About this week’s show:
- Individuals can hedge, but you can’t hedge the entire system
- In an ideal free world, gold would be the ideal currency
- The Euro will break, and it will be a chaotic process
About the guest: Felix Zulauf; born 1950, is the owner and president of Zulauf Asset Management, a Zug, Switzerland-based hedge fund, which he founded in 1990. Zulauf Asset Management has $1.7 billion assets under management, according to MacroAxis. Read more on his blog: http://felixzulaufblog.blogspot.com/
The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
“We can only accept a certain overvaluation. When the overvaluation goes beyond a certain limit, we cannot live with it. If you have a shock by increasing the value of your currency by 30 or 40% in a short period of time, then you have a serious retraction, and you could even destroy economic structures, and that is what we cannot tolerate.”
– Felix Zulauf
Kevin: We have a guest today, David, that our listeners requested back. After hearing the show a few years ago, we had listeners who said, “When are you going to have Felix Zulauf back?”
David: When I get a chance to look at Barron’s magazine, I read it cover to cover when they do their round table; that is twice a year. For 20 years Felix has been one of the members on that round table, along with Abby Joseph Cohen from Goldman Sachs, Mark Faber, Fred Hickey until recently, we will miss his contribution. But they have a variety of opinions. It is always interesting to me to see the difference between those with vast international exposure and experience, those who live elsewhere, and those who are in the U.S. Those who are in the U.S. usually speak with one voice, and I think Fred Hickey is sort of a standout who has a different opinion on many different things.
But this Barron’s round table discussion – the two voices that tend to stand out today are Felix Zulauf and Mark Faber, and I love reading their comments. Their analysis usually runs against the grain, not for the sake of being contrarian, but because they are thoughtfully engaged on a regular and routine basis, and I appreciated the honesty and the integrity that they bring to the process, constantly reappraising their assumptions and the world that we live in.
Kevin: One of the things I appreciate is they don’t seem to be struggling for position in that round table. They are very humble and I think about Felix. Felix doesn’t make any bones about the fact that he is not trying to predict the future. In fact, he says he really can’t.
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David: Felix Zulauf – a number of our listeners directly contacted us to request you as a guest, once again, for the Commentary. William White was the last voice we heard from Switzerland. Now, your perspective is a little different. You are a veteran trader, an investor for more than 40 years, and twice annually, of course, you can be found in the Barron’s magazine, the round table discussion, with other investment luminaries, and that is where our listeners could find you, as well. It’s good to have you back on the program again, although it has been many years since you’ve been on the program.
One of the advantages of four decades’ experience in the field of economics and finance is that you’ve seen cycles come and go, you’ve seen fads come and go, you’ve seen ideas gain prominence and then be proven either correct or discredited. Let’s start, if you will, with an overview of the current ideas and trends which are commonly believed, but which may lack credibility to a man of your experience.
Felix: Oh, that’s a big question that covers virtually the whole spectrum. You know, the interesting thing is that when you live with markets for such a long time you go through different phases, different periods where different things really counted in the markets. And there were periods when you could use certain formulas that worked and all of a sudden you enter a new era where the old formulas don’t work anymore. For instance, in the 1970s, we had the inflation problem, and we had the breakdown of Bretton Woods, and that distorted what used to be a stable environment in the ’50s and the ’60s. And in the ’80s and part of the ’90s, authorities used primarily fiscal stimulation to get the economy going, and you had the buildup of debt, and actually, with Greenspan came a new era, that was monetary stimulation. And monetary policy most of the time was always too easy for too long, and that gave that another kick. And we seem to have run out of certain stimulation for the world economy because all of a sudden all these things do not work anymore.
In the last few years we have gone through the biggest stimulation effort in history, in terms of monetary policy and at the beginning in terms of fiscal policy, and what you see today is a really lackluster global economy that is growing at very low rates, probably the lowest outside of a recession, certainly in nominal terms. And despite all the monetary stimulation and money printing, you have inflation rates heading south, and we have gone through inflation cycles now, actually, since the 1970s where you have always lower highs and lower lows in the cycle, and we used to call it disinflation and now we have many economies seeing inflation rates in negative territory.
