FS Insider recently spoke to hedge fund manager Felix Zulauf to get his take on the state of the global and U.S. economy. Felix shared his thoughts on what a recovery could look like and why he sees this as a long-term issue. Read below for excerpts from his interview on FS Insider. If you’re not already a subscriber, click here.
For audio, see Felix Zulauf on Why It’ll Take ‘Years’ to Recover from Crisis.
What’s your take on the economic and political situation at present?
We went into this pandemic with a world economy that was already slowing down decisively. Europe was virtually at zero growth early in the year and the U.S. was at 1% growth. China had slowed and only had hesitant signs of stabilization. So, the world economy was slowing down and falling below the 2% growth, that usually is the sign of recession. Then we got a world pandemic and of course, this created a tremendous shock with the lockdown going from Asia to Europe and then to North America.
The world economy is in a free fall. We have the biggest decline ever in modern times. This will lead to a huge drop in corporate earnings, in my view. The authorities are trying to backstop the system by providing fiscal help which is enormous and providing monetary help to backstop the credit system. The fiscal help will only begin to work once the whole employment situation normalizes and the restrictions and the lockdown are removed completely. Without that, the fiscal side cannot really work.
The monetary side is helping to backstop the credit markets and the stock market obviously likes it very much. And so, stocks are rallying because people think that this was just a V-shaped decline due to the virus and will be V-shaped, rubber band effect to the upside and we go back to normal. I disagree with that view.
I think this is a decline that has triggered off a lot of problems. We entered this decline with the biggest debt the world has ever seen. Total debt out there in the world relative to GDP is more than double what it was at the last business cycle peak in 2007. And then you go down and your cash flow dries up, and your revenues dry up—that creates all sorts of financial problems. When you have a lot of debt, that means the default risk is going up very high. The central banks are trying to backstop that, but they cannot backstop everything.
Stay ahead of the news! Subscribe to our premium weekday podcast
So, we will have a huge wave of bankruptcies running and working through the system. I do not know exactly how this will work out. I do not see a V-shaped recovery, rather a U-shaped or even more likely, an L-shaped with the horizontal line being bumpy. That means whenever the fiscal stimulus begins to work, you have a bump up. And once the fiscal stimulus rate of change goes down again, you bump down again. I think that could be the case for the next one to two years.
I think the economic outlook is anything but rosy. I think it’s very, very serious. I do not see how the corporate sector will be able to deliver a lot of earnings growth and in that kind of environment, you have to understand that the corporate sectors in the Western world and also in the Asian world, went into this in the weakest financial condition they ever have been. The U.S. corporate sector was running a financial deficit of 500 billion, Germany was running a deficit of 100 billion euros, France of 100 billion euros, the U.K. owed 45 billion Sterling and Japan was running a slight surplus. China of course has a huge financial deficit of over 10% of GDP.
The corporate sector has entered this difficult economic situation completely unprepared. They have been buying stocks and pushing their stock prices to cashing option plans for top management and the board instead of really having precautionary steps for a rainy day. I think over the next two years, you will see a lot of balance sheet repair work that will restrain economic growth; and therefore, I fear, a relatively dismal economic situation.
On the monetary side, so far, the U.S. has not crossed the red line where central banks finance governments directly. The Bank of England said they will now finance the government directly. This is crossing a red line, and this is very dangerous stuff. So eventually, I think all central banks will do that and it promises we will end this decade in a very inflationary environment. So far, the Fed has not crossed that line, but the way I see the real economy, I think eventually they will do so. The European Central Bank has not crossed that line yet either, but they are very close to doing so because their system is really breaking apart.
I think this is a very interesting and new situation for my generation and for younger generations. Our parents have lived through things like this, but we haven’t, and therefore we do not know how this will work out. We have the monetary side that is very positive for the equity market, of course. But we have to wonder what will happen to equities once they realize that the real economy is not going to deliver what they are expecting? When they realize there is not going to be a rubber band effect in the real economy to the upside, that the earnings outlook will remain dismal for much longer than what they think right now. I think we will most likely have a market environment with big swings up and down between the extremes of fear of missing out on the upside and fear of the economic damage on the downside. This will create huge swings.
The bond markets are more or less finished because we have gone through the disinflationary process, and I’ve been a bond bull since the early 1980s. I think you have to sell your bonds in Europe and in Japan and everywhere. Maybe the U.S. Treasury bonds are the last ones to turn around. I do believe that this has implications for the currency markets.
Right now, the dollar is weakening a little bit. But I believe that the outside world has more problems than the U.S. That has to do with the huge debt burden out there in the offshore market that is denominated in US dollars. That is basically a short position in the US dollar that is at least 12 trillion. That has more than doubled since the last business cycle peak. All those companies, indebted in US dollars, are being strangulated as their currencies have been declining for quite some time.
I think the Fed is trying to address that through swap lines. The person out there that needs that swap line the most is China, for political and strategic reasons. The Fed has not opened the swap lines with the People’s Bank of China. I think at some point the International Monetary Fund has to step in as a broker. And until there are enough dollars around to nourish all those who need dollars to pay back their loans that are denominated in US dollars, I think the US dollar will remain relatively firm.
That is a big problem for some, like the eurozone, where you have a currency concept that is very strange and not solid and rigid. And in situations of stress, rigid setups usually break. I would not be surprised to see some European banks being nationalized over the next couple of months because the stress in the system will rise to enormous levels. It’s very, very tricky.
Gold is a beneficiary of this the deflationary problem. The over indebtedness of the world economy, very low economic growth and the mini depression that we now have, has created so many problems that the central banks are trying to fight it by debasing our currencies. That can be expressed in a higher gold price. So, it’s a remarkable situation that we are living through.
You said this a larger economic problem beyond just the coronavirus itself and that you believe this is going to be a much more protracted recovery scenario. Can you explain that?
Every four years or so you have an important low in the stock market, like we had in 2016 and now in 2020. Those who believe in the four-year cycle say this is an important low, and it may be, and it may run up longer and further then than I originally believed. I thought that in the first bounce we could run to 2700 or so. I thought that over time, we would bounce back 50% to 2800. That’s where we are right now. It seems right now the market wants to go higher, and maybe for longer.
We have a 40-week cycle coming up, the low is in July, so it may have a retest then. Historically retest of the stock markets are in two weeks to six months. We could have a retest then because I think the economic news will not improve. The coronavirus statistics are beginning to improve globally, though not yet in the U.S., but that will come also. And then the risk is whether we will have a second or a third wave as we had in the Spanish flu. If we loosen the restrictions too early, we run a high risk of a second wave, which would then lead to another lockdown, maybe later this year or early next year.
I don’t think we are over this yet, there are huge liabilities out there that cannot be serviced anymore. This is not going to be a short-term affair. This is going to be a long-term affair. And this probably creates lots of trading opportunities for shrewd and experienced traders. For investors, it’s much more difficult.
Click here to listen to the full interview with Felix Zulauf. If you’re not already a subscriber to our FS Insider podcast where we interview book authors, strategists and industry experts from across the globe on all things economics, finance and markets…