IceCap: Europe, Bonds and The Ski Holiday by IceCap Asset Management
Laughter and bubbles followed by…
Whispers, murmurs and furrowed brows filled the room. Without looking harder, you could also sense puzzlement, bafflement and even obfuscation. Yes, it was scene.
Only minutes earlier the room was filled with laughter, bubbles and the very best French and Italian foods only a local could find. And then it happened – someone dared to suggest all wasn’t quite well in the mathematically challenged land called Europe.
Defensive arguments tilted heavily towards subjective and emotional appeals stammering that only Europeans know what it is to be European. Offensive arguments simply deteriorated to offensive name calling.
Michael Mauboussin Tips From Great Investors [Pt.2]
This is the second part of a short series on Michael J. Mauboussin's research document reflecting on 30 years of Wall Street analysis published in 2016. Q3 2020 hedge fund letters, conferences and more The document outlined Mauboussin's observations of successful investors throughout his three decades on the Street. This article starts at point six. Read More
Just when we thought the momentum peaked, it reached another level with the wager – “I’ll bet you a ski holiday that the Euro doesn’t break apart.”
Now, it was at this point our original conclusion was confirmed, and it was also the point when we felt a bit uneasy about the entire situation. After all, if we declined the wager we would be seen as not being a true believer in our investment outlook for Europe. And, as our readers know, nothing could be further from the truth.
Yet, the wager itself was laced with irony. The exact moment in time when we are in fact proven correct, ironically will also be the exact moment in time when anyone with a vested interest in the Euro loses significant wealth. How would we ever collect on our well-earned ski holiday? As we are not supporters of stealing from the future poor, we declined the wager – but retained our dignity.
The un-lazy summer
Lazy summers are usually the time when you invest in lazy days at lazy parks, lazy lakes and even lazier beaches. Yet, if one took their nose out of their favourite summertime book, they would be shocked by the rather un-lazy restlessness enveloping the world.
During this usually slow time of year, world events have been anything but slow. For starters, another military conflict escalated between Israel and Palestine. Whereas previous conflicts were dominated by missiles and bombs fired across the border, this one saw the dreaded boots on the ground. In addition, Israel’s latest military strategy to protect its people has resulted in over 30,000 artillery shells being fired into Gaza. As you would imagine, damage is extensive. Cease fire and peace talks are being mediated by Egypt, all while the rest of the middle east stews.
If that wasn’t enough to interrupt your summer of bocce, then consider the newest, current situation in Iraq. Yes, only a few short months ago, Nobel Peace Prize winner, President Obama declared that American troops had finally finished their jobs meaning Iraq was now free to stand on its own two feet.
American guns vs American guns
Literally hours later, the entire country returned to chaos as the jihadist group – ISIS (Islamic State of Iraq and Syria) violently took control over many parts of the country. What makes this latest Iraq situation interesting is that ISIS was heavily involved in the Syrian civil war and received substantial military equipment and support from none other than – America.
Today, President Obama has reordered American “military advisors” back into Iraq to help the local government fight ISIS. So, now we have American troops using American military equipment, fighting against a American declared Islamic terrorist group who also happen to be using American military equipment, who also happened to be supported by the American government while fighting against the Syrian government.
Confused yet? It gets worse
It also just so happens that there is another country who doesn’t care much for ISIS. But it also just so happens that this country has interesting relationships with America, Iraq and Syria. This is where everyone’s favourite axis of all evils enters the fray – yes, we are talking about Iran.
Whereas Iran is predominantly Shi’a, ISIS is predominantly Sunni. In the middle east, these two major Islamic denominations have long been at odds and have been a key dividing line between the various conflicts in the region.
As there are no free lunches anywhere in the world – Iran’s offer to help the Americans fight ISIS comes with a small cost or favour. In exchange for helping the next good fight, Iran simply asks for the nuclear sanctions to be lifted.
What could possibly go wrong with this arrangement?
The entire situation reeks of military equipment and foreign policy irony at the highest levels. While Iraq yet again, burns to the ground, there is some good news. In 2002, the Bush government estimated a war with Iraq would cost about $60 billion. Today, the final calculations are reporting the total cost to be closer to $6 trillion.
