Stock market crash and deflation at hand

Dieter-WermuthOne of the most prestigious German market strategists and fund managers Dr. Dieter Wermuth sees a promising investment opportunity in Hungary. He buys and recommends buying Hungarian forint, Hungarian government bonds, and Hungarian stocks.

The co-founder and majority owner of Wermuth Asset Management – having its head office in Mainz and managing ten billions of euros in total – and the former investment strategist of Citibank, WestLB, and other leading European financial institutions, says in his interview to that it is worth buying assets, mainly, government bonds in countries where the national currency has devaluated in the last few years, where the stock market has declined significantly in the last months, or where state-owned or stated-controlled monopolies exist. Russia, Turkey, and partly, Hungary are countries like that.

He accounts for the shift in his investment strategy by the deflation threat in European economies which are free of monopolies and state intervention.  Inflation plummets dangerously because a price war started in non-manipulated, free markets.

The interviewee points out that as much as every asset manager look forward to the strengthening of the dollar, they should not hope for it since the opposite would be the case. In two years, the euro will strengthen up to $1.50.

Zentai Péter: You seem to be one of the most pessimistic market strategists: you have warned against the forthcoming deflation in the weekly „Die Zeit” and the daily „Die Welt” for months. As the economies – especially, in Germany – have started to grow, I do not understand where the threat is being…

Dieter Wermuth: Growth is very fragile in the Eurozone and in the whole European Union. The national economies, the producers, and the consumers, of course, are still far from recovering from the severe economic downturn of 2008-2009.

Things might easily get out of the hand of European Central Bank, if my fears are realized and the inflation rate goes into negative territory. The ECB benchmark interest rate will remain at around 0 percent, however, the inflation rate might fall to negative 2 percent. This scenario is quite realistic.

At the moment, the inflation rate is 0.7 percent in average in the EU with a base rate of 0.25 percent. So there is no deflation and some indicators also predict economic growth – especially, in Germany. It seems like we are out of the woods. Why are you still worried about deflation?

When I say that we have not recovered from the crisis of 2008-2009, I am speaking about the huge capacity oversupply. Even if little is spoken about it publicly, this is one of the most severe consequences of the dramatic crisis that started five or six years ago.

A significant part of the available assets, technologies of the agricultural, industrial, and service sector are still unused.

At the same time, consumption is stagnation due to high unemployment rates, hitting whole Europe.

As a result, the economic players do not have the power to raise prices. Instead, they are forced to enter a price war. Whether we deny it or not, there is a price war going on within and between the market economies.

Based on historical experience, a constellation like this is the opening act of every age of deflation.

What is your argument about the price war based on? Could you give me an example?

The car industry is a typically a “war-torn” area, as well as, the food industry. The German trading chains have been operating with the smallest possible margins for a long time; they constantly have to undercut each other’s prices.  Price war is everywhere where there are no monopolies and the market economy is functioning properly – in other words, in economies that are not manipulated. Economic areas ruled by monopolies do not engage in price wars…

Let me get this straight! The only way to stop deflation is stopping capitalism? If free competition was hindered and state intervention was introduced? Such attempts are made in made countries, including mine. Does that mean they are doing the right thing? Do you think that we would benefit from socialism these days?

Of course, this is absurd. However, it is a fact that those countries which want to introduce monopolies or which already run some – for instance, Russia, Venezuela, Argentina, or potentially, Hungary – do not face deflation threat. In developed, capitalist countries, this idea is plain absurdity; one cannot simply change the nature of a real capitalist economy…

What actions should be taken by the Eurozone and other developed, capitalist countries that are rejecting the restriction of free trade in order to prevent deflation?

First of all, the ECB benchmark interest rate should be reduced to zero. Furthermore, similarly to some Scandinavian countries, the ECB and the national central banks should pay negative interest on the excess reserves of commercial banks that are kept by them.  We need to make sure that banks lose if they just store money instead of putting it into the economy.