And as monetary policy doesn’t work the way the authorities expect it to, they have obviously gone to the next stage, and the next stage, what they are using today is currency devaluation. The U.S. always used it as a weapon to help her economy, and then the Japanese came on in the fall of 2012. Now, the Europeans are on it, and the other Asians are beginning to devalue their currencies, not aggressively yet, and probably it will all end once the Chinese kick in. That may be down the road another year or so. So, we are trying that road, and that road won’t work either, because it will work in the very short term for those who devalue decisively, but it is not going to work for the world in total because the more aggressively one trading block devalues, the more deflationary pressure that introduces into the global pricing system.
And that’s the problem we have today. In U.S. dollar terms, we have globally priced manufactured goods down 10% year over year. That is something you only see in major economic crises, actually. Maybe the number is a little bit distorted because of the high-flying dollar up until recently, but still, it shows you that there is more deflationary pressure in the process at work than anything else, and one has to wonder what comes after currency devaluation when the world ends up in a crisis or in a recession and what will authorities use next? And I do not know the answer, but I doubt that all the big players are going to accept, over the long term, that others are going to aggressively devalue their currencies, and let them walk away with that.
And therefore I think you will have a situation globally where the geopolitical process is going to deteriorate. I think we see signs of that already. I think the trading blocks are rather, politically speaking, moving apart from each other, and not closer together, so I think it is deglobalization, to some degree, that we are seeing, and we do not know where that leads to. And that brings on all these questions of what works in the markets and what doesn’t, and what will the authorities do next? Because in today’s world it seems that, like in the 1970s when on Thursday afternoons everybody was running to the ticker-tape to see what the newest M1 and M2 and M3 numbers were at that time, and they took a clue from there for the market for the next few days. And today, it is all monetary policy again, but it is a completely different dimension than it was at that time.
So, I do not have an answer, I just think we are going through cycles, but the eras that we have lived through in the last 40 years have been changing, and I think market personality has also been changing. And I have been a deflationist since the early ’80s and I discussed that with Alan Greenspan at that time, before he was Fed Chairman, on a regular basis. At that time, that was a very unpopular topic, because the world was fascinated and focused on inflation problems, and now we are here after more than 30 years of declining inflation rates and declining interest rates, and I would never have believed that I would ever see negative nominal bond yields for government paper of longer duration.
And here we are, in the euro area we have virtually two trillion euros of government debt that offer a negative yield, and 10-year governments in Switzerland are in negative territory and I expect German bund yields to also fall into a slightly negative territory over the coming months. So, it’s a completely new setup, and when you have virtually zero yields, or negative yields, you are pricing all sorts of efforts of those yields and interest rates. And that is, obviously, distorting. And you know the effect when you go from one percent to half a percent, that virtually doubles your PE ratio, so to speak, in a way. And the whole question then is, how long can this go on? And I do not have a firm answer on that.
I think we are now six years in this bull market. If I am not mistaken, the U.S. has never seen a bull market longer than six years, so maybe we are going to set records, but the risk is that sometime later this year, we will have a bigger shake-out than most expect, at least in the U.S. market, brought on by the currency changes of late, and what it all means for copper profits, because as long as you have an economy that struggles along in positive territory in gross weights, and as long as you have earnings not falling apart, you can inflate equity prices to unbelievably high levels. The problem probably arrives once the market realizes that maybe the fundamentals are not as expected, and then the problem may start.
I am not sure we are there yet at the end of a bull market in equities. I doubt that, but I think we could have a big shake-out in the U.S., probably less so in Europe, because Europe is now in a similar situation to Japan in 2013 when they started the aggressive QE, and the money that is printed cannot be taken up by the real economy for structural reasons, and therefore it stays within the financial economy. And as it stays in the financial economy, it inflates asset prices and it continues to inflate asset prices until something gives. And that something could very well be corporate earnings.