Naturally, this must be great news for the economy, and will only further help the accelerating recovery. We say this tongue in cheek, of course, yet when the talking heads and big bank economists sharpen their pencils while calculating the latest GDP figures – defense spending and procurement are major contributors.
And speaking of boots on the ground, it appears that any day now the Russia-Ukraine conflict will also escalate to boots, rifles, humvees and other ground hitting equipment. This too will be good for the global economy – at least that’s what you will be told.
However, the situation in Ukraine is anything but positive for the global economy. Now, there will be many investment reporters and analysts who will tell you that Ukraine doesn’t matter. After all, the country’s economy is roughly the same size as that of Oregon.
Obama vs Putin
And, while Oregon may lay claim to producing some of the best pinot noir and micro brews in the world – it cannot lay claim to being the spark that ignites the latest reincarnation of the cold war.
While, the good old days of Reagan vs Gorbachev have passed us bye, the days of Obama vs Putin are just getting started. In effect, investors will be wise not to mistake the Ukrainian crisis as a civil war drummed up through years of domestic cultural differences.
Recall that the real sparks started to fly just as Ukraine declared itself broke – yes, yet another country discovered that you cannot indefinitely spend more money than you collect in taxes. And it was at this moment, Europe strolled in offering a bailout package to help the Ukraine government get through their little money problem.
Problem solved – or at least that’s what we were told. Of course, never to let a good crisis go to waste, Russia saw this as a perfect opportunity to gallop into Kiev offering an even better money saving deal. Fast forward through Maiden Square riots, strong-armed riot police, a fleeing president and an annexed peninsula and you will get the Ukraine-Russia conflict of today.
There are two reasons why understanding this is important for your wealth. First, the long-term prospects for the next great war have increased significantly. Domestically, Russia is really struggling from an economic perspective. The growing divide between the wealthy and everyone else is perhaps greater in Moscow than anywhere else – including London and New York.
The wealth gap in Russia is especially sharp due to the lack of true capital markets. Instead of having free competition and objective regulation, Russia’s economy is dominated and completely controlled by the business oligarchs. If you are in doubt about the strangle hold of these modern day business barons, we invite you to open a restaurant in Moscow and see what happens. We await your reply.
Meanwhile, many non-oligarchs are suffering economically and are simply not happy. And it is this unhappiness that is the target of America and Europe. The western world believes the best way to defeat Putin is for him to be defeated by his own people. And the easiest way to achieve this is to cut off Russia from the rest of the world and then literally watch the government and oligarchs fall apart as well.
Reaganomics accomplished this in the 1980s, so why not Obamanomics in the 2010s? This is why the Western World has embarked on a coordinated strategy to impose various economic sanctions against Russia.
To get started, Canada, USA, the entire European Union, Australia, Norway, Switzerland, and Japan all listed the names of various Russian individuals and Russian companies who are no longer permitted to travel within these countries and who have had their financial assets frozen.
Failure and confusion
There are two challenges with this strategy. For starters, the world’s economy is incredibly complex and dynamic – using linear thinking to solve a non-linear problem can only end with failure, confusion and the inevitable finger pointing. In this case, assuming trade sanctions against Russia will only hurt Russia is a little naive. Yet, this is exactly what has been happening.
As you would expect, Russia responded with their very own sanctions against all of these countries making it illegal for Russia to buy any meat, fish, milk, cheese, yogurt, fruit, and vegetables, from anyone outside of Russia.
While this playground-style tit for tat may appear predictable, the results have been unpredictable – not to the average person, but to the governments at least.
In Russia, it seems that the slowing economy, impending war in Ukraine and sanctions by the west have had the opposite effect. Putin is in fact gaining from this charade. The Russian people are rallying behind him and against the evil Americans and Europeans.
At the same time, European farmers are also up in arms, but not against Russia and Putin. Instead they want to be compensated for their lost revenues and blame only their European governments. European Union flags and fresh peaches have been burned, with the threat of more harm against fresh produce should the farmers not be paid for their lost sales.
From an economic perspective, sanctions from both sides of the latest cold war are hurting the entire world. Latest European GDP data surprised both the talking heads and big bank strategists by barely producing any growth during the last 3 months. The European Union proclaim this is merely a pause to refresh – the great European recovery will go on as they command.
