Virtual SIC 2020: Felix Zulauf

Virtual Strategic Investment Conference 2020: Notes from Felix Zulauf Interview - CMG

Well, a recession is the part of the business cycle that cleans the system from the excesses of the previous expansion. And a recession usually lasts only two to three quarters or less than a year, and it does not really change the thinking and behavior of economic subjects (like the corporate sector, managers, and the individuals/consumers).

• A depression is different. A depression goes deeper, and it lasts longer.
• I think this is not your grandfather’s depression of the 1930s. This is very different. There are a few similarities, but there are very important differences.
• This depression, I think, will last at least two years. It could last much longer. We have had a decline so far, what we know from all the numbers that we are off about 10 percent. GDP is down about 10 percent, more or less.
• So, we go from 100 to 90. And as we recover, as we open up, as we loosen the restrictions, et cetera, we may go back to 94, something like that.
• And then, the most important difference to a normal recession, you get into the second-round effects.
• It’s very important how you enter such a decline. When you enter the decline with very strong balance sheets, et cetera, and very strong cash flow–positive corporate sector, then it’s no problem. You do not go into a depression; you stay in a recession and you come out of it quickly.
• But this time, we entered this decline with the corporate sector that has more debt than ever around the world, a corporate sector that was running large financial deficits, which means they had to borrow to pay all the expenditures, including dividends and buybacks, et cetera. The deficit in the U.S. was about $500 billion last year.
• In Germany and France, it was about $100 billion euros, in the UK, about $45 billion.
• And now we have, at the present time, the last two months, we have approximately $100 billion net cash flow in the U.S. corporate sector per month. That means we have such tremendous pressure on managements to really cut costs.
• And that’s the next step (that we will see), and this is what is very different from recessions. Corporations now they have to repair the balance sheet, and this is what Richard Koo really made famous when Japan entered the Big Depression in 1990—he called it the balance sheet recession.
• That means that you have to repair balance sheets. You have to bring your equity capital up. You have to cut costs to the bone, et cetera, et cetera.
• You cannot do that in two or three quarters. This is a multi-year process that is on the way. And that means (when) you cut costs and you cut somebody’s income at the same time. So that means a lot of the jobs that have been lost will not come back.
• And this turns the sentiment of the private households much more conservative. It also turns the sentiment of the corporate sector because there are many subcontractors, much more conservative.
• And that is the difference from a normal recession. It’s a much longer process at the lower level because you stay below previous break-evens for much longer than used to be the case in previous recessions. That’s the main difference.

FELIX: You know, in the 1930s, we had no social welfare. It was virtually zero. It started to build and grow since then. I could show you a chart of how it has grown. It’s a growth industry.

• Social welfare is a growth industry. It is now maybe at 30 or 40 percent of GDP in social welfare in many countries. We didn’t have that. We also had a 20 percent deflation.
• We might have mild deflation of maybe two percent or so, very mild deflation in coming quarters or coming two years or so, but we won’t have 20 percent. (SB Here: Dr. Lacy Hunt sees inflation going from near 2% to -2% so call it -4% deflation.)
• That means our GDP will not be cut in half, as was the case in the 1930s.
• We also have a completely different framework to work with in central banking and in fiscal policies. Think about, most of our fiscal authorities have run deficits, before this crisis hit, that were bigger than at the deepest point in the U.S. depression (1930’s).
• The S. government ran about 2½% fiscal deficit in 1934. That was about the most they had during that period. So this is very, very different.
• They had the gold standard, so they could not create liquidity unlimited as they can today. So it’s a completely different frame work.
• Today it’s much more comparable to what happened in Japan when Japan started to support the system. And they have been supporting their system ever since, over the last 30 years.
• They put on a yield curve around zero percent, they basically socialized the bond market. It’s a nationalized bond market. It has no use anymore for savers. That’s what it is.
• There is no growth in an economy like that.
• The other factor that is on the bearish side is demographics. We should not forget that. I have been pointing to the demographic challenge for years in my publication, because, you know, from the early 50s to the early 90s, the world population between zero and 65 years old grew by about 25 million per year.
• We declined to zero in 2018. Now we are negative and it will be shrinking down to 12 million negative growth into the early 2030’s.
• This creates a much different background for economic growth than what we had previously. So, this is the challenge that we are facing, and we cannot change demographics overnight with a little bit of money throwing at the system. You cannot change that.

FELIX: Well, obviously, when you are in a balance sheet repair process, you do not take up new debt, and if you do not take up new debt in a credit-based economy, you cannot grow.

