Felix Zulauf: Bracing for a 'Soft' Economic Depression

By Eric Roseman

On October 20th I attended a private seminar in New York City and listened attentively to one of Switzerland's best money managers to get a perspective on the global market crisis.

There are only a few global-minded investors I really listen to when it comes to gaining insight on the markets. Most of today's money managers are too mainstream and remain obsessed with beating their benchmarks. What a waste of time.

My favorite market seers in Europe include Marc Faber and Felix Zulauf.

I've been following Felix Zulauf's career for about 15 years. In 1990, he founded Zulauf Asset Management AG in Zug, Switzerland. He currently manages money for global investors in the Zulauf Europe Fund, which is actually profiting during this disastrous year. Zulauf was bearish starting in 2006 and positioned his funds accordingly.

The ‘Soft' Depression

Zulauf believes we're entering a soft economic depression. If not for the government's backstops on October 13 to prevent further stock and credit market seizures, a depression would have followed. Zualauf is convinced the markets would have crashed.

His prediction of a severe recession will take the S&P 500 Index down all the way to 550, possibly 500, or 35% lower from current levels. Stocks have already plunged 40% from their October 2007 highs. Zulauf is adamant: "U.S. stocks are still not cheap. The S&P 500 Index trades at 1.7 times book-value and the Dow more than 3.5 times book. This is still expensive."

The Swiss advisor now predicts a very different world will emerge as a result of widespread government nationalization of banking. These efforts - started in the West - will send the wrong message to emerging markets, also likely to follow the same course of full or partial nationalization.

This will also mark the end (at least temporarily) of the globalization theme, as markets will gradually be closed to foreign competition amid a marked increase in government regulation of financial markets. He also expects foreign currency controls as economic distress accelerates.

According to Zulauf, a "soft depression" lies ahead. And Europe might be the focal point because the banking system there is worse than in the United States.

"There's a disaster unfolding in Eastern and Central Europe. These countries are now unwinding leverage, namely Hungary, Romania and Bulgaria. They've borrowed heavily in foreign currencies and now have to pay those funds back as bank liquidity dries.

Hungary, for example, has borrowed heavily in Swiss francs, at low rates, and with the forint collapsing the debt burden only grows more acute. Eastern Europe remains the high-risk focal point in Europe because of these chronic deficits."

The End of the Euro?

Zulauf also believes Italy, Greece and Spain will eventually exit the single European currency, or the euro.

He seriously doubts the euro - in its current form - will survive beyond 10 years as government deficit ceilings are breached amid a bulging credit crisis. The 15 members comprising the Eurozone must keep budget deficits at 3% of GDP or lower in accordance with the Maastricht Treaty.

Euro Dives Off a Cliff in Early July

Europe went through a major currency crisis when the euro's predecessor, the ECU (European Currency Unit) plunged in September 1992.

This happened after both the British pound and Italian lira had to exit the ECU after serious devaluations. Both countries were suffering from high interest rates, recession and rising unemployment. At the time, the ERM or European Exchange Rate Mechanism proved too challenging to continue and both countries finally let their currencies float freely by September 17. Betting the pound would devalue months before, Quantum Fund founder George Soros earned more than a billion dollars shorting the pound.

Toxic Bank Debts Transferred to Governments, Spreading the Contagion

According to Zulauf, banks have transferred their toxic assets or securities to government balance sheets. The bad debts have not disappeared. In this case, governments will be responsible for holding these illiquid securities and increasingly, other bad investments or even non-performing loans. This makes government debt or bonds a bad long-term investment because central banks and finance ministries are collateralizing near-worthless paper.

Another experienced guru alluded to a similar point two weeks ago on CNBC. Legendary hedge fund investor, Julian Robertson, Jr. of the Tiger Funds (1980-2000) is betting on rising long-term interest rates in the United States as the cost of Treasury issuance goes ballistic over the next few years. In his eyes, government debt is a bad bet.

Best Buying Opportunity in a Generation

Despite his bearish tone, Zulauf believes global equities will offer one of the best buying opportunities in a generation sometime over the next 24 months. This includes real estate. He's expecting stocks to stage a powerful bear market rally off the October lows.