Unfortunately, the now broad European recession is only getting started and the effects of Russian sanctions will really start to bite as the summer turns into autumn. Charts 1 and 2 illustrate the value of international trade between Russia with America and Europe. It’s very obvious, the longer these trade sanctions continue the worse it will be, especially for Europe.
Regarding the sudden lack of European growth, the real surprise wasn’t from Italy or France, but rather Germany. Yes, the German admittance of a recession fell like a lead balloon. It seems that the economic roaring engine of Europe has finally succumbed to the economic stalled engines of the rest of Europe.
And when speaking of the rest of Europe, investors should first spend time in Italy. The country has the 3rd highest debt total in the world – only America and Japan have borrowed more. Italy’s economy is so bad, that it has been in recession in 11 of the last 12 quarters.
Fans of the Euro argue that newly appointed (not elected) Prime Minister Matteo Renzi is going to turn things around. It is said his youthful enthusiasm and penchant for getting people to work together is the perfect recipe for Italy’s future.
If you exclude the debt, there’s no debt problem
We’ve never met the new Prime Minister, but we’re sure he’s a swell guy. Unfortunately, unless he’s prepared to pull Italy out of the Eurozone, Italy will meet economic and financial failure. Those in denial, simply grab a calculator and pour over Italy’s debt load and their tax revenues – it’s beyond us how this can work.
Italy’s Primary Surplus
Of course, one of the main financial arguments supporting Italy’s return to sound fiscal health is their primary account surplus. It is true – Italy is running an enormous surplus and this is good. However, before one runs off touting the strength of Italy’s finances, one should really sit back and ask “what is a primary account surplus”?
Economists everywhere will tell you that the primary account calculates how much a country collects in taxes while subtracting how much it spends. Simple enough – but there is one minor adjustment. Interest payments on debt are excluded from the calculation.
Recall that Italy has the 3rd highest debt total in the world. The country and the entire Eurozone is in the middle of a severe debt crisis. In other words, if you leave out any accounting for debt and interest, you are ignoring the very item that is causing all of the problems to begin with. In effect, if you don’t count the debt, there’s no debt problem.
It’s akin to saying if you exclude all of the body fat, that person isn’t overweight. Or, if you exclude all of the people who finished ahead of me in the running race, I finished first. We think you get the point.
Excluding the interest payments on debt seems a tad disingenuous. Others may call it deceitful, or dishonest. We often refer to old world as the mathematical fantasy land called Europe – this misuse of the primary account surplus data is simply another example of why the situation is so bad in Europe.
And then there’s France
We will be the first to admit that when describing and forecasting France’s economic fortune, we have been rather unkind. Yet, as the data continues to roll in we continue to be proven correct.
France remains an economic nightmare, and we believe a negative wave of social protest is building across the country. Economic despair breeds social despair – France is in serious trouble and the longer Europe ignores the problem the more difficult it will be for France to recover. And if France doesn’t recover, it will be the final beginning of the end for the Euro.
To understand just how bad the economy is deteriorating in France look no further than the most obvious – the job market. At the end of July, over 3.4 million people were without work. In addition, there are another 1.4 million people who want to work but have completely given up hope of ever finding a job. By comparison, at the worst moment in 2009 “only” 2.5 million people were without work. And if deteriorating economic news isn’t enough to convince you that France is unraveling, then simply spend a few minutes following the people in charge – yes, the country’s political leaders.
France – where everything soars
It has been well documented how previous French President Nicolas Sarkozy’s approval rating went from hero to zero in less than two years. This record breaking feat resulted in him being voted out of office in record breaking fashion.
At the time, the French thought it couldn’t get any worse – but it did. Newly elected President Francois Hollande strode into the Elysee Palace with a commanding 62% approval rating and quickly shed the marble floors of anything associated with Sarkozy and his right-leaning policies. Taxes on the rich soared, taxes on business soared, political patronage spending soared, which inevitably caused unemployment to soar and the amount of borrowed money to soar.
The only thing that didn’t soar was Hollande’s approval rating. Today at 17%, it is perhaps the lowest political score ever registered by any elected official on the planet. What does Hollande do? He blames everyone but himself and cans most of his cabinet.