• You know, it’s as simple as that. So the private sector won’t grow by much. It’s impossible in this sort of environment.
• What you can do is the government sector can step in. And the government sector can replace part of the lagging demand from the private sector. But then you go into more government expenditures, work programs, et cetera, et cetera, and you finance all by printing money, and the central bank buys the debt, et cetera, et cetera. You can do that.
• When you do that, you create a less efficient economy—you create more debt. More debt eventually reduces the productivity of debt. I think Lacy Hunt did a great job in showing that in his presentation and the velocity of debt continues to decline.
• So that means the central bank can shovel as much money into the system as they want, but you do not get the private sector taking that money as a loan and do something in economic activity terms. For instance, in March and April, the Fed put a lot of—injected a lot of money into the banking system. It goes all through the banking system. The immediate consequence was that the banking system in the U.S. grew by about 12 percent immediately. That hit the point where the banks hit the border of the capital adequacy function. That means they cannot lend anymore because their asset base has ballooned. That means it curtails the lending process in a sense.
• So these are unintended consequences that are happening in the very short-term, actually. In the long-term, zero interest rates, lead to a planning economy, a planning economic system. And you—I don’t have to tell you a communist system is not efficient.
• It doesn’t create prosperity. It leads to political backlash. It leads to a revolution against the authorities, et cetera, et cetera. And that’s when gold comes in. Once the constituencies lose faith in the authorities and their governments, then they run away from the system and they run away from that money, and that’s when the gold market takes off.

FELIX: I think for the first one to two years, the problem is rather mild deflation, and mild deflation is a bigger problem.

• Once, I talked about inflation with a central banker and I asked him why he wants two percent inflation as a target, because it doesn’t make sense to me. With two percent inflation, I lose half of my savings during my working period in life, so it doesn’t make sense.
• He said, well, a little bit of inflation makes the wealth distribution process much easier politically, you know, and it’s true.
• If you have mild deflation, it’s tougher, because you have to cut in some areas and cutting hurts much more than increasing less. So it’s a psychological thing.
• I do not see inflation as the immediate threat. I could see it a few years down the road. If the economy stabilizes and the programs and the financing by central banks grows bigger and bigger, then of course, you will see certain scarcities.
• You will see cost-push inflation. That is possible.
• From there, it takes quite the bit of a quantum leap to hyperinflation.
  • We probably see hyperinflation right now in Argentina. Argentina is in a miserable economic situation. The people run away from the currency.
  • They do not trust the corrupt government. The currency in the black market rates at half the price that is the official price relative to the US dollar.
  • And they when such countries get into such a mess, they increase the money printing process. And then the currency collapses like you have seen in Venezuela and in Iran, et cetera, and then you go into hyperinflation.
• Usually for hyperinflation, the precondition you need is economic misery. That means prosperity goes down. You get to certain social revolution, a distrust vis-a-vis the governments, the authorities, and then you need direct financing by the central banks of government expenditures, and so far only two central banks have announced that.
• The first, interestingly, recently, was the Bank of England, which was sort of shocking.
• And the other one that is more dangerous is Brazil. Brazil announced a few days ago that their central bank will finance directly the government. So Brazil is in a situation that has a very weak economy, weak structures, high corruption, and a weak currency that is beginning to collapse against the dollar. You see it in the charts very clearly.
• And if they start financing directly, they run the risk of hyperinflation.
• Two other countries come to mind that are in a similar boat, Turkey and South Africa. So I would be very concerned about those. They all run large current account deficits structurally, and that’s a big threat.
• I think, for us, for the industrialized world, we are not there yet.
  • First, we have mild deflation for two years, then we might have mild inflation.
  • And if we then start to see the things I just mentioned, I will get worried about in the second half of the decade, not before.
• So I don’t see that risk, immediately. I know a lot of people are talking about it. That’s a monetary thing that they believe, you know, money supply growth translates into inflation or hyperinflation.
  • I disagree with that because velocity declines because the real economy cannot use up that money and do something sensible with it.

FELIX: Well, obviously, we live in a world where we all run fiat currency systems. We have a fiat-based economic system and monetary system. And eventually you run the risk of high inflation.

