Global Market Outlook August 2012

Our view on global investment markets: August 2012 The Flounder Keith Dicker, CFA Chief Investment Officer [email protected] www.IceCapAssetManagement.com

Flippin and floppin

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The King The Flounder is the true king of the sea. Its graceful movements and ability to blend with rocky bottoms ensures many peaceful days in the wild blue yonder. Patience is yet another exemplary trait it can go about its way for days bothering no one while being unbothered itself. The flounders life is slow, abundant and peaceful - until it isnt. The moment the flounder is disturbed from its idyllic life, its only defense mechanism is some serious flippin and floppin. While this flurry of activity provides initial relief the end is inevitable. It was nice while it lasted, but the flounder suddenly is no more. Since man first learned to walk upright, there have been many villages and then towns and then countries that have all floundered at some point. Certainly those toppled by war and disease deserve our empathy. Today however, its the good old fashion money problems that is turning once vibrant countries into floundering states. Considering the Worlds largest economies are printing money with reckless abandon, its important to know which ones are floundering and which ones are resting quietly under the sea. The Flounder Meter While every business and industry implicitly believes in its

August 2012 The Flounder

meaningless acronyms and language, nothing compares to the financial services sector. This industry, the one who gifted us APR, ISM, RSP as well as Core CPI calculated to the 3rd decimal point, is the unchallenged king of senseless terms only a risk manager would love. In response to these unnecessary complications, IceCap is introducing a necessary yet simplified tool for measuring the state of the Worlds leading economies The Flounder Meter. This new metric considers the combination of money printing, bank bailouts, debt levels, government spending and borrowing costs for a given country. The Flounder Meter will finally allow everyone to see through the smoke and mirrors and decide for themselves whether a country is in good financial health. The inaugural results are shown on the next page. Unsurprisingly, Europe is the biggest flounder in the sea. Yet, the only difference between Europe and other indebted countries is the cost they pay to borrow. Should long-term interest rates rise, America, Japan and Britain will be joining Europe at the top of the Flounder Meter. Europe 4.5 Flounders In the economic fantasy land called Europe - the amount of money borrowed vastly exceeds the amount available to repay. At the same time, economic growth and tax revenues are no where close enough to service this debt. Europe remains a financial basket case, and a

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Chart 1: The IceCap Flounder Meter

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Country / Region

Money Printing

Bailing Out Banks

Too Much Debt

Too Much Spending

Too Expensive to Borrow

Europe

Britain

USA

Japan

China

Canada


Source: IceCap Asset Management Limited

Tapas, Rioja & Zurich


very dangerous one at that. We believe that when the Greek dam finally breaks, investors will be surprised of the financial reaction. And this is only Greece. Whereas Ireland, Portugal, Greece, and Cypress have already floundered for everyone to see, Spain is just getting started. And because this isnt just a bad dream, we must consider the numbers involved. The combined total of bailouts required for the aforementioned countries is over EUR 260 billion. Spain meanwhile has nearly EUR 900 billion in liabilities outstanding. Better still, what money Spain is able to currently borrow costs them 5% and more. For comparison, USA, Britain, Germany, Japan and Canada all borrow for less than 2%. Yes, Europe has agreed in principle to lend Spain EUR 100 billion to shore up their banks. But what most dont realize is that this simply replaces the amount of deposits that has fled the Spanish banking system. The Spanish people and companies can see the writing on the wall and it is telling them to get their money out of Spain. Simply transferring your money to another bank in Spain isnt enough the risk of having your money converted to the old Spanish Peseta is causing people to stock up on tapas and rioja and take the short journey to safety in Zurich. Unfortunately (and ironically for that matter), what happens in

