The Other Zulauf . . .

In 2010, I did an extensive interview with Felix Zulauf. He and his son, Roman, are launching a new hedge fund. Joe Dedona, head trader at our Institutional Desk, sat down with Roman for this interview:

Roman Zulauf is Co-CIO of Vicenda Asset Management, an alternative asset management company based in Zug, Switzerland.  We were fortunate to spend some time with him and hear his outlook for the next 6 months. His thorough macro analysis will make this father Felix proud.

Its midyear and the fixed income markets have had this big sell-off in May, particularly in emerging markets. What went wrong?

Over recent years, the Fed’s QE policy unleashed massive capital flows into emerging markets as they offered more attractive yields and growth potential. This pushed up asset prices in the emerging markets, mainly their fixed income markets and to a lesser extent their equity markets. Consequently, their currencies appreciated sharply against the USD, which over time became a drag for their export industries. That is why the authorities in the emerging markets tried to fight the revaluation of their currencies and bought USD and sold their domestic currency. By doing so, they had to increase their domestic money supply and thus added more liquidity to their credit systems, which accelerated domestic lending, credit growth and the internal demand. As a result, emerging markets’ external balances began to deteriorate during that period.

Recently, the Fed has openly discussed the possibility of tapering its QE regime if the economic recovery is sustainable. Although we are far away from a new tightening cycle by the Fed in the classic sense, the possibility of tapering QE is a de-facto tightening in the post-2008-QE world. Moreover, in anticipation that the global economy may surprise on the upside, rather than on the downside, the banks’ treasury departments in the US have started to front run the Fed and sold some of their bond inventories. The rise in US yields was substantial as 10y Treasury yields rose from 1.62 to 2.2% over the course of May. However, prolonged sell-offs in US fixed income due to Fed tightening or at least de-facto tightening because of such expectations usually have serious consequences for emerging markets. Now, the process as described above for emerging markets has gone into reverse: rising US yields have triggered capital leaving the emerging markets. Consequently, their currencies have come under pressure and yields are rising. This has led to a reduction of liquidity in their economies.

So do you think that is only a temporary setback in the multi-year bull market in emerging markets fixed income and currencies?

No, I think that we have seen the top in the bull market for emerging markets fixed income and currencies.

Are there any emerging markets that look particularly weak?

Yes, there are some that stand out. First, there is Brazil. Brazil is going through the classic emerging market boom/bust pattern: weak balance of payments situation, the darling for carry traders for the last decade, sensational bull story as main beneficiary of the China boom etc. Since early 2012, sentiment towards Brazil seems to have changed due to the slowdown in China and the end of the commodity super cycle. As the currency has depreciated substantially, inflation concerns have come into focus. That is why the Brazilian central bank has had to hike rates this year from 7.25% to 8.00% despite a weak domestic economy. Brazil is a perfect example of the process described above.

Further, I think that Turkey is at a major reversal point. Their current account deficit is 6% of GDP; all financed by foreign capital inflows, predominantly portfolio investments into Turkish fixed income. The central bank has cut rates several times in order to prevent the currency from appreciating, which of course just fuelled the domestic credit bubble even more. Private sector loans have tripled since 2008. External debt amounts to 40% of GDP and a third of this external debt has a maturity of less than one year. You get my point. Turkey is a highly leveraged economy and thus is extremely vulnerable to rising global yields and a reversal of global capital flows. The May sell-off in global fixed income marked the turning point in Turkey. The central bank is now concerned about rising inflation due to a depreciating currency and thus rate hikes can be expected over coming months as the currency will weaken further.

And then there is Mexico. Of course, the industrial reshoring from US companies from China to Mexico is a great development. However, being long Mexican fixed income was very popular over the last couple of years and was probably one the most crowded trades until last month. I think we have seen the bottom in Mexican rates, too.

Peripheral yields in the Eurozone have substantially come down after Draghi promised to launch a bond purchase program if needed. Where do we stand regarding the Euro zone crisis and European economy?

Well, Draghi’s speech last summer was really a temporary turning point in the Eurozone crisis, at least in the financial markets. Peripheral bonds and European banks have rallied strongly. However, the situation in the Eurozone’s real economies has been deteriorating despite the rally in the markets as the credit crunch has intensified. As the Eurozone in aggregate is a balance of payments surplus area a decline in economic activity is very deflationary. Thus, this is supportive for the Euro and the reason why it has gone up. This process may continue for a few months up to the point where the side effects of an appreciating currency lead to a further decline in the economy and will at some point trigger a reversal of the rally in the peripheral bonds. The potential selling pressure on Eurozone debt will then be immense as Draghi’s verbal intervention last summer led to one of the most spectacular moral hazard trades in recent history. Once this happens, the ECB will then have to step in and use its OMT program to buy those bonds. This should then end the Euro advance. Peripheral bond yields are now in a bottoming process that can last a while. But watch out for developments in France. France is in recession, its unemployment rate is at the highest level since the introduction of the Euro and it has been running a current account deficit since 2005. France will be hit hard by the current strength in the Euro. Then there will be elections in Germany in September. The most likely outcome will be a grand coalition between Merkel’s conservative party and the social democrats. They are talking about increasing income taxes as well as introducing a wealth tax. This is anything but a magic formula for stimulating your economy.

Let’s move on to Japan.  Abe has acted on his promise to stimulate and inflate. Does the Yen continue its free fall or is the recent firming a trend change? 

The structural down trend for the yen is still intact. However, the first phase of this decline has been sharp and quite dramatic. Therefore I don’t expect any further decline in the near term but rather a consolidation for the next couple of months between 100 and the mid 90s.

