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Zulauf Sees Unprecedented Risks: Zhou Fears Deflation

April 7, 2015

crystalballThe head of the People’s Bank of China, Zhou Xiaochuan, says that China must be “vigilant to see if the disinflation trend will continue, and if deflation will happen or not.”

The Governor’s remarks, delivered at the Boao Forum for Asia, constituted a rare admission by an official of the People’s Republic that things have gotten worrisome.

And if they’re worrisome for China, they are at least worth a frown in the rest of the world.

This hasn’t kept some analysts from treating the remarks as good news, on the hypothesis that such words indicate the imminence of further central bank stimulus. I suppose if someone starts coughing I might take it as a sign of his health, on the double assumption that he’ll take his medicine as a consequence and that the medicine will in fact be healthy.

Asian markets yielded no unambiguous verdict on how these coughs ought to be taken. As they became public, China’s Shanghai Composite Index fell somewhat, Hong Kong’s Hang Seng rose. And of course, there was a lot else that was going on, so whether either of those moves was to any degree a response to Zhou is, more than usually, guesswork.

The Acting Man Interview

Those of us (I shamelessly include myself in their number) who find Zhou’s observation more a matter for frowning than for relief find our mood echoed in an extraordinary interview that ran recently in the much-watched blog,  Acting Man, where on March 26th Frank Suess posted his conversation with a prominent Swiss investor.

The interviewee, Felix Zulauf, is the principal of Zulauf Asset Management, and a former global strategist for the UBS Group. He said that central banks have intervened on such a large scale of late that they have left “global financial markets … more distorted than ever before and accordingly the risks are very high.” This “can’t be compared to previous situations.”

Zulauf brings a fresh twist to all the talk of a “new normal.” Usually the term is used as a means of re-assurance. The crisis atmosphere has abated; a “new normal” has developed. Whew. But to Zulauf, that’s the problem. It is now “normal” that zero and even negative interest rates have undermined the value of assets.

Zulauf’s observations preceded Zhou’s, but the conjunction is natural. Even if Zhou’s remarks are taken as evidence of further stimulus; that is simply another confirmation of the new normal.

Three Possible Outcomes

Zulauf sees three possible outcomes of the new normal: one of these is the inflation-breeds-deflation scenario. A weakened Chinese currency will reinforce global deflationary pressure, dampen down both prices and profits “and finally the real global economy.” He doesn’t see that as the most likely of the outcomes, but it certainly drew Suess’ attention.

Later in the interview Suess, after noting that Zulauf’s fund has had a lot of exposure to Asia over the years, said that China’s government is confident about growth, predicting a 7% number this year, and asking Zulauf what he makes of that.

Zulauf said that the 7% figure is “a joke.” China’s growth is “now beginning to fall below 3% and won’t stop slowing for several years”. China has to play down its problems because it is afraid that capital will rush for the exits.

Further, he denies that there is any “painless” way out, though central bankers keep looking for one:  worsening the situation as they do so.

Also in the short term, and looking to Europe, Zulauf said that he will not be surprised if German 10-year Bunds, which now yield 0.25%, goes into negative territory. “There is plenty of liquidity around and the banks cannot lend it out,” and it is distressing that Mario Draghi’s response is to weaken the Euro further, creating another trillion of them.

Zulauf’s interviewer, Suess, is the CEO and Chairman of BFI Consulting and a former senior manager with Price Waterhouse.