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Switzerland doesnt always stay in Switzerland. As soon as the Spanish, Italians and others deposit their money in Paradeplatz Square, the Swiss National Bank quickly turns around and uses this new money to buy the equivalent in Euro. In effect, the Swiss are arguably the biggest buyers of Euro in the World today. Just as Frankfurt tries to demolish financial mathematics, so do the Swiss. As a result, those seeking safety in Swiss Francs may actually be taking on significantly more risk than they originally intended. Meanwhile, Spanish property values continue their descent, the economy is in deep recession, and the autonomous communities are in desperate need of cash. Yet the federal government has no cash available. In other words, Europe lending Spanish banks EUR 100 billion is the same as sticking your finger in one leaky hole only to soon see another sprout up. Considering the Europeans have already used most of their fingers and toes to plug holes in Ireland, Portugal, Greece and Cypress its only a matter of time before they run out of digits. The Spanish Spiral has already started and there are only bad choices available to stop it. The first bad choice is for Spain to begin running massive trade surpluses it has to sell more to other countries than what it is buying. Presently, this impossible task can only be achieved if Spains labour costs were cut dramatically. Lower input costs will make Spanish goods cheaper on the World market.


Watch out for Italy


Italian economy is the amount of money it borrows you just know a financial catastrophe is lying straight ahead. Money printing, too much debt, too much spending, bailing out banks, and excessive interest rates for the southern European countries helps Europe to almost push the Flounder Meter off the charts. Chart 2 on page 5 shows current growth rates across Europe. Nothing is getting better, in fact the best that can be hoped for at this point is stagnation. Our view on Europe hasnt changed. Europe simply refuses to allow any country to default on its debt. Europe believes money printing and other monetary gimmicks will save the day. Mathematically and economically this cannot work. In the end, the ECB will eventually print trillions of Euros believing it will save the day. Regardless if Europes mountains of debt is held by investors or the ECB, the debt remains and it cannot be paid in full. The only question that remains is whether the ECB launches their massive money printing scheme before or after the European system reaches its pinnacle. The end result is inevitable, how it plays out is not.

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Unfortunately, politics alone guarantees this path to economic freedom will not be chosen. Now of course, even if Spanish workers were prepared to accept the draconian wage cuts necessary there is no certainty that other countries will allow Spain to gain significant market share. In short, this option is dead in the water. In our opinion, the other option is much more likely to happen. Yet, the short-term pain involved means no politician will be endorsing it anytime soon either. Spain needs to leave the Euro-zone and reinstate its former currency the Peseta. To date, Spain is the biggest flounder in Europe. It is already flippin and floppin around, yet due to this being the slow summer month of August, no one really cares yet. Over the next few months, the World is going to start caring a whole lot. And then there was Italy. Wine, food, espresso and afternoon naps certainly supports the case for Italians being crowned lifestyle kings of the World. Come to think of it, if you allowed me to accumulate close to EUR 1.7 trillion in debt, Im pretty sure I would have enjoyed life as well. Unfortunately for Italy and its Goldman Sachs lead government, their easy lifestyle is about to flounder. Italy has the 3rd largest debt in the World. Yet, its economy is only the 10th largest. When you consider that the only thing growing in the