So I think in the U.S. we have the problem of multinational corporations headquartered in the U.S. and reporting in U.S. dollars, that all of a sudden the overseas earnings are worth less and we could end up with negative or declining earnings for this year as a whole for the S&P 500. And that could shape the market somewhat. In Europe, it is just the other way around. I think there the earnings are going to surprise on the upside. And you have to keep in mind that usually multinationals operating worldwide do have a foreign exchange hedging program, but they usually hedge only part of what is out there, and usually they are on a 12-month hedging schedule. And we have now had a little bit over nine months of strong dollar move, so I think we are coming to the point where it begins to bite in the earnings of the corporate sector, and therefore the surprises in the U.S. will be on the negative side, the surprises in Europe are on the positive side, and you see that also in Japan where the surprises recently have been on the positive side. So, it’s an interesting world.
David: It’s an incredibly interestingly world. Niels Bohr, one of the great physicists of our day, commented that prediction is very difficult, especially if it is about the future. And that’s where we find ourselves, looking to the future and saying, “Well, we have new monetary policies that are being pursued, and we have this sort of economic forecasting and portfolio construction which assume a certain degree of freeness in the marketplace.” I wonder, to what extent have the central banks of our day, led by Draghi, Bernanke, and now Yellen, Kuroda, Carney and others – to what degree have they suspended cause and effect via monetary policy and limited that freeness element in the free market leading to us to something more of a command and control environment?
Felix: Well, I think that is good point that you are raising, and monetary policy has been a contributor to our whole system moving more and more away from free market systems, but it is not the only cause. There are political developments when you have gone through a period of long prosperity, the political process likes to distribute that prosperity in a different way, and we go to more government intervention and more redistribution. And then we had the belief that we wanted to smooth the business cycle because the down part of the business cycle is very unpleasant.
And the interventionism has grown bigger and bigger and bigger, and it is putting the free market society out of order. It cannot function anymore because it is not allowed to function. Had we allowed free markets to function, we would have had our serious recessions along the way, but structurally, the world would be in much better shape. We would not have the high debt burden. We would not have the deflationary problems. We would not have inflated asset prices that make the upper class richer and richer and the lower class relatively poorer and poorer.
So, I think this whole belief in interventionism has really created a much worse world for the vast majority of people, and that is the bad thing. Free market and free spirit ideas, unfortunately, lost their power and lost their attraction for politicians. And that’s the sad part. I don’t want to elaborate more on that because that’s a pretty sad story because that’s not very bright future for the longer term. I think we are moving more and more into a command-style economy with the free market part shrinking and the government share and the controlled part rising. And that, by definition, will lead to a situation for the masses of people that means less prosperity, harder work, less good life, more control, less freedom.
And maybe it’s because I’m getting older that I see these things that way, maybe it’s not, I don’t know. But I’m not very fond of these trends. I don’t like them. I think it’s the completely wrong mindset that our politicians are applying to the system, and I would have loved to have seen them apply more free spirit, more free market thinking, and less interventionism. It’s very clear what they had to do to get out of this mess. Nobody talks about it. Not even the investment community talks about it, and not even economists talk about it. All they had to do is reduce the red tape in our system dramatically on a step by step basis, and they had to reduce the role of government dramatically on a step by step basis.
And this would, of course, in the short term, be negative for the economy, but that could be counterbalanced by infrastructure investments that our economies need, over there in Europe, and over here in the U.S., and also in Japan. And all you need is, really, the right mindset, a program, and the will to execute, and unfortunately, our political process is so short-sighted that we don’t do what is necessary and therefore we cannot exit that messy situation. Because a lot of people, particularly in the upper class, benefit from what is going on, at least in the short term, not in the long term. But when you do well, who complains? That’s human nature.
David: We talked about smoothing the business cycle earlier through monetary policy, and over time it seems that leverage, also, is a part of what has kept growth on track. But we also believe as leverage has grown, that total systemic risk is reduced or offset by hedging, reinsurance programs, spreading the risk around via derivatives. What are we failing to imagine, which might, in fact, be the greatest issue or cause of instability over the next several years?
