The Pain of Deleveraging Will Be Deep and Wide

Felix Zulauf, Founder, Zulauf Asset Management

By LAWRENCE C. STRAUSS

AN INTERVIEW WITH FELIX ZULAUF: A bleak long-term view on stocks.

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AS THE CREDIT CRISIS INTENSIFIED LAST WEEK, radically altering the Wall Street landscape and the government's role in stabilizing the financial system, Barron's sought out Switzerland-based Felix Zulauf for a global macro perspective. A longtime member of Barron's Roundtable, the founder of Zulauf Asset Management is now equity-averse -- he prefers gold and government bonds -- but further out, sees untapped growth potential in emerging-markets.

Gary Spector 

Barron's: It's been an unprecedented time in the financial markets, with Lehman filing for bankruptcy protection, Merrill Lynch being bought by Bank of America and AIG getting rescued by the U.S. government. What's the fallout going to be?

Zulauf: The leveraging-up in this cycle is reversing, and we are now deleveraging. When a huge system -- that is, the global credit system dominated by the investment-bank giants that have been the major creators of credit in the last cycle -- turns down, the fallout is going to be terrible.

Deleveraging is a very painful process, and will run longer and deeper than anybody can imagine. I've been fearful of this.

So far, what we're seeing is the pain in the financial system. Later on, we'll see the echo effect of the pain in the real economy. I can't understand economists talking about no recession or mild recession. This is the worst financial crisis since the 1930s. It's different than the '30s, but is the worst since then, and the consequences will be very, very painful for virtually everybody in our economies.

So it's a global downturn?

That's right. It started out in the U.S., but it is a global event, led by the [excessive lending practices that grew up in the] housing boom in the U.S. But we also had housing booms in some of the European countries, and in some of the emerging countries. People are already talking about a glut of unsold homes in China.

How will these countries fight this severe downturn?

Governments, particularly those in the industrialized economies, will use fiscal stimuli to prop up the system and prevent them from collapsing. Usually, those stimuli are a little too small to really have a lasting impact, which is usually spent after two to three quarters. So we could have a pop in the market in '09 and the economy into 2010, and then it disappears again; then there is the next fiscal program, and so on. That can go on for a long time.

By issuing more debt, all of these governments are trying to stimulate deteriorating economies. But what do you see as some of the other consequences of all that additional debt?

Government debt is going to rise dramatically over the next five to 10 years. Government debt is at 300% of [gross domestic product] in most industrialized countries, if you calculate correctly. That can increase to 400% and 500%, but at some point the government-bond market will not take this without any consequences. That will lead to rising long-term interest rates. But because the economy is not on solid footing yet, short-term rates will stay low for a long time. So you will have a very steep yield curve for many, many years, and this is bearish for bonds since their prices keep falling.

What's your take on the inflation outlook?

Most governments and central bankers are still concerned about the inflation rate. I think for cyclical reasons that inflation will probably drop sharply into '09, partly due to lower commodity prices. But what's more important thereafter is that there will be a secular rise of the inflation rate, because governments and central bankers will be forced to reflate these economies in a big, big way, and this will be bad for nominal assets, whose value decreases because of less purchasing power. But it will be good for real assets at some point of time in the future. For example, companies can adjust by raising their prices and growing their incomes.

What does all of this deleveraging, in which firms try to get various forms of debt off their balance sheet, mean for those involved?

When the deleveraging starts due to declining asset prices, there is no one there to reverse it. I cannot see the private sector stopping this and turning it around. It has to be the government, together with the central banks, and they are starting to do that.

What's your assessment of the steps Federal Reserve Chairman Ben Bernanke and U.S. Treasury Secretary Henry Paulson have taken to stem these problems?

It's a challenging job. Bernanke and his team and Treasury are doing the utmost, but doing the utmost means they're always one step behind. So far, it seems that the Fed is constrained by not being able to expand its balance sheet. It has replaced a lot of Treasury paper with other paper of lower quality, and the level of Treasury paper on the Fed's balance sheet has now reached such a low point that it cannot expand more without really monetizing debt.

You can't stop this [downturn] or turn it around without going to monetization, a step the central bank hesitates to take. But eventually the developments will force the Fed to do it.

What's your reaction to Friday's announcement that Paulson is crafting a plan for the federal government to buy illiquid assets from various financial firms?

Treasury, together with the Fed, is taking a big step forward to keep the system from melting down. It will work, but it has to be at least $1 trillion in size and the Fed has to help by cutting rates. The idea is good; now the Treasury has to make it solid and the Fed has to lend its support. This is probably the beginning of a medium-term bottom. Usually a good bottom, even medium term, doesn't stand on one leg. In the coming three or four weeks, the low will be tested, but from there we have a chance for a good medium-term rally.

