Interview (excerpt) by “The Market”, NZZ
Felix Zulauf: "We Have Created the Biggest Excesses In Generations"
When things get turbulent in financial markets, experience is required. Felix Zulauf has experienced many boom and bust cycles in his almost fifty-year career as an investor and market observer. He is a harsh critic of central banks. "We have forgotten that recessions are a natural part of the business cycle", he’s said.
In the following in-depth interview, Felix Zulauf explains how the downturn (after the onset of the current crisis) 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", Zulauf said.
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.
"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
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.
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.
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 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.