We doubt Hollande’s latest economic revival plan will dig France out of its economic hole – yes, France has a problem but so does Spain, Portugal, Italy, Greece and others sharing the Euro currency. On the face of it, the differences between all of the struggling Euro countries are a combination of both internal and external factors.
Internally, the various governments are all clinging to the hope (there’s that word again) that things will pick up and companies will begin to hire again.
Externally, the folks at the European Central Bank (ECB) are hoping governments can continue to borrow and that the banks remain solvent. Of course, both of these wish list items are contingent upon companies feeling more comfortable to begin hiring again.
If you think you’ve come full circle, you have. The more the European governments and the ECB try to stimulate the economy, the more companies and wealthy individuals withdraw from the economy.
What happens next
Given this current and future economic landscape, in our opinion it is all but certain that Mario Draghi and his friends at the ECB will begin to print money soon enough.
To demonstrate the intellectual acumen of Europe’s greatest central bankers, all you need to understand is that in yet another attempt to stimulate the economy, they announced that short-term interest rates would become negative. This means instead of an investor receiving interest on their investment, they will pay interest on their investment. Yes, this isn’t a typo. Please read it again and let it sink in.
To further grasp this perspective, consider that many in the investment industry believe and support this latest and greatest stimulus tool. Go ahead and ask your investment advisor their thoughts on negative rates, their answer will probably surprise you.
Here comes more stimulus
In September, the ECB will announce yet another new round of stimulus (yes, they’ll never stop). This time they’ll launch the TLTRO (Targeted Longer Term Refinancing Operations). This is the 4th generation of their scheme to indirectly fund the European banking system. At this time, success is an apparent subjective measurement. We can only assume that since the Euro is still alive, the first 3 attempts of LTRO have been labeled a smashing success. The fact that the Euro area remains in recession, with rising unemployment and the shadow of deflation hanging from above, doesn’t matter.
The ironic thing is that even though the TLTRO hasn’t even started or has been given a chance to succeed, the ECB is already talking about providing yet more stimulus – this time in the form of direct money printing. At that time, investors should expect the ECB to begin buying government bonds directly from the Euro-zone countries, as well as buying newly created Asset Backed Securities directly from banks.
On the tax side, we have warned that if you have bank or investment accounts in Europe, you are about to slapped with a tax on your savings. This 10% tax has already been implicitly and explicitly approved by the IMF, the EU, and the ECB. For those in denial, take a few minutes and read up on Spain, after all they’ve already got this tax ball rolling and the real surprise here shouldn’t be that they’ve started it, but that they’ve made the tax retroactive.
The 0.03% tax on deposits was announced in June, but to make things simpler, the Spanish government has decided to make the start date January 1, 2014. The tax is expected to raise around EUR 400 million for the government. We suggest the number will be lower as smart investors and savers will see that this will be the first of many new taxes on savings, and begin to withdraw their hard earned money from the country.
And keeping with Spain, to better understand the true wave of unemployment sweeping the country, simply notice the entrance fees for museums and other national points of interest. In addition to the traditional tired pricing for Seniors/Children and Adults, a third tier for the Unemployed has been added – no further comments are necessary.
As of today, we believe Europe has about 12-24 months before it falls into a very deep recession. As the economic situation regresses, so too will the social and political situation. As a result, we fully expect private capital (ie. wealth from individuals and companies) to flee and seek home in other countries, markets and currencies. Our view has not changed – the US Dollar and US stocks will become a major destination for this money.
The Bond Market
At IceCap, we certainly don’t yet grace the covers of any celebrity-esque magazines, nor do we attract throngs of paparazzi whenever we leave the cozy confines of our offices. Yet for some strange reason many people are oddly interested in what we do on a daily basis. While investors everywhere have an obsessive fascination with the stock market – something that is a little too unhealthy in our opinion, we start off every morning with a good look at the bond market.
Become a dinner party maestro
In some ways, it’s perhaps easy to understand why the bond market attracts so little attention in the media and the regular big bank quarterly market updates. After all, if you want to host the most boring dinner party in the neighbourhood, simply serve some merlot and drone on about the yield curve, credit spreads and basis points.