But beyond a big move, he thinks the economic landscape is still deteriorating and earnings forecasts are too aggressive. Still, after the next big drop, he does believe stocks will be trading at incredibly low levels.

Zulauf is sticking to selective shorts, holds very little equities and is long short-term government bonds and gold, including a short-term hedge on the yellow metal. Though long-term bullish, he believes gold might dip to US$650 on this correction.

The only stock market sectors Zulauf believes are worthy in this environment are food and beverages and some major oil companies. Aside from these groups he's very light on equities.

Commodities will continue to suffer until China's economy stabilizes. China will do everything it can to boost domestic consumption and might experience a mild recession, claims Zulauf. Until China's economic growth accelerates in mid-2009, commodities will remain under pressure.

As for the U.S. dollar, the Swiss money manager ties its strong performance versus all currencies (except the yen) since mid-July to the destruction of credit and a shortage of dollars. The world is hungry for liquidity and the hedge fund world is deleveraging. He doubts the dollar's rally will extend beyond the first half of 2009 and recommends holding gold in a Swiss bank account.

Disclosure: none

Comments

[dieuwer:]

The ECU did not plunge in 1992, the pound did.

2008 Oct 29 08:39 AM

[sliman:]

Anybody know a good way to short the long US bond

2008 Oct 29 08:44 AM

[oldfolkdancer:]

Thank you for sharing what you got from the expensive Investor Conference. Wish I could have been there. Was there anyone who was optimistic about anything?

2008 Oct 29 09:20 AM

[Roger Knights:]

To short the long-term US bond, short TLT. (Or buy its countervailing "short" version, whose symbol I don't know offhand.)

2008 Oct 29 09:42 AM

[Smarty_Pants:]

Felix Zulauf always was a pretty sharp cookie. You could do a lot worse than to follow his play.

sliman:

You can play the short side of US long bonds via the UltraShort Lehman 20+ Trsy ProShares ETF (Symbol: TBT).

finance.yahoo.com/q/bc...=

2008 Oct 29 09:54 AM

[NOWHEREMAN:]

The Barron's Round Table did its thing twice a year in the mid-1970's. Zulauf, Faber and Mobius were the best of the best during that time.

The crunch here is similar in nature but includes a financial twist which was not present at that time. Instead of inflationary pressure, we have deflationary ones.

I personally believe that GDP will be the key for the Dollar. Accelerating debt with negative GDP will soon create a situation where US debt will exceed GDP by a wide margin. The "full faith and credit of the US" will not persuade the rest of the world that this debt will ever be repaid. The current strong dollar is strong only because most commodity trades are still exercised in dollars and repatriation as Hedge and Mutual Funds liquidate foreign holdings come home in the form of dollars.

Foreign currencies are sold, strengthening the dollar, the dollar is bought creating more dollars. The dollar float is also being exacerbated by the Treasury and Fed.

The Chinese currency has risen almost as fast as $$s, the difference is that in the last few days a policy shift appears to be taking hold. Devaluation rather than appreciation as it has moved from around .682 to .685 even as calls have been made by the US to let it appreciate more. The Russians are selling dollars, ditto Brazil and the Middle East has stated it will also do so to fund ongoing projects which are now in danger because of low oil. The Gulf States hold $2.5 Trillion in US debt.

The Dollar Rally is just that a rally in an on going Bear Market. How much further and for how long is moot. I doubt it will last to mid 2009.

Don't forget that the US is about to change.

Vote for Barak Hussein Obama, vote for change.
Lets see how the policies he espouses affect the US dollar immediately after the election.

Go Hussein.

2008 Oct 29 11:16 AM

[carey_jim:]

I notice the phrase "soft depression" was not defined.

The depression of the 1930's was also "soft" for the wealthy, in the sense that they didn't suffer financially at all and even had cheaper and more grateful and reliable servants.

But Hitler and Stalin were the price they ultimately paid for their "soft" lives.

This time around, if America suffers a depression, my guess is that our democratic institutions will find a way to spread the suffering to all classes.

Then the request for spare change might change to a request to lend a hand.

People who aren't used to working might find that hard.
.

2008 Oct 29 01:46 PM