When we last checked in with Felix Zulauf at the end of 2021, the stock market was perched near its giddy high—and the former Barron’s Roundtable member was looking for a steep market drop in 2022 from tightening monetary and fiscal policies. After that prescient but painful call came to pass, we caught up with Felix from his home base in Switzerland. An edited version of our conversation follows.
Barron’s: Felix, 2022 thankfully is drawing to a close. What now?
Felix Zulauf: I think we have to first take one step back for the big picture. I think that geopolitics and politics will play a more dominant role. We see the building of two major blocs—a democratic bloc led by the U.S. and an autocratic bloc let by China. And this means that the period of globalization of the past 30 years is over. I think we deglobalize for, let’s say, the next 10 years. That means the world will get less efficient and more inflationary. A safe supply chain will be more important than a cheap supply chain.
What is also important is that the autocratic bloc controls, at the margin, a lot of the commodities, be it oil or gas or certain metals. I think that the U.S. made a big mistake by using the U.S. dollar payment systems as a political weapon. Those nations that are not close friends with the U.S. will not store their foreign-exchange reserves in the U.S. dollar anymore. I think they will try to store their reserves in stuff—hard assets, commodities—instead.
Where does that leave the global economy?
Well, 2022 was the year of rising inflation and monetary tightening. That was the reason for lower prices in the equity markets. I think we are almost done, but not quite yet. The world economy is slowing, but we have also had elements like excessive fiscal support in certain countries like the U.S.
People misunderstand monetary policy because they look at the price of money. I look at the quantity of money. When you look at monetary aggregates in the U.S. or worldwide, their growth rate is declining sharply. Real M2 in the U.S. has had the most severe decline since World War II. So, if the Federal Reserve doesn’t change, and even if it hikes only 50 basis points [one-half percentage point] this month, the tightening of money continues, and eventually it will hurt the economy.
How does that play out?
We see that inventories currently are not high in all regions—in Asia, Europe, and North America—relative to sales. But if sales begin to slow in the first half of next year, as I expect, then I think we will see inventory reduction. Corporations will have to cut prices, which will bring profit margins under pressure and push earnings estimates much lower. And that is usually when equity prices decline again.
But stocks have been up strongly in the past couple of months.
I think the current rally from the October lows is a temporary affair. After a last bounce in January, I think we are in for another big decline due to what I expect from the economy.
But the good thing is that in 2023, we will see declining inflation rates. China has deep economic problems. The Chinese recession is as deep as in 2008. I think export prices, due to currency and other items, will decline. And oil is on the way down. People laughed at me when I said it could go to $50 or $60 [per barrel] by the summer of 2023. I still believe that is possible.
What are the implications?
This will be a tremendous relief for central banks. When oil comes down a lot and we have a whiff of deflation from China, that will give our central banks room to change policy and ease up—particularly if our economies are as weak as I expect. Whether it will be a recession or not, I do not know. It’s not that important whether it’s down 1% or up 1%. What’s important is that earnings decline, and that the inflation rate comes down and the unemployment rate goes up. And that will push for a Fed pivot. We will probably see that in the second quarter.
Is this what the bond market is sniffing out with the inverted yield curve?
I think so. I think bond yields are in a cyclical reversal that may take a few more weeks and may last into the first quarter. But 10-year bond yields could easily decline by 200 basis points in, let’s say, the summer months of ’23. This will be a tremendous bond market rally.
Which no one is prepared for.
But I think it will be a temporary rally, about six to nine months. Because, as [central banks] ease up, that excess liquidity will flow into those commodities I mentioned. That will be the start of the next big up leg in the commodity market, driven by scarce supply and not by robust demand. All you need is a normalization of demand.
And then, of course, inflation will come back from late 2023 onward, and will probably go even higher in ’24, ’25, than it has been in the current cycle.
Even higher than the 8% we’ve seen in the consumer price index?
Yes, I think it will be double digits. I think the price of oil goes up in 2024-25 and could easily trade near $200. And that gives you a CPI in 2025 of over 10%. And, of course, bond yields will also move up then, from late ’23 onward in the next cycle.
