emerging markets will also slow but from a higher level. However, the emerging markets do not have the same handicaps that the developed markets do. For instance, while China did create a massive real estate bubble, its banking system is much better capitalized than say European banks, as they have received two major recaps from the Chinese government already. So, in China, this should limit the downside.
Felix, thank you so much for sharing your time and insights with us once again. We look forward to speaking with you in the near future.
For more insight into Zulauf’s approach to investing, watch “The Investment Philosophy of a Seasoned Investor.”