Interview

Felix Zulauf: «We Have Created the Biggest Excesses in Generations»

The investor and market observer is a harsh critic of central banks. They ran a monetary policy that was way too loose in the upswing, thus creating a huge mountain of debt. «We have forgotten that recessions are a natural part of the business cycle», he says in an in-depth interview.

Mark Dittli
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When things get turbulent in financial markets, experience is required. Felix Zulauf has experienced many boom and crash phases in his almost fifty-year career as an investor and market observer.

In an in-depth interview, Zulauf explains how the downturn of the past few weeks should be interpreted, when and where he sees buying opportunities, and why he hopes that the Covid-19 crisis will lead to a fundamental rethinking in the financial world. «It is a disaster that our central banks have pursued a monetary policy that was far too loose during the expansion. This has fueled the excesses in debt», said Zulauf.

«Our entire society has forgotten how to take responsibility. We have forgotten that life consists of setbacks and that you have to have safety margins for difficult times»: Felix W. Zulauf

«Our entire society has forgotten how to take responsibility. We have forgotten that life consists of setbacks and that you have to have safety margins for difficult times»: Felix W. Zulauf

Picture: Karin Hofer, NZZ

Mr. Zulauf, equity markets have suffered a sharp fall in March. Have you ever experienced a crash like this?

The intensity reminds me of 1987, but the speed is without precedent. It is unique that stock markets collapse by more than 30% within two weeks, straight from their historical high. But then again, the fundamental situation is also unique. I've been in business for almost fifty years, but I've never seen the global economy shut down so quickly. Many people still do not realize the enormous economic damage caused by the measures to contain the Covid-19 pandemic. The world will not be the same after this.

Is the economic damage larger than in the aftermath of the 2008 global financial crisis?

Yes. 2008 was primarily a real estate and banking crisis that spread to industry sectors through contagion effects. Most of the service sectors remained unharmed, though. This time, all sectors are affected, especially services. Tourism, restaurants, hairdressers, countless small businesses: if they have to close for two months, their cash flow dries up and they cannot survive. That is probably unique in history. According to estimates by the Ifo Institute in Munich, such closure leads to a loss of economic output of 7 to 11% after two months and up to 20% after three months. The decline will be determined by the duration of the restrictions. All in all, the economy will experience a brutal fall in the first half of the year. If authorities around the world act wisely, we'll see a stabilization in the second half of the year.

Don't you expect a V-shaped recovery of the economy when the worst part of the pandemic is over?

No, because the recession is starting a domino process. All the excesses from the expansion of the past ten years come to the surface now. Remember: The level of total debt in the world today, compared to economic output, is more than twice as high as in 2007. We have created the biggest excesses in generations. This debt is now increasing the downward pressure. In addition, the global economy was already in a slowdown mode even before the Covid-19 shutdown. You could see that the economy was slowing down in 2020, so it was right to start the year with an underweight in equities and an overweight in bonds. Then came the Covid-19 shock. And on top of all that, we saw the beginning of a new price war in the oil market in early March.

Isn't a lower oil price good for the global economy?

No, not in this case. The shale oil industry in the United States is practically bankrupt. These companies have more than $900bn in debt outstanding. Risk premiums in the high yield segment, where investors for years have not paid attention to the balance sheet quality of debtors, are skyrocketing now. This eats its way through the financial system, jeopardizes the refinancing of many companies and thus also affects the real economy. Once again, this shows how dangerous an excessive build-up of corporate debt is.

Central banks are pumping liquidity into the system, governments are setting up support programs. Is this useful?

Fiscal policy measures can only take effect when the restrictions are lifted and people are allowed to move again. Afterwards they have a supportive and later a stimulating effect. The gigantic amounts that central banks are pumping into the system have to be imagined as follows: They plug the huge deflationary hole that the Covid-19 crisis has torn open, and they prevent the meltdown of our financial system. In that sense, that's the right policy to follow. If the economy then normalizes, these liquidity injections can have an inflationary effect. Of course central banks believe that they could skim off this liquidity again, but they have shown in the last cycle that this remained a pious wish.

Are these support programs even necessary, in your view?

During the crisis: yes. In principle, however, fiscal policy should be balanced over the cycle; increase government debt in the crisis and then reduce it in the expansion. But apart maybe from Switzerland, nobody adheres to this principle. Take France, for example: They haven't had a balanced budget for almost forty years. They don't even know what a surplus is. The same principle applies to monetary policy: It is a disaster that our central banks have pursued a monetary policy that was far too loose during the expansion. This has fueled the excesses in debt. The problem with central banks really starts with the fact that a handful of people think they can control the economy. This is presumptuous. It is this attitude that weakens our market economy system. Recessions are a natural part of the business cycle. Companies who make negligent mistakes must be punished and eliminated. As a society, we have to endure that there are not only fair weather phases, but also recessions from time to time. If we can no longer accept this, then we cannot be saved. Then we will just pave the way to a planned economy with a long-term decline in prosperity.