Alternatively, it’s pretty easy to turn into a dinner party maestro – crack open any bottle of pinot noir, don your newly purchased Google-Glasses and talk about your latest win in the stock market. There’s no doubt everyone will have a smashing time, yet when you wake the next morning you really should toss aside your previous night’s feats of strength stories and dive head first into the bond market.
Unknown to most investors and advisors, the global bond market is valued at over $70 trillion and larger than their beloved stock market. More importantly, we’ll share with you why you should shed your stock market envy, and develop a better understanding of the bond market. Because, what’s about to happen next in the global financial system will certainly create severe morning headaches for investors and tax payers everywhere.
Whereas stock market groupies will tell you that strong profits and earnings are the key drivers of stock market returns – they are in fact missing the boat. In fact, since 1927 stock markets generally do better when profits are growing slowly, and actually do worse when profits are soaring.
There’s also a failure to understand that there are times when earnings and profits have very little influence whatsoever on stock prices. Inflation and real interest rates are also key drivers of stock market returns – yet, if you are going to start talking about inflation during your dinner party, you might as well start serving merlot and call it a night. After all, if you think people do not understand the nuances of the bond market, try sprinkling the conversation with powdery bits of price increases. Yes – a party killer to be sure.
Yet, research has been crystal clear – whenever inflation is declining from high levels, stocks and bonds perform very well. Fortunately, the alternative is also true – whenever inflation begins to rise from very low levels both stocks and bonds will perform well.
Today, inflation is certainly declining which should elicit “yays” from our stock market friends. Yet, if want to be a party pooper (or realist – take your pick), you should also tell your guests that when inflation continues to decline through a somewhat magical/opaque line the opposite happens – stocks and bonds decline.
In general the biggest problem in our financial world today is that around the world inflation is declining straight through this magical line. Chart 3 on the next page shows Europe’s current experience with inflation and this is what should be discussed during your dinner parties. Granted, there are countries who are experiencing price increases and this will always be the case. However, since 2009 various measures of inflation have been on the downtrend and this isn’t exactly good.
We’ve written before how the world’s central banks are completely occupied with trying to keep inflation at a stable rate, all of the time. The folks tasked with this job have had some serious training. In fact, those in charge have pretty well dedicated their entire lives to understanding why prices move up and down. This group of men and women are so dedicated to their trade, that they’ve spent their entire career in academics studying and developing economic theory.
Put another way, few of them have actually worked in the real world. Whereas everyone else in life has to learn through a few hard knocks every now and then, the biggest knock facing most of our central bankers is wearing the wrong loafers to their afternoon fireside chats. We’ve been told the mocking and ridiculing can be rather uncongenial at times.
Understanding the background of our central bankers is crucial to understanding why and how the global financial system is about to enter a rather interesting phase.
The world’s challenge is that our central bankers believe they can in fact control the business cycle and inflation, which will then be reflected in financial markets. What is making this uncomfortable for many people in the real world, is that the actions of the central bankers are doing the opposite – they are making matters worse. And, worst of all, the central bankers don’t seem to understand that it is their very actions that are creating the severe distortions we are seeing today.
We’ve also written before that the central bankers have been digging a hole now for 5 years, and instead of asking for help to get out, they are demanding bigger shovels to dig even bigger holes. Look no further than past, present and future actions by the European Central Bank for proof of this pudding.
As a result of ineffective actions by our central banks, this global decline in inflation is a reflection of the lack of consumer and business confidence to spend and make capital investments. Our overall investment thesis has been very clear – our governments’ reaction to the 2008 credit crisis simply transferred all of the bad investments from the private sector to the tax payer.
And this brings us to the bond market
Virtually every country in the world spends more money than they collect in taxes, and no group of countries has done a better job at this than those that formed the Euro-zone.
Attempting the impossible
This collective group has so much debt, that a recent study by the Bank of International Settlements concluded it would take 20 consecutive years of surpluses to simply bring debt loads back to levels previously reached prior to the current crisis.
Considering that this has never happened before, we have little confidence that this type of spending constraint can be accepted and implemented by any of the respective governments.
There is only one way possible for any person, company or government to spend more money than they earn – they must borrow to make up the difference. And as long as the Euro-zone countries are able to borrow, they’ll be able to extend the charade a while longer.