Chart 2: Growth is floundering in Europe & Britain



-4.00%

-3.00%

-2.00%

-1.00%

0.00%

1.00%

2.00%

3.00%

4.00%

5.00% Italy GDP

-2.00%

-1.50%

-1.00%

-0.50%

0.00%

0.50%

1.00%

1.50%

2.00% Spain GDP

-12.00%

-10.00%

-8.00%

-6.00%

-4.00%

-2.00%

0.00%

2.00%

4.00% Greece GDP

Source: OECD -3.0%

-2.0%

-1.0%

0.0%

1.0%

2.0%

3.0%

2010 Q1

2010 Q2

2010 Q3

2010 Q4

2011 Q1

2011 Q2

2011 Q3

2011 Q4

2012 Q1

2012 Q2

Britain GDP

Financial point of no return


Britain, USA and Japan 4 flounders The British, Americans and Japanese are cemented into no growth economies backed by increasing debt, increasing deficits, and increasing money printing to keep political and financial life afloat. The only significant difference between these guys and Europe is their cost of borrowing. Mathematically speaking, as long as you are able to borrow money at interest rates lower than your sustainable rate of growth life should work out just fine. However, the moment your borrowing costs rise you have a problem. Now, this problem is manageable over short time periods. However, the real crisis begins as soon as you reach the point where others refuse to lend you more money. This also happens to be the point where the amount of money you must devote to interest payments alone begins to overwhelm your entire financial position. Presently, neither Britain, America nor Japan are in this boat. However, unless the global economy rebounds both quickly and strongly, Japan is clearly heading towards the financial point of no return. As a percentage of GDP, Japans 230% debt load would make even the Greeks blush. Unlike Greece however, Japan has been able to borrow money at very low rates directly from its citizens. Unfortunately, demographics are not aligned and the number of Japanese entering retirement is just beginning to tip this favourable

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situation against the Japanese Ministry of Finance. At some point very soon, Japan will become reliant upon foreign investors and we have feeling that these investors will not at all be happy earning < 1% on long-term loans. As the Japanese government currently allocates almost 50% of their tax revenues to interest payments on their debt, the financial impact of Japans cost of borrowing rising from 1% to 2% will be devastating. And if you thought the European debt crisis has become all too consuming, just wait until Japan elbows their way on stage it wont be pretty. China 2.5 Flounders For years, Chinas economic model has been the envy of the World. The Chinese actually did nothing special except recognise a great opportunity. While the Western World feasted on the American lead doomed monetary policy China simply opened a few factories to build the much sought after LCD TVs, Ipods and everything sold at Wal-Mart. Soon enough this cash bonanza forced Chinas government to loosen its own purse strings and to begin building new roads, bridges, power stations and entire cities to satisfy all the new workers. This capital spending spree made the Western World giddy with excitement, and justifiably so there was money to be made. Today however, viewing the Chinese economy as a stand alone

Imbalanced = Balanced


miracle is incorrect. The global economy is just that global. The unquestioned slowdown in the US and Europe is also causing the Chinese factories to slow which inevitably causes Chinas capital investment machine to slow as well. Unfortunately, the slowing of Chinas capital investment programs stops the real estate and construction industries in their tracks. The infamous Chinese ghost cities were not free. They absorbed billions in capital investment and now Chinese investors, including banks are sitting on a growing pile of non-performing assets. At this point, the Chinese government is unsure how to react. Its a fact that their banks have suddenly become zombie-like, making the prospect for additional capital investment less and less likely. And just as Germany has figured out, its difficult to export your way to prosperity when the rest of the World is not in any mood to import. Meanwhile, the real crux of the Chinese economic problem is their savings rate. Whereas the American vision of saving is simply to use Groupon, the Chinese do it the old fashion way they simply dont spend much of their money. While the Western World would love to have this problem, saving too much money is just as bad as saving too little money. It creates an imbalanced economy where in Chinas case, growth has been primarily supported by capital investment in roads, buildings and the like. While initially good, this intensive capital spending spree

eventually reaches a point where each additional road, building and city adds no economic value and in fact begins to produce negative returns for investors. Chinas standing in the Flounder Meter shows it as being in better financial shape than most others. Yet, the point we make is that the debt problems in Europe and America will affect China, and more importantly just as America has an imbalanced economy, so too does China. Canada 1.5 Flounders Since the 2008 financial crisis, Canadians have been very fortunate. Due to then Finance Minister Paul Martins decision in the mid 1990s not to allow the Canadian banks to merge, Canadian banks avoided a lot of the nasty American real estate schemes and have collectively held up very well and shine on todays World banking stage. The 1990s was also Canadas chance to shine on the Worlds austerity stage. At that time, Canada finally fessed-up to its money problems and dutifully raised taxes, cut spending and systematically pared down its debt over time. Then as the millennium finally arrived, so too did the beginning of a glorious run for commodities this was really the icing on the cake and propelled Canada from the bottom of most G7 financial metrics straight to the top.


