The Big Picture Part I

[private]This is the first instalment of my notes of the highlights from some of the excellent speeches at the CFA Institute annual gathering held this year in Edinburgh. This section covers the comments of Felix Zulauf and Russell Napier. Two big picture themes inevitably continue to dominate professional investors’ concerns:

1     Sovereign debt problems in the Eurozone, US, UK and Japan

2     Global imbalances between the US and Asia, especially China.

Felix Zulauf is a well known Swiss professional investor, probably most famous for his appearances as a member of the annual Barron’s Roundtable, where his record of forecasting future directions in the stock market has always impressed me. On this occasion he was certainly among the most gloomy of those present, having recently sent a note to his clients suggesting they reduce their risk exposure.

He argued as follows:

  • All monetary unions fail in the end, and there is every chance that the Euro will prove to be one of the shortest lived in history. The only way that the Euro can survive is if (1) it introduces fiscal union as well as monetary union; and (2) it adopts a weak (not a strong) currency as its objective;
  • The spending cuts and other disciplinary measures imposed as conditions of the bailouts of Greece, Ireland and Portugal will push Italy, Spain and these “peripheral” countries (Portugal, Ireland, Greece) back into negative growth. There is a 90% chance, in his view, of a new recession in Europe this year if current policies persist.
  • The scale of the retrenchment imposed on the peripheral countries is so severe that that pain will soon become unbearable and faced with endless years of declining incomes voters will insist on quitting the euro rather than go through with them.
  • Italy is more likely than Spain to be the next country to face a credit crises, in Zulauf’s view, as there is virtually no demand for its bonds outside its own banking system. If one of the PIGS strikes a debt restructuring deal, the others will demand the same, which will almost certainly lead to a new banking crisis sooner rather than later.
  • Policy­makers all across Europe, with the UK as an honourable exception, are coying the United States) are dragging their feet about confronting the realities of their debt burdens in the hope that some kind of solution will emerge later. Unfortunately no such permanent solution exists.
  • Zulauf expects a stock market correction this year of around 15-20%, led by a decline in the commodity complex (oil, metals, agriculture etc). But he does not expect a repeat of 2007-08 (a 50% market fall) this year. That he thinks will come later, possibly in 2014, as the full impact of rising real interest rates hits home.
  • Despite any short term correction, real assets, such as equities, real estate and commodities, still remain the best asset classes to own over thelonger term. The likely decline in commodities this year will lead to good buying opportunities later.
  • Gold remains a fundamental core holding, in his view, as does the Swiss Franc. The Dow Jones gold price ratio has gone from 1:1 in 1980 to 40:1 in 2000 and is now back at 8:1. Zulauf expects it to go to parity again. (If gold falls, stocks will fall even further).
  • China will surprise everyone by tightening its policy sooner and more sharply than people expect. Growth is already slowing and the Chinese are losing some market share to the USA in some areas, thanks to the modest rise in the Chinese currency so far.
  • Emerging markets will be the ones who “take the punch bowl away” in the economic cycle, the historic role of the Federal Reserve. The Americans have not noticed that “Beijing is now calling the shots, not Washington any more”.

This last point was also supported by Russell Napier, a strategist with the broker CLSA. He agreed that it will be emerging market countries, not the US, which kicks off the “great reset “of interest rates to higher post credit-crunch levels. (Editor’s comment: We all know it is coming; the only question is how long it can be delayed, eg by the US or others falling back into recession).

  • US Treasuries (government bonds) are facing classic bear market conditions – a combination of falling demand, as China and others seek to diversify away from their dollar-dominated foreign exchange reserves,  and rising supply, as the public debt and future liabilities of the US start to fall due. The bear market in Treasuries, says Napier “will last decades”, and in purchasing power terms, they will “never get back to current levels”.
  • Rapidly rising inflation in many emerging markets is forcing them towards adopting a more independent monetary policy, not the traditonal one of pegging their currencies to the dollar. This will lead to a reduction (net selling) of their holdings in US government bonds.
  • China is adopting what Napier called “the Nixon playbook” of anti-inflationary measures, including credit controls, price controls and currency controls – everything to avoid the interest rate rises that would otherwise be required. He thins there is a 50-50 chance that there will be a significant Remnminbi revaluation within the next six months.
  • The US stock market has historically been vulnerable to a setback when inflation approaches 4% – as it did in 1969, 1973, 1987, 2000 and 2007. The cause is not so much fear of inflation itself, as fear of the Federal Reserve’s reaction to it.
  • This time round, with US inflation (officially at least) still well below the 4%  level, the pain of early interest rate rises is too great for the US economy to bear for now. But inflationary pressures are rising and the dollar will remain under pressure.
  • There is little long term value in US equities as current valuations are not at attractive levels. However many investors may not be hearing the right story about how the best defensive assets to hold. Gold and the Swiss Franc were the best safe havens in 1968, in similar conditions,  but few advisers will be pushing them forward at the moment, as neither generates any fee or commission income.

This ties in neatly with the enjoyable analogy provided by Professor Meir Statman, a leading figure in the study of behavoural finance, to describe the not always laudable practices of the investment industry. When we go to the movies, he said, we suspend our disbelief and happily follow the fictional goings-on on the screen – until, that is, the lights go up and we return to the real world around us.

The trouble with the investment industry, the Professor went on, is that “we love the movie [the promise of higher returns], but they never turn on the lights”. This crack won the loudest applause of the whole event. Given that the audience consisted entirely of professional investors, this may be telling us something!

More notes from the meeting, plus my comments, will follow shortly. [/private]