Zulauf: Keeping the Euro Together Is a Fatal Error

The chance of a new global recession is growing, says Felix Zulauf, one of the most prestigious portfolio managers of the world based on his relevant prognoses and financial success, in his interview to alapblog.hu.

At the yearly conference of the Uhlenbruch Verlag, the Swiss investor summarized his lecture: the inevitable and accelerating devaluation of the Chinese yuan and other Asian currencies will significantly contribute to the emergence of a new global recession. The other reason for the expectable impoverishment and economic erosion is that the politicians do not let the euro fall apart. According to him, a German exit from the Eurozone would allow the European economies to grow and become more competitive. However, until these problems are not realized by everyone, the European Central Bank and other central banks will continue with the easing policies and the investors will allocate more and more money to equities. As a result, the stock prices will increase further, which will last longer than anyone would expect.

Zentai Péter: Do you short the Chinese currency, the yuan?

Felix Zulauf: Absolutely yes. The Chinese eventually cannot escape from their problems through any other way than weakening their currency. In order to maintain their economy, they need to provide liquidity to the system. And this, by definition, will weaken the yuan.

You mentioned in your lecture that soon the yuan would fall by 20 percent …

My estimation is that the yuan will fall by 20 percent in the next two years and probably by even more in the next four-five years. This is a long-term trend. In a very real crisis, the dollar-yuan exchange rate could go back to 8.50 but it will definitely reach 7 yuan/dollar in a short time.

What other asset classes are you and the Zulauf Asset Management focusing on? What else would you recommend to other portfolio managers?

Based on what we see in China, we are not very keen on Hong Kong, on the Chinese banks, and in general, on the Chinese and Hong Kong real estate market. However, the European and American equity markets will stay up and rise ever further due to the high liquidity. We have high speculation, high valuation, and high asset allocation towards equities but we do not have the trigger point that would project a bear market. In order to reach that point, a supreme condition needs to e fulfilled, namely, the tightening of the monetary policy. Right now, the monetary policy is very easy and will be even easier. That is the reason why markets can stay up and go higher for longer than anybody believes. And this will continue until people realize that a huge bubble has been created.

And this will be followed by an economic crash?

We are heading toward a global recession. The structural deficiencies of economies and the low degree of innovative adaptability do not support good growth in the industrialized world.

If China’s growth slows down and as a result, – as you said – the yuan depreciates, the Western economies will weaken even more. Firstly, due to the slowdown, the absorption capacity of the deflating Chinese market will decrease. Secondly, due to the weak currency, the cost of exporting to China will significantly rise.

I repeat: we will have a global recession.

However, this economic downturn will not be like the ones we have seen before. Those recessions were preceded by huge recoveries. This time, we do not have a boom. It will be much more like a slow erosion, a slow decline. It will reach a point where social tensions rise and people riot… And then, the authorities will probably try to restore order through fiscal policy.

You have also made comparisons with the 1930s.
I just pointed out that the euro for the European economies was like the gold standard in the 1930s for the whole world. The Eurosystem puts the same obstacles in the way of the economic reconstruction as the gold standard did eighty years ago: it makes it impossible for countries to devalue their currency. The economic and social interests of the peripheral countries of the Eurozone would require them to freely set the value of their currency. But they have no room for maneuver. Therefore, they have to deflate their real economy to adjust to each other.

The Chinese economy is also under a deflation pressure, which is a result of years of systematic inflation. Now, they try to fill up their excess capacities by cutting prices of traded goods and devalue their currency. And whole Asia will follow this practice. This will put the companies of the Western world under pressure, which will find it increasingly difficult to compete with the Asian firms and will face falling profits.

However, as long as the economies do not weaken to some degree, these problems will not come to surface. Then, all of a sudden, the stock markets will begin to slump.

What is your opinion about European Central Bank cutting interest rates and introducing an easing policy in the future?

What the ECB is trying to do is to weaken the euro. But this is very difficult because the euro is a structural current account surplus currency. This means that there is constant money inflow from trade in the Eurozone, which creates surpluses on the current account and makes it hardly possible to weaken the currency.

We are all familiar with this problem from Japan. The persistent current account surplus has kept the Japanese yen strong and pushed toward higher and higher exchange rates – for instance, against the US dollar – for a long time.

The turning point was the Fukushima catastrophe. When the Japanese lost their nuclear power, they had to import oil and gas, which deteriorated their external account, and ultimately, weakened them into a deficit. Only then were they able to devalue the yen.

So Europe also need as “Fukushima-like” shock?

I do believe that Europe is in a deflation phase.

The best for Europe would be to dismantle the euro. An optimal solution would be if Germany left the Eurozone and the reintroduced Deutsche Mark strengthened, allowing the euro to weaken and to become a deficit currency. In this way, the European economies could become more competitive and begin to recover. Of course, this is politically impossible.

The other gigantic problem that undermines the economic upturn is the huge amount of debt. The first step toward reducing the sovereign debt is acknowledging the problem. That will also create difficulties for us asset managers – as well as, for pension funds and investors – but we have to accept these losses. We are living in a prosperity that is not real. It is a fiction.

Let me quote my words from 1999: “The introduction of the euro is the dumbest decision Europe has made since the Treaty of Versailles in 1919. Europe will feel sorry about it because it will lead to a lot of pain – in the human, social, and economic sense.”

Still, you said that you had even increased your holdings of bonds and shares in your portfolio. This is hardly practical pessimism…

We invest in companies – both on the equity and debt side – that do well even in these difficult economic times . Most of these companies pay little interest. Furthermore, our portfolio includes Swiss sovereign debt, Swiss government bonds.

As an investor, what do you think about the real estate market?

Real estate markets are local markets, not global markets. Any hot place where the wealthy people like to stay is probably in a bubble. That is true for New York, for Saint Tropez, for London, for Zurich etc. At the same time, in the rural areas, real estate is not overpriced in most cases. The real estate bubbles have always been inherent elements of economic cycles, thus, no great significance should be attached to them.

The real problem is that our authorities believe that they can solve the crises by just printing more paper money. The only reason that no inflation is created is that the real economy is unable to absorb so much money; there is a lot of unused capacity. If the companies are already unable to utilize the resources, why would they put more money into new investments? This problem should be addressed by investing in infrastructure: building roads, railroads etc.

I am convinced that we will be poorer in ten years’ time.

Here in Europe?

Everywhere. Zero growth, stagnation, riots – all over the world.