Felix: An individual, and individual corporation, even an individual country, perhaps, could hedge some risk, but the risk of the system, as a whole, cannot be hedged. You have to be aware of that. And of course, it is human nature that wants risks being hedged because nobody wants to live with high risks. But the more we hedge risks, and the more we believe that there are no risks, that means the bigger the systemic risk will eventually become. An example is all the managing of the business cycle. You know, we really succeeded in flattening and smoothing the business cycle. In the last 30 years it has been smoother than at any time before. However, we did so at the cost of building up huge systemic risks and imbalances. We have never had a debt situation like the current one.
When you look at global debt, how it has jumped over the last 15 years, it has more than doubled, global debt outstanding, it’s unbelievable. And I have nothing against credit, but you have to differentiate between productive credit and unproductive credit. Productive credit is when you make an investment, and that investment pays a return, and out of that return you can amortize your debt and you can pay and service your debt to pay the interest, and at the end, you still make a return on that investment. That’s productive credit. Unproductive credit is, you just spend it and you consume it, be it for consumption, a car, or a vacation, or heating, or whatever – you just consume it, and the debt stays there.
And that’s the problem we are in. Most of the government debt today is unproductive debt. Most of the corporate debt is productive debt, but not all, because corporations do make wrong investments, and then they have to write it off. Most of the private household debt is unproductive debt. So, the degree of unproductive debt and the size of unproductive debt in today’s economy is just mind-boggling. And it is a restraining force. Even at these low interest rate levels, people always say when interest rates are so low you can afford more debt.
Well, mathematically, that is true, but you have to understand that every individual has a capacity limit of debt. And I think more and more individuals and economic subjects in the world are hitting that capacity limit and cannot go beyond. And once you hit that point, it slows down economic growth. When you combine it with the aging in the demographic statistics, then you are destined to grow at lower and lower rates in the future. And that’s where the world economy is, in my view.
It’s also important to understand that it’s not just Europe and Japan that has bad demographics. The U.S. has much better demographics, but the emerging economies, the emerging markets, have very bad and deteriorating demographics, too, except for the Muslim states. But Korea, Taiwan, and China have very bad demographics. So, if you combine debt with demographics, you have very slow growth, and what our policy-makers want is, they want to go back and bring our economies back to growth rates that prevailed in the 1980s and 1990s where the world was able to assume more and more debt, and therefore exaggerated final demand. And if you try to do that, it is a useless undertaking because you rather distort the whole economic system.
David: We have the transmission mechanism, if you consider the monetary policy that is in play today. You mentioned this earlier with Europe, where money is staying in the financial economy. It’s not going into the real economy. We have seen the same thing in the U.S. And it appears that the transmission mechanism for monetary policy is broken. Perhaps this is a combination of reaching capacity limits for debt and demographics combined, yet the government continues to assume that more debt is just fine. In spite of not having exponential growth in the economy, we are continuing to see an exponential growth in liabilities.
And the question of timing – how long can that continue? Is this something that continues on for decades? Is this something that continues on for years? Months? What are the natural limits, particularly when you have a printing press? We know what the natural limits are for an individual or a corporation, you will find that priced into the marketplace very quickly. But if you own a printing press, how long can you forestall those limits?
Felix: That’s a good question, but I doubt I have a good answer to it. We always worry, and personally, I’m a worrier because I bought my first shares in 1968. That was just about near the peak of the secular bull market, and I learned my lesson, and then from 1968 to 1982, which was a long stretch, and in the professional formation of an individual like me, that was a dominating part, and markets were going up and down and up and down without any progress. But the progress was in the real economy. It seems today just the opposite. The progress is not in the real economy, rather more in the financial economy. So, we always worried, and I always worried how long this was going to continue, and it seems that there is always another rabbit they can pull out of the hat. I do not know.
What I do know is that we could enter a new era. As I explained at the very beginning, I think the next era could very well be an era where the controls increase substantially, and that could include capital controls and things like that where we are moving more and more away from what a free economic system used to be the case. It doesn’t mean that markets have to be bad. Look, in recent years, in the last ten years or so, the best stock market in the world was Venezuela. And even in dollar terms, it was the best stock market in the world.