Minting fresh loonies


While today Canada ranks very well relative to other Western World countries, it still runs a deficit. Except for the commodity powerhouses, most provincial finances are not improving. At the same time, conversations about Canadas near-mythical real estate markets are turning more worrisome. Whether you believe it to be cyclical or structural, Canadas slowing economy is negatively effecting its debt load. And, on a more sinister basis, should Canadas long-term interest rates increase by even 1% both residential and commercial real estate will decline. What has us most concerned these days however is the Bank of Canada. Just last month we wrote about Mark Carneys acknowledging his dislike for socializing private sector losses onto tax payers. Yet, what really concerned us was his admiration for the Worlds other central bankers and his pride for belonging to the central banking brethren. At this point in time, Canada is the only G7 country not to print money. And justifiably so - Canadas financial conditions certainly do not warrant such draconian measures as schemed by the famed central bank brethren. However, on August 20, 2012 all innocence of the Bank of Canadas monetary policies has been lost for ever. The Globe & Mails front page story As strong loonie pinches manufacturing, Carney faces auto workers opens the money printing can and openly questions if

the Bank of Canada should begin minting loonies to devalue the Canadian Dollar. At this point in time we can only hope that Mr. Carmichaels article is his own perspective. If however, Mr. Carmichael has suddenly morphed into the Jon Hilsenrath of the North and has in fact become the unofficial spokesperson for the Bank of Canada, then Canadas innocence and financial respect is about to be lost. Not to despair, this loss will be a gain a gain of an IceCap Flounder and a rise in this unfavourable ranking index. Not seeing the big picture Remarkably, what is lost upon most people is that the enormous debt loads accumulated over years enabled us to live beyond our means. Today, the financial stress created by this borrowing binge has created huge fissures in the global financial system. These fissures are the result of money that has been borrowed but cannot be repaid. In the financial World, we refer to this as deflationary, meaning the bad debt acts like an anchor on the economy and results in low to negative growth for all economies involved. This deflationary process cannot be stopped. Billions in debt simply will not be paid and investors will have to take losses. Policy makers however, are trying their darndest to stop it. They believe the way to stop this deflationary force is to print money. The

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Deflating or Reflating


hope is that by printing money, the bad debt will be paid back over time and the global economy will not decline. This process is referred to as inflating or reflating the financial system. In effect, we have two giant forces coming head to head. We have the man-made deflationary force coming in one direction and the man-made inflationary response coming from the other direction. There can only be two outcomes, and neither one is pleasant. Should the deflationary wave prove too powerful, the global economy is headed for a very deep and prolonged recession. Should the inflationary wave overcome, one should expect the global economy to produce low real growth but with hyper inflation. At this point in the game, deflationary forces are overwhelming reflationary efforts. In other words, the total losses from the ongoing financial crisis continue to be greater than the total amount of money printed. Considering we have had over $5 trillion in stimulus, this is no laughing matter. One thing is for certain, the central banks and governments of the World are dead-set on reflating the global economy. As they are presently behind the ball and losing the game, one must fully expect to see plenty more money printing from the Americans, the Japanese, the British and especially the Europeans. Europe is hanging by a single financial thread called Germany. Ironically, despite the

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aura of German financial magic, even this disciplined financial nation isnt strong enough to stop the deflationary wave from engulfing Europe. Now, we fully admit that the entire deflation versus inflation concept sells few newspapers and advertisements, yet this is the single most important issue facing the financial World today. Of course, considering that the majority of investment professionals today all earned and learned their stripes during the mega 1982-1999 secular bull market, it really isnt a surprise this all important dynamic isnt reaching clients and their kitchen tables. Meanwhile, an entire generation of new hires over the last 5 years have learned to analyse markets based upon how much money will be printed by central banks money printing is accepted as normal to these young bucks. To offset this industry imbalance, you simply need to ask yourself why is there so much effort going into money printing and other bailout policies? Crime does pay The prestigious award for being the only person in the entire World who would never ever be offered a job by a major bank goes to Sonny Curtis.