What grade do you give the central banks for their performance?

For the time before this current crisis, I give practically all central banks a miserable grade. But in the crisis they do the right thing. Well, the Fed's rate cuts would not have been necessary, they are of no use in the current situation. But it is important that the central banks provide credit lines for the entire financial system and inject liquidity. It was extremely important that the Fed opened Dollar swap lines to foreign central banks. These swap lines are probably even too small. China and other emerging economies in particular should receive this lifeline. The IMF will probably have to step in here, because the dimensions of the Dollar amounts required are monumental.

Why is that?

Over the past decade, a huge mountain of Dollar denominated debt has been built up outside the U.S., especially in emerging markets, and particularly in China. According to the BIS, these loans increased from $5.8 trillion to more than $12 trillion between 2009 and 2019. When the crisis hits, short-term loans are often not extended because lenders turn risk-averse. Then debtors have to scramble to buy Dollars in the market. As the Dollar rises, the debt in the debtor's home currency increases, which in turn increases the pressure on them even more. Weak economies such as Turkey, Brazil and South Africa are caught in a vicious cycle. That's why I've been warning for some time about investing in emerging markets, including China. They just have a huge Dollar debt problem.

Do you expect a «Lehman Moment» in this crisis, the collapse of a major market player?

In every crisis there are companies that perish. It won't be any different this time. Given the excessive indebtedness in the corporate sector, one would have to expect some spectacular bankruptcies. But given the speed with which central banks have acted - much faster than in 2008 -, this will no longer threaten the financial system per se.

Is there a risk of a banking crisis?

With so much stress in the financial system, there is always this danger. In this regard, I am most concerned about Europe, because it has the structurally weakest economy and the weakest banking system. With the rigid regime of the single currency, the weaker members of the Eurozone won't have the benefit of a devaluation in their currency. The one factor you have to look at today is corporate debt as a percentage of GDP. In the U.S., this metric is currently at 75%, in Germany at 95%, Italy at 100%, Switzerland at 120% and in France at 200%. I'm worried about Italy and Spain, but I'm even more worried about France and its banks. In the last cycle, the French turned the big wheel in lending and completely exaggerated. I doubt that European banks have enough capital to be able to absorb bad debts. I think a nationalization of some banks in the Eurozone will be inevitable.

Is the Euro at risk again?

The Eurozone is facing an important test. The Euro is a misconstruction. The Northern group has so far – understandably –resisted any communitization of debt. But if the Northern Euro members continue to do so in the current crisis, the weak states in the South will not be able to avoid introducing capital controls. Otherwise they will suffer a flight of capital to the North, and their banks will collapse. If, on the other hand, they agree to a communitization of debt, then the previously strong countries like Germany or the Netherlands will be dragged down by the weak and with them the entire continent. The move to a centralized state economy like in France would then be inevitable, and prosperity would decrease across Europe. The coming months will be crucial for the future of Europe.

What's next for equity markets?

Stock markets are at the beginning of a bottoming process. The packages of measures taken by the authorities support the trust of market participants. This is a process of several weeks, and setbacks to the lows of late March or even slightly below cannot be ruled out.

What will trigger these setbacks?

In April, companies will report their numbers for the first quarter. Then you will see the first concrete signs of the economic damage. The outlook for the companies will be bleak because they have no visibility at all over the course of business. It is also unclear when the debt problems in China and other emerging countries will surface. Both could provoke setbacks in equity markets. Also, should the pandemic curves not flatten out as quickly as we assume today, markets will dive again. Over the course of the coming weeks, we should gradually gain more visibility, and after that a sustained recovery in equities can begin.

How long will this recovery last?

That will depend on developments in the real economy and the behavior of authorities. I would question whether investor confidence and animal spirits will come back so quickly. We also don't know what will happen to the pandemic next winter. I am currently assuming that the greatest damage to the markets is behind us at the moment, that we will continue to see large fluctuations for some time and then stock prices will rise towards the end of the year. My expectations for afterwards depend on new information.

When would you buy stocks again?

If you can live with fluctuations, you can buy during the setbacks in the next few weeks. A lot of negatives are priced in, and central banks support the system. But consider: If you look at the Stoxx 600, the index with the 600 largest European companies, it has largely been in a sideways movement with large fluctuations for the past 20 years. This is a challenging environment, and I expect that to continue.

How do you deal with it as an investor?