But, would you really have liked to invest in Venezuela ten years ago in the real economy? The real economy is a mess. It’s a dramatic mess. And it’s a controlled situation. The people cannot take the money out of the country. So it creates the imagination that everything is fine because the stock prices go up. That’s wrong. I think, looking at stock prices, and taking that as a guide in which direction future prosperity goes, is the wrong way of looking at it. Venezuela, obviously, has high inflation, but even adjusted for inflation, it has been a pretty good performance. Why? Because the money cannot go outside of the country, and they print money, and therefore the money has to go somewhere, and it inflates stock prices.
Now, this continues until it doesn’t anymore, and then you have a currency reform, and then you can start anew. Will that really make you rich, and wealthy, and prosperous? I doubt it. And my fear is that some of the industrialized countries could, over the next 20-30 years, move into such a situation. That is my biggest fear. Because it would be terrible, particularly, for our children. I could live with that, but I think, for our children, for the generation of our children, it would be horrible. And that’s why I’m criticizing, wherever I can, what policy-makers are doing, when I think it’s wrong.
David: When you say that it’s not the real economies that are driving prices, it seems that, to some degree, if you have two nickels to your name, you are being forced to become a speculator. We turn to currencies really quickly and one of the assets which are the charge of central bankers is currencies. We are seeing massive currency volatility over the last six to 12 months. What, in your opinion, is driving the dynamics within the currency markets and the current volatility that we are seeing?
Felix: Well, obviously, it is the difference in the structural and cyclical setup of different economies, and the application of different policies in those economies that raise the value of exchange rates. And we have seen the U.S. in a terminal stage of QE and perceived terminal stage of low interest rate policy and approaching the point of normalization, as they call it, and we see, at the same time, that the Europeans go one step further, and enter a more aggressive period of monetary policy easing and quantitative easing and creating new money and buying bonds at unbelievable quantities. So, this difference, obviously, is an important factor in driving currency values.
And then, it really depends on what the setup is, how market participants are positioned before you go into such a situation where major changes make exchange rates move. And the setup here, and you have to go back a little over the last ten years or so, we have come out of a period where the U.S. central bank was the most aggressive in monetary easing and money-printing, and they made the U.S. dollar very cheap, and therefore created a situation where the U.S. dollar was used as a funding currency worldwide, outside of the U.S. And when you look at the quantities of debt created, denominated in U.S. dollars, outside of the U.S., it’s pretty mind-boggling.
The emerging markets, alone, according to the BIS statistics did it on a basis of about 6-7 trillion U.S. dollars and the total, according to BIS, or the latest number I have in mind, is about 9 trillion, so I would assume that it is at least 10 trillion, if not more, U.S. dollar-denominated debt outside the U.S. And as long as the dollar is stable, or weak, that’s fine. The problem arrives when all of a sudden the dollar begins to rise, as it has done since the middle of last year, and rises dramatically, due to the cyclical shift in policies among two major blocks. And then, obviously, for those indebted in U.S. dollars it means that your debt on your balance sheet is growing every day. And that is an unbearable situation and it resembles the position of a short position.
And therefore, those have to do something about it and they have to cut losses short by hedging, by closing positions, and I think part of the outstanding 10 trillion has been done, but that is probably a very small part. I think a bigger part is still ahead. So, I doubt that the recent dollar run is all there was. I think we are now going through a correction, and that correction could last several months, and it will be justified by softer U.S. economic numbers that will come along, and that is going to be justified, and the correction is all about repositioning by the speculators.
I think you will see that the real dollar debtors out there, those who are short the dollar, they will use this correction to reduce their position, and that will support the U.S. dollar, and that is why I think the correction of the U.S. dollar will not be very deep. It could be lengthy, several months, but it won’t be very deep. I think it could be, if I had to guess, I would say about 7% from top to low, but several months in duration, and after that, I think the structural forces of that dollar-denominated debt out there, will continue to push the U.S. dollar higher.
Because when you look around in the world, what currency would you really like to have your capital, your own wealth, denominated in? Would you like to have euro? Can you really trust that currency, which is artificial, and tries to combine 19 structurally different economies with one set of monetary interest rate and foreign exchange policy? That doesn’t make any sense. The history of monetary unions is not a good one. They virtually always break apart.
David: So you see a competition for safe havens, of sort, between the Danish, Swedish, Swiss, and U.S. currencies?