Secondly, we should to introduce quantitative easing (QE) in Europe as the Americans did. New money should be pumped into the economies and drastic bond-buying programs should be launched.  In this respect, the main condition would be the introduction of Eurobonds which would be guaranteed by all of the 18 Member States of the Eurozone. Unfortunately, this cannot be realized this due to international and sovereign legal obstacles.

In your lately published articles, you projected a stock market crash. On what score?

On the score that shares are incredibly expensive. In the last two years, stock markets in the United States and in Europe have increased by 50 percent on average. In contrast, company earnings have risen by 6 or 7 percent in the same time. The time is definitely nearing when the market will finally focus on the poor company earnings and, as a result, prices will substantially fall on the capital markets.

The markets were way too optimistic on the growth opportunities of both the American and the European national economies. And they priced them accordingly. I think that people will soon awaken as while consumers and households in the Eurozone are still heavily indebted, the United States is dutifully paying off its debts.

In such circumstances, they cannot count on high levels of consumption, only on high levels of unemployment. The nation states – due to their obligation to reduce their debt – cannot afford to effectively rev up their economic engine since they would fall back into a debt trap.

So what will you do? What will your coworkers, the fund managers do with the billions of clients?

We are primarily buying bonds for our clients. For instance, Hungarian governments bonds – even with a maturity of 10 years. There is no inflation and, at the same time, the Hungarian securities yield more than what is achievable here. We usually buy securities of markets or of governments whose currency has significantly devaluated recently. This has already happened to the forint. Another aspect is that the given market is already past price drops and crashes – like the Russian, Turkish, Indian, Brazilian, or Argentinean market.

It sounds like you were “fishing in troubled waters” from the outset…
From a market point of view, we do not consider Hungary or Russia as “troubled”. However, certain monopolistic positions exist that ensure dividends and its predictability. This applies particularly to Russia. We like to buy the securities of Gazprom. Once again, these days, the stocks of monopolies – promising high dividend yield – seem to be a good investment to our asset managers.

The other day, in one of your articles, you urged the German government to maintain high energy prices. This proposal contradicts the other one, namely, that the states should make every effort to stimulate the economy…

High energy prices result in a more efficient use of resources by companies and domestic consumers and the rationalization of production. It also ensures that larger investments are made in technologies and in renewable resources that would create jobs and stimulate infrastructural modernization. CO2 emission – including CO2-based transport, shipping, and production – should be punished by much higher taxes.

Shouldn’t the government, such as in Hungary, reduce the utility prices in order to increase consumption?

On the contrary! By reducing utility prices, people are encouraged to consume more, which hinders the renewal of the energy sector that would stimulate the economy.

What is your opinion about the foreign exchange markets? Do you believe that the dollar will appreciate?

I do not think so. The fact that everyone – at least the experts of the forex markets and the overwhelming majority of the bankers – have been predicting the weakening of the euro versus the dollar for years but it has never occurred should serve as an omen.

The reason is that nobody takes into account the huge gap between the balance of payment of the European Union and the United States. The EU – together with Norway and Switzerland – has a larger balance of payment surplus than any other economic region. The balance of payment of the U.S. is, however, weak.

Of course, we have some dollar securities but only because of diversification. I tell my clients that they should rather expect that the dollar will weaken to 1.50 per euro in the next two years.

If this is true, the United States becomes an even more attractive, cheaper capital market…

The faster pace of growth of the American economy (compared to Europe) is already “encoded” in the markets. The capital market of the U.S. is already more expensive than that of Europe. The European stocks trade at a P/E ratio of 14 in average, compared to 18 for the American stock market. (The Schiller P/E ratio does not indicate the actual value of the markets but the inflation adjusted earnings of the last 10 years – Ed.)

Furthermore, the euro will strengthen because an increasing share of the market players start honestly trusting in the survival of the currency. The soon-to-be-established European banking union and integrated banking supervision will also reaffirm this belief. As an inevitable next step, the market will price the exchange rate of euro based on the expectation that the Member States will jointly guarantee euro-area government bonds. Ultimately, Eurobonds must be introduced.