According to macro strategist Felix Zulauf, founder and president of Zulauf Asset Management and Vicenda Asset Management in Zug, the almost seven-year-old bull market is over. China is to the current cycle what the US housing market was for the Global Financial Crisis in 2008. It will take years to correct the excesses that were built up in China.
Mr. Zulauf, the markets had a terrible start into the new year. Is the almost seven-year old equity bull market over?
Yes, the bull market came to an end last spring. A new bear market has begun. The coming downturn will be proportional to the excesses that were built up during the boom years. The bull market lasted for a very long time and was primarily fuelled by monetary excesses. And these excesses will now be corrected. And bear in mind, there is no longer any backstop for markets.
What do you mean?
In the past, investors could count on the Fed to bail them out – the Greenspan and Bernanke Put, if you will. Now, however, the US central bank – and it’s still the world’s most important central bank – is keen on raising interest rates. It wants to normalize monetary policy and to end quantitative easing. As a consequence, a sudden about-turn in the Fed’s policy is unlikely.
How big a correction do you expect?
A typical bear market in the US since the Second World War was about 23%. However, this time around I expect a more vicious downdraft. I expect the S&P 500 to drop to a range of 1200 to 1400 – right now the index stands at about 1870. Compared to its all-time high that’s a correction of almost 50%. The German Dax could fall to around 7000, while the Swiss Market Index will see a similar down-leg. There is a real chance of a bigger correction than many investors realize. This is particularly true when there is a weak economy – which I expect.
Do you think the Fed will continue to raise interest rates?
Hardly. I think that the December rate hike will remain the only increase in this cycle and that there will be no additional moves. Depending on how severe the impact of the falling stock market will be on the economy, the Fed might even reverse their rate hike. That could happen towards the end of this year or at the beginning of 2017. The US economy could cool much more rapidly than many expect.
What makes you think that?
Right now, inventories both in the US but also in many Asian economies are much higher than usual. If sales do not increase materially from current levels – and that is my base case – companies are forced to slash production. As a consequence, data from the manufacturing sector are bound to disappoint in the months ahead. At the same time the Fed balance sheet is shrinking slightly, whereas in China it is falling precipitously, while in Europe we have the situation that Mario Draghi’s verbal interventions might no longer work. We are at the end of an era.
The end of the era of quantitative easing?
Exactly, the era of QE is over or at least nearing its end. Central banks and economists have learned that printing money does not solve any economic problems and does not lead to stronger growth. It did not even help to push inflation higher. The Fed’s interventions during the financial crisis in 2008 were crucial and the right thing to do. Everything that followed, however, was a mistake. In light of the lessons learned over the past years, I do not expect central banks to resort to quantitative easing again anytime soon.
Even though in the past the Fed intervened each time the stock market wobbled? Janet Yellen might start another round of quantitative easing.
For 2016 this is inconceivable, in my view. The Fed is now made up of different members. Granted, former Fed chairman Ben Bernanke, who believes in printing money, would probably administer the same medicine. Janet Yellen, however, has a different philosophy: she is very much focused on labor data. And those look good at the moment. However, labor market data are lagging and not leading. To focus only on employment is like driving by looking in the rearview mirror.
Would it be positive for markets if the Fed unexpectedly announced QE4?
I believe that in such a scenario we would see a relief rally in equities. The dollar would weaken and commodities and stocks would surge. However, there would not be any impact on the real economy. Any improvement would therefore be built on sand.
How bad is the situation in China?
China is the epicenter of the looming crisis. China in today’s cycle is what US housing was during the financial crisis in 2008. In 2008, China reacted quickly, resorted to fiscal stimulus, which saved the boom and even amplified it. In addition, however, the liquidity from the QE-program in the US flooded into the country, which even accelerated the uptrend – in terms of credit growth and investment, the boom in China grew into the biggest excess in the history of mankind.
And this boom is now over?
Not even autocratic China can escape the laws of economics. If you expand capacity to the point at which the return on capital no longer covers the cost of capital, the boom will end and a correction follows. And we have been in this correction since 2012. The rest of the world has not fully grasped this, as it is used to growth rates of 10%. However, China’s growth has been slowing to officially 6 to 7%. In reality, I’d say it is closer to 2% – despite massive stimulus by both the central bank and the government. This cycle will only be completed when the excesses are dealt with. Hence, the downtrend will continue....MUCH MORE