Felix: Well, the Danish krona is linked to the euro. It’s not an official peg, but it is pegged to the euro, and they will try to keep it that way. The Swiss franc is a special situation. We tried to cap the strengthening of the Swiss franc with a cap at 120 euro, Swiss franc at 120. And once the ECB decided to go on this QE program, the Swiss National Bank had to remove that cap because you cannot have an economy that is doing relatively well, Switzerland, have the same aggressively expansive monetary policy as the ECB, and therefore the decision was right. I would have done it a little sooner than that. I would have done it a year ago or so.
So, the Swiss franc will remain a strong currency, but we can only accept a certain overvaluation. When the overvaluation goes beyond a certain limit, we cannot live with it. We can always live with an overvaluation of, let’s say, 15-20%, and against the currencies of our major trading partners. And the euro zone is our major trading partner, and Switzerland’s export industry, which is virtually half of the GDP, really depends largely on that. So, we can live with a 15-20% overvaluation because it forces us to keep becoming more and more efficient, more and more productive, to constantly move up the value chain and move to more value-added industries and services and products, and that is very good for the prosperity of the vast majority of the people.
But, if you have a shock by increasing the value of your currency by 30% or 40% in a short period of time, then you have a serious recession and you could even destroy economic structures, and that is what we cannot tolerate. And therefore, I said a few years ago when we had the problem with the Swiss franc strengthening, I said there is no way for Switzerland to escape currency control. Eventually, they have to introduce currency control. It’s such a small currency market, it’s such a tiny country, and if the world all of a sudden decides, “We want to own Swiss francs,” it destroys our economy, and therefore we can only live, I think, in today’s world where things are so out of balance everywhere, we will eventually need currency controls. The Swiss National Bank has not done it yet because they don’t want to go into a currency control situation, but I think there is no escape in the medium term. They have to introduce it.
And that is another important point brought up. If we enter an era in coming years of more and more currency controls, you have to decide very early where you want to be with your capital, because all of a sudden it could mean that when currency controls are applied, you are either locked in, or locked out, of positions you want, or you don’t want to be. So, you have to make your decision very early and think about it, where you really want to be with your capital.
David: A question, because obviously last year gold performed well as a currency. That’s the elephant in the room. Where do you want to be with your capital? Gold is something of a transnational currency. Or do you think that that would fall under the controlled elements that we have described, in the context of deglobalization and politicians trying to control more and more, capital controls, a return to what we had in the ’80s and ’90s being something that we will see in the future? Do they begin to control the flows and pricing of gold, as well, as a means of making sure that you don’t have capital mobility?
Felix: In an idealized free world, gold would be an ideal currency, because it has no debt, it is not mismanaged, and it is available at relatively limited quantities, and you cannot create them overnight out of thin air. So, it would be an ideal currency in terms of storing your wealth, but we don’t live in a free and idealized world, and I think, eventually, gold will fulfill its function that it lends you protection against mismanagement by politics and policy-makers. But the question is then, if it does give you the protection by, let’s say, rising dramatically in price, does one really believe that you can walk away untaxed from such gains that are your hedges against bad policies? And there I have my doubts and reservations.
David: We’ve talked a lot about the liquidity in the emerging markets and the debt that has been developed there, six to seven trillion just in the last decade or so. It brings to mind the crises of the last several decades, Mexico in ’94, Asia in ’97, Russia in ’98, Argentina in 2001 and then again more recently. What does the world look like with the U.S. running smaller trade deficits, and emerging markets no longer accumulating surplus dollars at the rate we have witnessed in the recent past?
Felix: Well, actually, the trade deficit is part of the current account deficit and you have to look at the current account deficit, because that is the channel through which the U.S. supplies dollars to the rest of the world, and through trade and services. And that current account deficit has been shrinking over the last five or six years or so. That means the U.S. has supplied less and less dollars through this channel to the rest of the world, and therefore there is, probably, some sort of temporary shortage, so to speak, because, as I explained before, the world has brought itself into a very large short position of U.S. dollars, and when you then tighten, or restrict, so to speak, the supply of U.S. dollars, as has been happening in recent years, you all of a sudden bring the dollar to an eruption and that has happened over the last nine months or so.