• By definition, when you can print money and you can print yourself out of, you know, immediate problems, eventually you add up those problems over time and you end up in an inflationary world.
• That will also come to the industrialized world eventually, I believe.
• So, bonds, when they trade as low as they trade right now, that’s a very unattractive proposal for investors, you know. That’s actually a certificate of confiscation. And that’s what they used in the late 1970s when they became slowly attractive for a 30- or 35- year bull run, you know, a 40-year bull run bond.
• So I think bonds are in danger. It’s a guaranteed loss in many countries.
• In the Eurozone and in Switzerland and in Japan, it’s a guaranteed loss in nominal terms and it is a guaranteed loss in real terms for many others. That means that pension funds that are obliged to have a certain percentage in the fixed-income area are at risk because they have guaranteed losses in the future.
• And I think this is going to be one of the next big crises—the pension fund crisis in many countries—because pension funds are paying out pensions that they cannot earn anymore, and they are actually soaking up capital from the young and distributing to the older generation, which is unfair.
• So I think eventually there is going to be a major problem and the shortfalls are tremendous. In the U.S. alone, public pension funds are down to 60 percent of what they should be to cover their future liabilities. And it’s very similar in many other countries.
• The private pension funds are a little bit better or are quite a bit better, but they are not covered in full these days anymore.
• So I think this is a problem for the future. And it all means that in a broad sense, we will get poorer in real terms eventually.

FELIX: Europe has a bloody history, and because of that bloody history, after World War II, France and Germany, the two arch-enemies came together and said, “We have to do something about it.” So they founded the Common Market.

• Eventually that grew into the European Union, and that was a good idea, actually. The Common Market was a very good idea.
• And then they introduced the Monetary Union. It came about due to the wall coming down in Berlin, and the French feared the too-powerful Germany, and they said, “We have to integrate you more into Europe.” So they agreed on a monetary union, and that’s when the problems really started because it is a complete misconstruction.
• It forces centralization because the different economies are completely different structurally and have different productivities, et cetera, et cetera.
• Having the same monetary interest rate, currency, policy, and this means that the differences become bigger, so you create more and more imbalances. The weaker get weaker and the stronger get stronger, et cetera, et cetera.
• So you have to rebalance that through a center. And that’s where the whole process turned into a centralization effort, and you know what that means?
  • When you try to centralize large regions, you lose productivity and your competitiveness goes down, et cetera, et cetera.
• And that’s the mess in Europe. Now, we are at the point where that rigid structure of the euro is going to be tested.
• The euro is a dogma. It’s a political dogma. You cannot discuss it. It’s a bad thing, does a lot of damage and harm, but it’s there and we don’t talk about it. We don’t discuss it. It stays there.
• So as it stays there, when there is downward pressure in the economies, it needs a rigid system. You have to compare it to like fixed-exchange rates between the member nations of that European Monetary Union, and you lose the ability to adjust because you’ve lost your currency as an adjustment tool.
  • For instance, if a weak economy would suffer badly, the currency would drop and they would import less and they would become competitive in exports, and so it would be self-correcting. You lose all that.
• Therefore, the weaker ones are demanding help from the stronger ones. So they want to mutualize the debts because the weaker ones are building up more and more debt all the time, whereas the stronger ones finance them.
• And obviously, this creates anger between the two. And what they came up with today was a sort of a eurobond. The Germans didn’t want to go into a eurobond because it’s a debt mutualization. So they decided instead of a one trillion eurobond, they decided we have one half trillion or 500 billion of an increase in the budget, and the northern states pay for it.
• In the EU, all 27 member nations must agree to get it through. Austria already said, “We reject it. We don’t agree with that, et cetera, et cetera.
• So it’s going to be a long process. And in the meantime, the pressure on the weaker nations and economies continues and intensifies. And that’s a big problem because the banking systems in those countries are hardly in a condition that they could absorb all the loan losses that are coming over the next few quarters.
• Therefore, because we have the bail-in clause in Europe (put in place since the last crisis), that means that depositors could lose their deposits and get, in return, shares of the bank, so they could increase the equity capital of the bank by using depositors’ money. When depositors realize that that risk is increasing, they run away with their money and they run away—not just from that bank, but they run away from that country.
• And I think the risk is that some of the southern countries have to introduce capital controls. That means they have to lock in the capital in their countries and in their banking system because otherwise it would weaken their banking system in addition to the weakness of the loan losses.
• And if you have that, capital controls inside a monetary union, it’s basically the end of it.
• I mean, it loses all confidence among investors, and investors in the world will turn away from the euro. And the euro would then probably have a decline of 15, 20 percent, or whatever.
• So I think the euro over the next 12 months is really at risk of breaking down. If you look at the chart, it has a long-term uptrend line and it comes through at about 108, 107. We are right there. We are now jumping off. Actually, yesterday I went tactically long some euros just for a short-term trade. But my strategic position through options is to be short the euro against the dollar. And, you know, it could decline to 98.5 or something like that against the dollar. That’s a tremendous move for the foreign exchange market. And that’s why I would recommend using the option market to place such short positions.
• So it’s coming to—it’s coming to a decision, you know. And I think it’s going to happen this year.