As we have seen in the 1970s, it’s the second up wave in inflation that is really bad for the bond market. In the first up wave, the bond market follows timidly, but stays far below the inflation rate. In the second wave, the bond market will try to catch up. And that will be a devastating move in the bond market, a terrible bear market in bonds, in 2024-25.
My jaw just dropped.
I always call this the decade of the roller-coaster market. It is fantastic for active investors and those who can time the cyclical swings. But it will be horrible for passive investors with a 60/40 [stocks/bonds] portfolio, which was so good to them for the past 15 years. If you don’t want to end up with very poor returns, you have to time the cycle.
Not a good time for long-only growth investors, either.
Growth investors are in the camp of the linear projections. And the world is not linear. The world is part of nature, and nothing in nature is linear. It’s always cyclical. But I think that leads me to growth stocks, if we have another selloff in the first few months of the new year. That will provide us with a great opportunity to go long equities. And I think in the first leg up, the growth segment, the nifty 10 darlings of the Nasdaq 100, will lead. If I’m right—that later in the year commodities will then come back strongly—then bond yields will go up from late ’23 onward. Then, value stocks, the cyclical stocks, the commodity-related stocks from energy to metals to agriculture to precious metals, all those will do very well and fly. And the growth stocks will then die.
Do you see this pattern across regions?
Yes. I think this is worldwide. But I would be very careful of where to move money. Overnight, your Russian exposure was worth zero, because you couldn’t touch them and you couldn’t sell them anymore. So, I don’t know what happens with China. I don’t expect it to become so extreme next year, but it could become so in some time in the following years, because these two powers, U.S. and China, are in conflict with each other. As an individual investor, I would be very careful, and I would not invest in China and Russia.
What about the rest of Asia?
Taiwan is the Saudi Arabia of semiconductors, in a way. And, you know, I fear that Taiwan will be one of the major trouble spots. But it’s very clear that [China’s] President Xi Jinping has said that within the next five years, Taiwan will be integrated. I think that does not go on without any major disruptions and problems. I would rather select the European or U.S. semiconductor companies.
Europe is the most-hated region among international investors.
Well, Europe, believe it or not, had the best rally of all the markets from the late September/early October lows. And this in the face of probably the worst economic situation they are facing. Europe is the big loser of these conflicts with Russia and China.
But it doesn’t necessarily mean that European stocks cannot go up. If you look at Euro Stoxx 50, that index is down from its high by only about 8% or so. And it has had a dramatic rally. The stocks are cheap, and for a good reason. If you buy European stocks, you have to be very selective and buy those that have their headquarters there but sell and are positioned in a way around the world that they can continue to grow. If they cannot do that, it’s over.
What about currencies?
In the second half of this decade, we will see our fiat money system really going into a major crisis. You have to understand that our world needs growth. And we have not had enough growth in recent years because the demographics are a negative and productivity is relatively low. And I think that’s a structural problem.
In recent years, we were able to have the government supporting our system by increasing their expenditures and going into deep budget deficits. And the central banks financed all of that. With what I described about the bond market in coming years, that road will not be possible anymore. And, therefore, we will see sharply rising bond yields, let’s say in 2024 and ’25, where you will probably see in industrialized economies certain governments go bust, bankrupt, like what we have seen in developing economies.
But in every crisis, the dollar appreciates.
I think the dollar has a rally in the first half of next year when the world economy weakens, as I described, but that should really be the end of the dollar bull market that started in 2008. I don’t expect it to collapse immediately because the alternatives are not that attractive, either. Therefore, the system will try to find new ways.
What I suggest is that the decade of the 2020s is a transition period where the old system is ending and several entities will collapse, and a new system will be born by the early 2030s. I’m pessimistic for the 2020s and see roller-coaster markets in that very volatile world, but I see a silver lining for the next decade when I think a new, long cycle can start again.
And lots of volatility immediately ahead. Thanks, Felix.
Write to Randall W. Forsyth at email@example.com