Felix, a bit more than a year ago, the mere announcement of tapering by the US Federal Reserve triggered a shock wave through financial markets. You called this the butterfly effect which might feed into a worldwide correction. Now we have had tapering since the beginning of the year, and all major asset classes are gently moving up on very low volatility. Is tapering really a problem?
Felix Zulauf: It was a butterfly effect for the moment because the world feared a liquidity tightening which immediately sent emerging market interest rates higher and their currencies lower while the dollar firmed as capital flowed back to the US. The Fed will be done tapering by September or October, but other central banks will take over. We have seen for many months now that the Chinese are printing more money than the US. On average, they have created Renminbi for the countervalue of 50 bn $ per month over the last six months. This is an enormous amount. Then the European Central Bank is willing to add 1100 bn € over the next two years which equals an expansion of 50% of its balance sheet. So we will continue to swim in a sea of liquidity. The question is whether there might be other events and developments that may not be camouflaged by liquidity which could cause a change of investor expectations. Liquidity is one thing, but there are fundamentals also.
What fundamental development could that be?
Zulauf: We think it could be China. In every cycle you have a dominating excess which reinforces the cycle on the upside, but when it turns, it reinforces it on the downside. Last time, it was US and parts of European housing and in the previous cycle technology investments that created excesses and overcapacity. In the current cycle it is emerging markets, and the big gorilla is China.
Can’t Beijing control that?
Zulauf: The dimension of the Chinese cycle was enormous. In 2011 and 2012 alone, China has consumed as much cement as the US had in all of the 20th century. The credit creation in the last five or six years is mounting to the total loan outstanding by the US banking system. The excesses are mind boggling. Now anecdotal evidence tells us that the Chinese investment and construction boom has not broken yet, but it has cooled. But when it cools after a boom like we had, it’s probably the end of the cycle. However, investors still believe that the Chinese authorities can manage it because it is an autocracy. Once this assumption changes, it will have a negative effect on markets, but we do not know when exactly that will be.
After the end of QE1 and 2, equity markets corrected. Could the completion of QE3 be a trigger for the scenario you mentioned?
Zulauf: I doubt that we will see real monetary tightening by central banks. That’s the interesting thing about the current cycle. Investors are prepared for a conventional ending of the cycle with higher growth and capacity utilization resulting in higher inflation, rising interest rates and tightening liquidity that leads to a bear market. But it could be very different this time. If all of a sudden something went wrong in China, we would have another deflationary episode. If China’s currency goes down 20%, this affects pricing in traded goods and, therefore, corporate profits. All of a sudden, investors might look at the valuations of their stocks and realize that the emperor has no clothes.
Spanish, Italian and French bond yields trade on 200-year lows. Is the Euro crisis over?
Zulauf: The Euro crisis is not over. The intensity of the crisis was terminated by Mario Draghi’s famous “whatever it takes” speech in July 2012. The authorities have elevated the existence of the Euro to dominate every other issue. Of course, economics is such that you can’t have all variables fixed. If you can’t deflate to reduce the differences of the economic structures of the different economies and you can’t devalue your currency, the adjustment goes through the real economy. That’s what’s going on. Euro sceptics have taken almost one third of the seats in the recent European parliamentary elections which is a reflection of the unsatisfactory and discontent situation in the majority of the European economies. I do not see that the current set-up for the Euro and for the European economies is going to change for the better in years to come despite all the cheating and breaking of laws and contracts and treaties that is going on.
What does that mean for the EU?
Zulauf: That leads to a change in the political sphere which established parties are ignoring. Instead of taking it up and trying to change the direction of the Euro and EU from a more centrally planned EU to a EU of subsidiarity, they are just ignoring it. If you’re ignoring the warning signs, it will get worse over time. The changes to the European situation will not come from financial markets. It must come from politics. But the established parties will not change for a long time and therefore the conflict will intensify in the political arena. So my hunch is that the European recovery is not really leading up to expectations and will continue to disappoint citizens and voters. That will be expressed at the next elections. The problems could be dampened along the road if Germany agrees to a mutualization of debt and mutually financed infrastructure programs and so on.
So you distrust the current rally in European equities and bonds?
Zulauf: For the time being, European financial markets have a honeymoon that can continue for a while longer, but this is based on the expectation that the European economy will normalize. But this expectation could eventually be disappointed.
James, we have slow growth, no inflation, low interest rates and easy monetary policy as far as the eye can see. Are we living in the best of all worlds for investors?
James Montier: How I wish that that were true. The problem with the policy of raising asset prices is that you borrow returns from the future. You can think of it as the front loading of return. So what you’re really doing is pushing down future returns. So it doesn’t really help anybody a great deal in the longer term. Of course, in the short term the effect is positive as you get some sort of balance sheet repair through rising asset prices. At least that’s what central banks hope. But when you look at today’s opportunity set, you’re left with a set of assets where nothing looks attractive from a valuation point of view.
Even if interest rates stay low for a long time?
Montier: Even if we factor in low interest rates for the next twenty years, we’re still not seeing great opportunities. We can find stuff that may be fair value in that scenario, but it’s far from obvious. This is a very difficult time – in contrast to 2007, when risk assets were expensive but cash and bonds were priced to deliver reasonable returns, which is not the case today. It’s much harder to find anywhere to hide. So far from being the best of all possible worlds, this is almost the worst of all possible worlds.
Do your clients still believe in the much-cited low return environment? The further markets move up, the more you might have a credibility issue.
Montier: No doubt. We haven’t yet reached the kind of loathing that was displayed towards us in 1999 where we were just told we were complete idiots and several clients banned us from their buildings. I think there is a broader acceptance of the power of valuation, but the longer the rally goes on, the shorter people’s memory gets. Galbraith used to talk about the extreme brevity of financial memory and I fear that’s kind of what we’re experiencing now. People are looking at last year and say look, it can go up 30%, why on earth are you saying future returns are going to be dismal.
But markets have been expensive for quite some time. How opportunistic should a value investor be?
Montier: There are two possible states of the world: either they keep rates low for a very long period of time or they don’t. Anyone who says they know which one is going to happen is either a liar or a fool or possibly a linear combination with unknown weights. The reality is, nobody knows the future, particularly when it comes to policy rates. By second guessing we’re playing some sort of ridiculous beauty contest. Therefore we should try to build portfolios which are robust and can survive different outcomes.
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