Will JGBs sell off further as investors flee the dropping yen and worry about inflation?

The sell-off in fixed income was particularly dramatic in Japan where the 10y JGB yield jumped from an all-time low of 0.34% right after the BoJ decision in early April to almost 1% by the end of May and is currently trading at 0.83%. This massive increase in JGB volatility is frightening, given that the Japanese banks’ JGB holdings amount to roughly 900% of their tier-1 capital. Bear in mind that the BoJ launched the mother of all QE programs in early April. So far, the selling pressure in the yen has come mostly from foreign investors. The big players in Japan like the life insurance companies and pension funds have not been big sellers of JGBs, yet. The only big domestic sellers have been the banks, which sold approximately 5% of their JGB holdings in May. The Japanese have voted for Abe and thus explicitly for his promise to deliver more inflation. The rally in the Nikkei has increased his popularity. But I doubt whether his policy of trying to achieve more inflation will be for the good of the country. As a first unintended consequence of Abenomics, the BoJ seems to be struggling to keep the JGB market under control. This is not a good thing when your debt to GDP amounts to 240% and you have negative demographic forces at work.

Do Japan’s trading competitors continue to cut rates?   Are there any good currency trades in Asia right now?

Well, the Koreans have already complained several times over the negative impact of the declining yen to its export sector. I understand that they are tempted to cut rates, too. Nevertheless, it would be a brave undertaking to cut rates in an environment of rising US bond yields. China for example is currently going just the other way and has revalued the yuan by almost 2% this year. It is difficult to analyze China’s official data as transparency is a real issue. But one possible explanation for this might be that the pressure from domestic capital to leave the country is so high that they have to tighten domestic liquidity by revaluing the currency.

Some attractive trades in Asian FX at the moment are long EUR/SGD and long USD/MYR. Whenever the yen depreciated on a bigger scale over the last two decades, the other Asian currencies sold off as well but with a lag of a couple of months. I also like long EUR/TWD and long EUR/KRW. However, there will come a point in a few months when the long Euro leg of these trades will have to be switched into long USD (and short Asia FX).

Everyone thinks the US is the place to be invested as the economy is growing steadily and flows into US equities have increased. What’s your opinion on this?

Well, the inflows into US equities have been large, indeed. And the performance of the US economy relative to Europe or Asia has certainly been a driver for this. Nevertheless, a substantial part of those inflows into US equities have come from US companies themselves as they have taken advantage of record low corporate bond yields. That is why they have increased their balance sheet gearing by issuing more debt and used it for share buybacks instead of capex. Going forward, I see two possible scenarios. First, the broad based expectations of further economic expansion in the US and recovery in other parts of the world turn out to be right. If so, then global interest rates and the USD will rise further and lead to sell-offs in other asset markets such as global equities and emerging markets fixed income and currencies as expectations of Fed tapering would intensify. Or second, the economic recovery in the US and the rest of the world will disappoint and therefore speculation about Fed tapering would become silent. If so, then global fixed income markets, particularly US Treasuries and German Bunds, will rally. Tactically, I favor the first scenario but given that this four year old bull market in equities is maturing, I tend to expect more disappointments towards the end of this year and the latter scenario.

What is your opinion on commodities? The current thinking is the super cycle is over. What are some commodities to buy and some to avoid?

Yes, I do think that the super cycle in commodities is over. We not only have weaker demand globally for commodities but also more supply due to increased investments in commodity projects during the boom years. We already see that some major projects are getting abolished.  Resource projects worth $150bn have been cancelled or delayed over the past year in Australia alone. Base metals are short term heavily oversold and there’s a fair chance for a bounce over the next couple of weeks, particularly in aluminum. The forward curve in crude oil still signals a global shortage as the price decline has caused the Saudis to cut production since last summer. Hence, the odds are good that crude oil can rally in the short term. Gold is massively oversold and at least some bounces can be expected over the summer. But for a resumption of the longer term bull market, the outbreak of a new crisis is needed.

What are some of your favorite themes or ideas for the second half of the year? Anything out there that could trip up the markets or needs to be closely monitored?

We are about to leave the low volatility environment as global markets are starting to decouple from each other and decorrelate. Therefore, trading is crucial in this environment whereas the buy and hold strategy in many asset classes are getting dangerous. As I believe that the bull market in emerging markets fixed income and FX is over, I like short exposure to those that have weak fundamentals like Turkey and Poland. Since joining the EU Poland has benefited a lot through EU sponsored infrastructure projects but is now about to fall into recession for the first time since it joined the EU. The Polish central bank has cut rates aggressively from 4.75% late last year to 2.75% last week. But two days after they cut to 2.75%, the central bank already had to intervene in the FX markets to prevent a further decline of the zloty. By doing so, they basically signaled that the cutting cycle is over. But this is not because of a strengthening economy but rather due to a weakening economy, negative balance of payments dynamics and a currency that is under heavy selling pressure. This is a bad combination. My favorite trades are long EUR/TRY and long EUR/PLN as well as being short Turkish fixed income. Once the expected rally in the Euro is over, one should switch the long Euro leg of these trades into long USD. In equities, my preferred trade is long volatility as the four year old bull market is maturing.

Thank you very much Roman. In case someone is interested in Vicenda Asset Management, how can they get in touch with you?

The best way to contact us is to visit our website

Roman Zulauf is Co-CIO of Vicenda Asset Management, an alternative asset management company based in Zug, Switzerland.  

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