This is the point when many investors and pro-Euro supporters will argue that all of the Euro-zone countries are able to borrow, and in fact each country is able to borrow at the lowest interest rate in history for each individual country.
This is indeed true. However, this is the point when IceCap reminds investors that there are two types of debt markets. The first is the one where the price or interest rate you pay is determined by the open market, with no interference or influence by other forces.
In 2012, the Euro crisis reached it’s latest crescendo and each country’s ability to borrow was at the mercy of the open market.
September 2014 The Ski Holiday
Within a span of several months, the cost of borrowing increased from 50% to 100%. In effect, the open market said these bonds are very risky and there’s a pretty good chance, investors will not get their money back.
What happened next was a second type of debt market where prices and interest rates are directly and strongly influenced by governments via their central banks. To prevent the Euro-zone from collapsing in 2012, the ECB (European Central Bank) implicitly guaranteed borrowing for each Euro-zone country.
This second type of market is one where prices are not determined by private investors and a free market. For our economic buffs, this is similar to a centrally planned market or a closed market place. For the average investor, simply think about how products and services were priced in the Soviet Union prior to the collapse of communism.
Our table 1 on the next page demonstrates the key differences between these two types of markets. Anyone who argues that today’s European bond market is a free market and that current prices reflect reality, really shouldn’t be in the investment business.
Some will argue that the continued bailouts and stimulus packages from the ECB will allow the Euro-zone to continue on its merry way into eternity. We believe otherwise. None of these stimulus programs are feeding money down to the unemployed. Many are becoming extremely frustrated, and this is being reflected in the high turnover of current governments, increased popularity of extreme right and left wing parties as well as a rise in popularity of separatists movements.
Every market has a release valve, and for Europe it will be the bond market. The beginning of the end, so to speak, really starts when social unrest reaches a new level. It’s at that point confidence rapidly declines and so too will the European bond market.
Today, those that are comfortable investing in bonds issued by European governments, banks and insurance companies really don’t appreciate how far and hard this market can drop. The entire bond market is really like the Hotel California – getting in was easy, but just don’t try to leave. This is the point when the Euro bulls will discover the true market price for their Euro fixed income bonds.
Investors in Canada, the USA, India, Australia and elsewhere should really pause to consider what happens when the ECB is unable to continue its support of the European bond market.
The breaking of the Euro bond bubble will be much different than the breaking of the Technology bubble. The key reason for the difference is that the bond market is the funding mechanism for banks, insurance companies and governments. Any struggles in this market will absolutely ripple across to the equivalent markets in other countries.
We want to stress that this is a very complicated subject and perhaps this is the reason why it isn’t discussed by other managers, the big box banks and the main stream media.
We encourage all investors to further research the European debt crisis and then to start asking their investment advisors some serious questions. And once you’ve achieved a better understanding, start planning for a real nice European ski vacation – we expect you’ll soon find a few bargains.
In our previous market outlook we warned of the potential for a shallow stock market correction. Markets did indeed pull back, and it was only a bit but just enough to get the media and market pundits riled up.
Be careful with high yield
We fielded many questions and concerns from investors asking if this was the big one. The pressure to sell out of stocks was actually more intense than at any other time over the last few years. Our research indicated that conditions for a dramatic market fall were not present and we therefore maintained the course.
As of today, the situation remains the same. Our internal market indicators focus on trend, momentum and sentiment and collectively they are not in a warning position. While our long-term view remains the same – we expect the US Dollar and US stocks to really soar relative to other markets, we are very aware that a near-term correction in the 10-20% range is necessary.
Bond markets, and more specifically the high yield bond market provided investors with a preview of what we believe is coming at some point down the road. In mid July, our research concluded high yield strategies had reached its maximum value and we therefore sold our positions. While we didn’t expect it to happen as fast as it did, but merely days later the high yield market fell over 5% and thus providing investors with a preview of what we believe will be occur at some point in the near future. The lack of liquidity in this market is frightening and anyone with investments in this market should be aware of the risks.
As always, we’d be pleased to speak with anyone about our investment views. We also encourage our readers to share our global market outlook with those who they think may find it of interest.
Please feel to contact:
John Corney at [email protected]
Ariz David at [email protected] or
Keith Dicker at [email protected]
Thank you for sharing your time with us.