Sonny Curtis


While Mr. Curtis is 75 years old, it certainly isnt his age that is preventing him from travelling in private jets, drinking Bollinger and dreaming up the latest elevator stories. Rather, it was one solitary act from 1958 that has landed him on the never hire list. At the time, he had no idea that writing the hit song I Fought the Law would come back to haunt him. While the lyrics make perfect sense, especially if you break the law the latest bank scandal to create no moral outrage will certainly see bankers everywhere rewrite Sonnys lyrics. When it comes to banking, every bank in the World knows it is illegal to launder money money printing is ok, but money laundering is a no no. And, if you include the axis of evil (Iran, North Korea and Libya) in the mix, well lets just say you are looking for trouble. Yet, none of this stopped British bank, Standard Chartered from helping Iran launder over $250 billion between 2001 and 2007. Naturally, this charade eventually came to light and one would think that helping Americas enemy launder billions of dollars would bring the wrath of the SEC, CIA, FBI, and the President. Nope, that would be wrong. In the end, there was no loss of their banking license, no one-way tickets to Cuba, and no forced push-ups in Times Square. Instead, Standard Chartered agreed to pay a $340 million fine. For most

people, $340 million is a lot of money. Yet, this amount is equal to exactly 0.14% of the money laundered. Peanuts. Their service fees alone would have covered this minor inconvenience. For comparison, everyones favourite kitchen queen Martha Stewart traded on insider information. She did illegally avoid a $45,673 loss on her venture, which earned her 5 months in prison, and a nice little electronic anklet as a souvenir. Her financial penalty was $225,081 or 493% of her crime. Yet, she didnt launder any money for Iran, nor as far as we know did she launder any napkins, table clothes or doilies for them either. In the end Martha did indeed fight the law and unlike Standard Chartered she didnt win. The lesson here if you are going to commit a financial crime, be sure to become a bank first. Otherwise, you better learn the lyrics to Sonny Curtis classic youll need something to waste away your idle time while in jail. Our Strategy While Americas favourite pastime lingers smack in the middle of the dog days of summer, the same cannot be said for the stock market. After all, summer is the time to relax, spend time with the family and certainly not frown over financial and economic despair this is something for September and October.

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The gloves are coming off


The recent stock market rally is a faceless one at that. While the average investor sees a higher market, professional money managers see a market with no leadership and no volume not exactly the prerequisites for a blast-off to the moon rally. During a sustainable stock market rally, one normally sees cyclical sectors such as industrials, mining, technology and discretionary stocks soaring past their boring cousins. In addition, trading volume is usually increasing exponentially by the day. None of this is happening today which should make growth investors somewhat nervous as we head into post labour day trading. September will bring us several significant events including the German high courts decision on the legality of the ESM (European Stability Mechanism), possible money printing by the ECB (European Central Bank, more money thrown down the Greek rabbit hole, as well as new debt issuance by Spain. And thats only Europe. America will decide whether to print more money themselves while Mr. Obama and Mr. Romney will take off their gloves and really kick start their negative campaigning. As a reminder, none of these events remotely touch economic or profit growth both which are normal drivers of financial markets. Instead, the financial World continues to hang on every thread and syllable uttered by central banks and governments.

This is clearly an unhealthy environment for risk takers and continues to create an asymmetrical dynamic between upside return and downside risk. In short, upside returns remain limited while downside loss remains significant. IceCap portfolios are positioned to preserve capital while providing liquidity for significant opportunities which we believe will occur in the near future. We favour cash, bonds and gold, with strategic positions in stocks and commodities. As always, wed be pleased to speak with anyone about our investment management capabilities. As well, we encourage you to share our global market outlook with those who you think may find it of interest. Please feel free to contact: John Corney at [email protected] or Keith Dicker at [email protected]. Thank you for sharing your time with us.

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Global Market Outlook August 2012

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