I saw that very early. I pounded the table in early 2014 and I said it again in mid-year 2014, and again in January of this year, so I think this is a cyclical bull run of the U.S. dollar. Whether it is the beginning of a structural relative increase in value versus other currencies over the long term, I do not know. It’s too early to tell. I just want to get the cycle right, and then we’ll have another look when I think the cycle is over. It’s not over yet. It’s just a pause, and it could be a lengthy and choppy pause, but it should continue thereafter.
David: It seems like the cyclical bull run on the dollar is something that not only shrinks global liquidity, but does reinforce a deflationary trend globally. Does that cause our trade partners to look very differently at the dollar system, the dollarized world that we live in?
Felix: I think they do not have the time to have a closer look at those issues. They are so messed up in their own local and regional and national situations that they do not have time to really think deeply about the structural issues and the longer term. The only ones who do that, I would say, are the Chinese, but they are also in a delicate situation as their economy is slowing down and will probably slow down for several years to come.
David: The Eurozone is something that you live with, living most of your time on the continent, and near to it. I wonder, what does the Eurozone look like in five years’ time? Does the EMU even exist in, say, ten years? And who is likely to move back to an independent currency? Greece? Spain? Italy? Portugal? France? Germany? Could we go back to the old deutschemark, or is that really what the euro has become, a proxy for German credit?
Felix: The fact is, the euro requires a higher growth for even the weakest members, because if you do not get higher growth to improve the economic situation of the people, and you don’t give them jobs, and you don’t give them income that makes their living more bearable and better, then you run into a political problem. Interestingly, the more a trading block like the Europeans go for devaluation, most people don’t understand that, the more they do so, the more they create more pressure in the intensification of the deflationary process of the global economy.
And that means, paradoxically, the more they inflate, the more deflation the world economy will eventually suffer, and the more intense deflationary process we have, the higher the risk is that the weaker members of the Eurozone cannot cope with the economic framework they are in, and therefore, strangely enough, what Draghi does, and he doesn’t know it because nobody explained it to him, the more he does what he is doing, the higher the risk that the euro will break, because the weakest members will not be able to bear it and to live with it. And therefore, I would say that within the next 5-7 years, I expect major changes in the euro. I do not believe that it will break apart just in one day and then it’s gone. I think it will be a process, and it will be a chaotic process, because the best thing would be to have a plan and then you can control the process.
If you have no plan, and even worse, if you are completely against it and you fight it, and it’s taboo, the more disorderly and the more chaotic the process will be. And I think Greece will eventually default, maybe not this time, maybe they can walk away again. Maybe they get the money from the Germans with which they can pay back the Germans. But eventually, Greece will default. When they default, they have to reform and restructure. When they restructure, they need to be competitive and to make it work they need a cheaper currency. They need a central bank to finance a new start, and the ECB will hardly be the financier for that.
And therefore, I think once Greece defaults in coming years, at that time Greece will not be able to stay in the euro, and they will exit, and that will create the prejudice for others, and others that are at risk, of course, are the obvious candidates – Portugal, Spain, Italy, and then the big question mark is France, because France cannot live inside the Eurozone for long in the current setup. And then, all bets are off. It will be chaos. Probably, they will try to save it in a smaller version, you have a few exits and things like that. But that will not be very pleasant, and it will be the result of a bad idea, badly introduced, badly run, and badly managed, and that is the price you have to pay for that.
David: The majority of our conversation today, Felix, has been about economics and finance, and we have ventured into a little bit of the social and political consequences. As we wrap up, we want to, if you would, look at the war cycle. Is there an overlay with the war cycle, for the current economic and financial picture we have just described?
Felix: Well, I’m not an expert on that, but when I look at the longer-term cycles, every second decade of the last 800 years there has been a major war, and you have shorter cycles of war activity, and all of those are pointing upward, and we have seen more conflict erupting recently, even in Eastern Europe, and I doubt that is over. Putin wants to rebuild part of the Soviet Empire, which I understand from a national point of view of the Russians. The Western Europeans have expanded their territory. The NATO block and EU block have expanded eastward. That creates conflict, of course. We have China rising economically and also militarily. I see that in the defense industry the Asians are the ones that are rebuilding their strategic defenses. They are spending more and more money on it. They are very concerned about it.