Could you elaborate?

What the Fed has to do is buy paper in the asset market, including Treasuries and corporate bonds, and create new money in the financial system -- because the deflationary process created by the deleveraging is at work. Deflationary power is growing dramatically, and the Fed has to replace the dollars that have disappeared into a black hole. The private credit system cannot do that anymore. The Fed and government are really the lenders of last resort.

From your vantage point, what do you see happening to the Eurozone's economy?

Short term, it will probably get a little bit worse in Europe, because we have a different policy mix than in the U.S. Your central bank has cut rates. They've been aware of the problem. The fiscal situation is expansive already, whereas in Europe we have tightening fiscal policy, and we have still a restrictive central bank that's looking at holding the value of the euro. So Europe could get hurt a little more than the U.S. in the short term, but I think it will do better over the medium term.

Why is that?

First of all, Europe can finance itself, meaning it's not dependent on outside money. It runs a slight current-account surplus and, net-net, it is not indebted to the rest of the world. The U.S. is indebted to the rest of the world; that's a major difference. Also, Eurozone households [collectively] run a financial surplus, while U.S. households have deficits. So when you look at the large European economies such as those in Germany or France, the consumer is in much better shape and the banks are probably in a little bit better shape than in the U.S., although some internationally active banks and investment banks are like their U.S. competitors.

What about emerging-market economies?

Even emerging economies are getting hurt. We have seen how real-estate prices in some emerging economies, from the Baltic States to some Asian countries, are coming down. But these countries have a better situation from a very, very long-term point of view because of demographics. They are much younger nations. They are much lower in their standard of living, they are going up the ladder, and they are competitive.

Another thing to consider is that current-account and trade deficits will shrink. So what used to be a big stimulus for emerging economies will be curtailed and it will hurt those economies in the short run much more than the markets assume.

What do you see ahead for the U.S. economy and elsewhere?

The U.S. economy goes flat for several years, and from time to time there probably will be major fiscal programs, each one bigger than the previous one, to help the economy. Europe will be similar; its potential growth is relatively low, with a stagnating population.

The emerging economies have much higher potential growth rates. They are going through a down-cycle, but they will come up again in the next cycle and have higher growth rates. But it is going to be a very tough 2009, a global recession. Whoever gets elected president in November will come through with a fiscal program. Monetary policy is really ineffective in this situation. When you have a balance-sheet recession and everybody is deleveraging, monetary policy cannot do the trick. It doesn't work because there is no one willing to leverage up their own balance sheet.

Around these parts there has been a lot of focus on Merrill, Lehman and AIG, not to mention Fannie Mae and Freddie Mac, which the U.S. government bailed out recently. What does the future hold for financial firms globally?

Bankers have to learn that banking is an industry like any other industry. The financial sector has grown dramatically over recent decades, and I think it has grown to a level that is too big in proportion to total GDP.

Global financial-sector debt has gone up fivefold in the last 25 years relative to GDP. So what you now see is a reversal back to the mean. That means that the financial sector as a profit generator, as an employer and as a provider of services will shrink over many years -- back to a level that is more normal than in recent years. The financial-services industry has been treated extremely well for a long time and people made a lot of money and created careers, etc. But it is going to be much, much tougher in the next 10 years globally.

Do you see any industries that look promising at the macro level?

First, we go through a down-cycle, and it will affect virtually every industry. After that down-cycle is over, particularly in the emerging economies that have higher growth potential, it will turn up again. It could again be infrastructure-related assets or commodity-related assets that will perform very well. If I'm right in this scenario, what will happen is we will create a stimulus to grow in the future. And those who grow the best in a world of stimuli will be those that have the highest growth potential, namely the emerging economies. And then we will see rising bond yields. They will go in cycles, of course, and they will not shoot up straight. But they will go up.

What investments look interesting to you?

In this environment, those who do not lose win. For the average guy, I'd say go into the most defensive position. I'm not really interested in any longs in equities. I'm holding a lot of government bonds on the long side. I suggest that American investors stick to shorter-term Treasuries with maturities of up to two years.

Any other suggestions for equity holdings?

If you have extra money left and want to be more aggressive, you can play the markets short-term. There are going to be a lot of runs up and down in a declining market.

This is all sounds very bleak, Felix.

I'm not interested in any longs in equities. If you are an optimist by nature and if you want to be long, the one area that you should look at is daily necessities, notably consumer staples. Companies like Procter & Gamble [ticker: PG], General Mills [GIS] and maybe Johnson & Johnson [JNJ]. Those are the defensive names. But I have absolutely no interest in investing on the long side in anything that is cyclical in nature, because this cycle could last longer on the downside and go deeper than most investors assume.

Thanks very much.