Anyone who has successfully tried to identify good stocks has made good money in this sideways movement. And anyone who has managed to time the cycle – something that has been frowned upon in the wealth management industry for years – has also made money. So anyone who has done exactly what the wealth management industry has proven to be unable to do, and which is why it says it is the wrong approach, has been successful. But all those in Europe who have followed the buy and hold strategy as preached by most asset managers and major banks are sitting on poor results. Only in the U.S. did the market manage to reach a new high – but only thanks to the questionable, loan-financed share buybacks of many companies. I doubt that this will continue in the future.

Are you fundamentally negative on equities?

No, absolutely not. When you buy shares of a good company, you purchase a share of productive capital. Good companies can always adapt to the environment and generate more income for the investor over time than a normal fixed-income asset. There are always spurts of one to two decades on the stock exchanges, where stocks can grow strongly thanks to low valuation and a generally benign market constellation. You have to be there. But there are also long periods in which this is not the case, such as during the time between the mid-Sixties and the early Eighties. Today, we are headed towards more and more government intervention and less and less freedom and free markets. This is not a climate for structurally increasing prosperity. And over time, this expresses itself in financial markets. That's why I advise investors to behave opportunistically.

What do you buy when you buy?

The order of my preferences is the United States, followed by emerging markets, and finally Europe. Europe simply has the most problems because the economic area is suffering from the misconstruction of the Euro and the EU. Emerging markets can recover, but it is too early because there are still many problems to be addressed. I have the most confidence in the United States because the economic system there is more free and flexible.

And which sectors in the U.S. do you buy?

The Information Technology and Healthcare sectors have weathered the crash best. These are probably the sectors that will be the focus of purchases in the next upswing. Cyclical stocks will only be attractive again when there is a clear economic recovery.

So would you buy the growth stocks again – the Googles, Amazons and Apples of this world – that were the leaders of the previous bull market?

Yes, certainly with a view over the next six months. Then we'll have to judge what comes next. From this perspective, we are not at the end of a real bear market today, because that would only be the case if the leaders of the old bull market had been discredited and thrown out of the portfolios. We are not that far today. We have just had the longest economic expansion in the history of the United States, and we have had a stock market boom of more than ten years. A cycle like this does not end with a mere month-long correction. A real bear market is only over when no one is interested in stocks anymore. You must feel sick when you think of equities. That's when you know that the right time to buy stocks for the long term has arrived.

What about bonds?

Yields for high quality borrowers have receded under fluctuations for almost forty years. We have now reached the end of a generation cycle in terms of returns. Bonds either have to be sold today or only have short maturities, which no longer brings any benefits in terms of returns. European bonds are most at risk because of the risks in the Euro that I have outlined. I would avoid them.

Is the forty-year bond bull market over?

Fiscal authorities and central banks are running programs that will have an inflationary effect over time. Accordingly, interest rates will rise again, first at the long end and after a few years also at the short. We will have an inflationary economic policy that will drive up inflation but not prosperity. This is bad for normal fixed income investments.

Will this be a favorable environment for gold?

Gold is an unproductive asset. Its price depends on the trust that investors have in the policies of the authorities. I expect the new decade to be beneficial for gold prices because central banks will continue to devalue our paper currencies, and confidence in policymakers will decrease. Gold should therefore be represented in every portfolio.

Do you think the current crisis will change the way investors behave?

I hope so. We should actually know that life is a risk. As a society, as a company and as an investor, you have to be prepared for crises and setbacks. It is clear that our healthcare system was not prepared for such a crisis. And only now do we realize that 70% of the basic elements for the pharmaceutical industry come from China. This is insane. I am a supporter of free trade, but today's crisis shows the fragility of our wide-ranging supply chains. What also concerns me is the short-term thinking of managers who have inflated their companies with debt to finance share buybacks. It is simply negligent. These managers should be fired. There is a lack of personal responsibility everywhere, not just among managers. Our entire society has forgotten how to take responsibility. We have forgotten that life consists of setbacks and that you have to have safety margins for difficult times. We live in a spoiled society where people think they are entitled to a wonderful life. Well, this right does not exist in reality. And the constant cry for help to central banks and governments whenever it rains will gradually cost us freedom and prosperity.

Felix W. Zulauf

Felix W. Zulauf is founder and owner of Zulauf Asset Management, based in Baar, Switzerland, offering investment advice for clients worldwide. He has spent almost fifty years in the professional investment business. He served as a member of the famed Barron's Roundtable for thirty years.
Felix W. Zulauf is founder and owner of Zulauf Asset Management, based in Baar, Switzerland, offering investment advice for clients worldwide. He has spent almost fifty years in the professional investment business. He served as a member of the famed Barron's Roundtable for thirty years.