So, whenever you have a situation where you have slowing growth for structural reasons, where you have declining prosperity for an increasing part of the population, you run into the risk of conflict because the people are dissatisfied, and they request changes, and some dumb politicians could use others as scapegoats for their own mistakes, and then you have a problem. So there could be more conflict ahead, but I am not expert enough to forecast them, really. I just think that we are entering a new era and the world will not be as it used to be in the last 20-40 years. It will be different, and I am not sure it will be more pleasant.
David: I know we concluded with that thought on the war cycle, but an abbreviated version of what you have done with Barron’s roundtable, not in terms of specific calls, but general asset classes, if we are moving into a new era and the last 20-40 years cannot be presumed to be the context we are in today, where would you want to invest, say, with a 12-month timeframe, or even shift gears completely to say, a 48-60 month timeframe, a 4-5 year timeframe? Too much may change beyond that kind of a scope, but would you give advice to your children or grandchildren to say, yes, be cautious, but here is how I would be positioned in the short run, intermediate run, or long run?
Felix: Well, I do have certain long-term visions, whether they are right or wrong, but I grew up as a trader, and I still trade. And I think what is most important in this environment is not to lose sight of managing your risks. Last time markets turned down in 2007-2008, if you didn’t do your risk management properly, you suffered serious losses. And nobody can forecast the future accurately, consistently. That does not exist. Nobody can. And I’m one of those nobodies who cannot forecast the future. So, the best thing to have, I think, is a business with a product that is in high demand as a daily necessity for people. That is the ultimate investment. That is the best investment you can have.
And you have your own company and your own business. That’s the best. Obviously, then, you want to have some real estate, so you diversify. You want to have some real estate, and you want to have it, primarily, in a region where there is a good legal system in place, where there is a good government in place, where you have a good demographic situation, where you have rising prosperity.
Then you buy real estate in those areas. Or, if you can pick up bargains in a crisis, that is always good. You wait until a crisis is there and then you pick up bargains in a crisis. I picked up bargains in the last serious real estate crisis we had in Switzerland, which was in the second half of the ’90s, so you could buy commercial real estate a few years old at 40% of their costs, and things like that. That’s what good value and good investments are.
In terms of bonds, at the present time, where we are, you can only be a trader. You cannot be an investor in bonds anymore because these low yield levels could last maybe longer than many perceive, but they are not sustainable. At some point there will be a normalization, maybe not the way the world thinks, maybe not through a normalization of the economy, maybe through a crisis. But if a cycle of defaults begins, interest rates go up. So, you cannot invest in bonds long term, but you can trade them, and I’m still long U.S. treasuries, that’s my biggest fixed income holding.
In equities, I think you want to be, again, in a system that has a good legal system where you have the entrepreneurship that is good, and you try to find companies that produce services and products that are in demand where consumers, for their daily necessities, cannot go around it. I would not go into deep cyclicals because you need timing capabilities to do that. I would rather go with solid blue chip types of companies. If this cycle runs longer than most think, then I think you will see, most likely, a new nifty fifty developing. That is where all the money is going and concentrating in companies where they feel safe. And it is the Disneys of this world, it’s the Nestles and Novartises of this world, it’s the Henkels of this world, those are just a few names.
So, you could see outrageous valuations when these stocks top. But there will be a down cycle and the next down cycle could be ugly. I do not know when it begins. My hunch is that it could start sometime in 2016, and then we will see. So, it’s very difficult to make, at this level of valuation, and after six years into a bull market, to make long-term recommendations in equities, although equities very long term, are the preferred asset class.
David: We always enjoy your comments via Barron’s or here on the program, and we appreciate you joining us from the east coast. Perhaps we will gather and share a meal and share conversation sometime in Zurich or Geneva next time we’re in Switzerland.
Felix: Oh, please do so. And thank you very much for having me, David.
David: Thank you very much, have a wonderful day.
Felix: You, too.
