Our view on global investment markets:

April 2013 Achtung Baby

Keith Dicker, CFA Chief Investment Officer keithdicker@IceCapAssetManagement.com www.IceCapAssetManagement.com

April 2013

Achtung Baby
To Russia with love While the debacle called Cyprus continues, many depositors who should be angry, are not. In fact many are holding court over brandy, vodka and macchiato describing how they pulled one over the never watching eyes of the Troika and their friends at the European Union, the International Monetary Fund and the European Central Bank. Meanwhile, the Troika is slowly coming to the realization that perhaps they are not the sharpest knives in the drawer after all. The reason for this epiphany is the mysterious case of the disappearing cash from Cypriot banks. Despite erecting iron clad walls around all Cypriot banks, someone, somewhere, somehow still managed to withdraw billions of Euros from these supposedly closed banks. In what only can be described in a Woody Allen-esque way, it seems the great leaders of Europe simply forgot to close the back door to the banks. Apparently, while the average Cypriot dutifully lined up at the ATM to withdraw his EUR 100 daily allowance, wealthy Russians and other Europeans simply flew directly to Athens and London to withdraw all of their money from the still-open bank branches. And just think during this entire time, Germany thought they were pulling one over on Russia. The sad part of the story however is that Cyprus once again has a giant hole to fill in their banking system all the while anti-Euro sentiment builds quietly across the continent.

Its alright its alright its alright

Berlin (1990): Inspiration from the German reunification was not inspiring. In fact nothing was going as planned. Ideas were not flowing, lyrics were not working, and the music certainly wasnt playing. The days were so dire, that Bono pleaded that their music would have to move people in mysterious ways, and be even better than the real thing. Never to give up, the rock band dug themselves in and declared they would keep trying to become one, until the end of the world. Berlin (2013): Inspiration from becoming the Worlds exporting super power had long vanished. Throwing their hard earned money at the Irish & Portuguese, staring down the Greeks while Athens burned, and forcing the Italians, Spanish and Cypriots to accept their way or the highway was reason for celebration. Everything was going as planned - until now. The September 22, 2013 German Federal Election is fast approaching and what previously seemed like a cake walk of an election win, is no longer. Euro skeptic parties are gaining traction across Europe and are now knocking on Germanys door. Chancellor Angela Merkel certainly has her work cut out for her. If she can successfully lead her coalition to victory, the coast just might be clear. Political failure on the other hand, could turn Europe into a zoo station.

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April 2013
Old is not new

Achtung Baby
just to agree upon the largely symbolic position of President. To make the story even more entertaining, the new President is anything but new. Somehow, 87 year old Giorgio Napolitano was arm twisted to once again return to Romes Quirinal Palace for another 7 year term. Of course, this resolves nothing in the Wonderful World of Italian Politics except to provide the anti-Euro, anti-same-old-government leader Beppe Grillo with even more comedic material for the next election sometime this year. Meanwhile, as Europe continues to churn nowhere, it seems that leading government officials everywhere have suddenly become fixed income experts. According to these financial wizards, declining yields from Italy and Spain is vindication that (once again) the worst is over. This is the point where we ask investors, government officials, and media to read beyond both the headlines and the first paragraph of investment reports. Just as the declining US unemployment rate is attributed to more and more people simply giving up hope (theres that word again) and not an abundance of new jobs; the decline in sovereign bond yields is the result of domestic banks and pension funds buying new bonds from their respective governments not an increase in confidence from international investors. While strong domestic demand for a governments debt is usually a good sign, forced demand is not. To fully appreciate the continuing demand for Spanish sovereign debt, look no further than the countrys social security pension fund which now proudly states www.IceCapAssetManagement.com 2

Just like every other bailout in Europe, initial estimates of the money required for Cyprus will be unsurprisingly low, as will the actual economic growth rates thereafter. Whereas the gatekeepers in Brussels initially estimated the Cyprus bailout package to be EUR 17 billion, the newest figure has jumped 35% to EUR 23 billion, and no one should be surprised one year from now when this figure is increased even further. For those who still care, this shouldnt be the least bit shocking. After all, the initial estimate for the Greek bailout was EUR 110 billion. Sadly, here we are 3 years and EUR 325 billion later, and there is still no end in sight. Elsewhere in the bailout world, Portugal had to officially request a 7 year extension to its repayment scheme. Meanwhile, rumours of Ireland once again heading to Brussels with cap in hand simmer as well. Meanwhile, Spain and Italy - the 2 big daddies of the European debt mess continue on a trajectory to nowhere, if thats possible. Despite higher taxes, reduced government spending, and the slow withdrawal of private capital, Spains fiscal position is not improving. To top it off, stories of unpaid bills have become legendary especially in the city of Madrid, which managed to increase its debt outstanding by 18% in just one year. At the same time, Italy is no closer to having anyone form a new government. In fact, it took the warring parties 6 rounds of voting

April 2013
Epic

Achtung Baby
Table 1: Capital contribution of ESM Member States

that over 97% of its assets are invested in Spanish Government Bonds. Considering that in 2007 less than 50% of its assets were invested this way, as well that 70% of purchases in 2012 occurred during the last few months of the year, this all-in strategy need only be described with one word epic. Of course, odds are this epic strategy will only end in disaster. First of all, the high concentration of investment is embarrassing for whomever is in charge of the fund. Fund managers, investment committees, and trustees have a fiduciary duty to the owners of the fund. Objective #1 for this group is to preserve capital and the diversification of assets, neither of which is being achieved. Next, this is really no different than directly raiding the pension fund assets. This is a shameful act and ultimately someone will have to pay for this Spanish mistake, which naturally leads us to Germany. Germany In simple terms, the generosity threshold of the average German is pretty close to being breached. Recall that initially Germany was required to only pay 21.72% towards any bailout. Granted this is a lot to pay, and a lot to swallow, especially for many Germans who believe they shouldnt have to pay anything for the poor money management skills of other European countries. Table 1 shows the exact bailout commitment for each Euro-zone country. While this table hasnt been bantered around any research reports for quite some, we believe it is worthwhile as it provides a

Source: European Stability Mechanism Fact Sheet

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April 2013

Achtung Baby
absence of these contributors means someone else has to pick-up the slack. The irony, and inherent weakness in the ESM, is that some of the stronger countries are likely to become slackers themselves. And with Italy and France becoming increasingly vulnerable (for different reasons), this leaves Germany as the only real financial superpower remaining to save the European day. German Federal Elections Regardless the outcome, September 22, 2013 will be a big day for current Chancellor Angela Merkel and her coalition. Since 2005, Ms. Merkel has lead the Government and arguably has become the single most important glob of glue holding the Euro-zone together. Everyone, everywhere must understand that if Ms. Merkel is defeated, so too is the Euro. As of today, current seating in the German Bundestag is as follows:

875 x leverage = AA+ credit rating

refresher on the magical World of European Mathematics. The European Stability Mechanism (ESM) is armed with EUR 700 billion to help the needy - what on earth could possibly go wrong? To begin with, this convoluted bailout scheme is here to stay until it isnt. A quick glance shows there are several reasons why the bailout fund could snowball and itself need a bailout at some point. For starters, many people often ignore, or conveniently forget that this EUR 700 billion fund is actually only supported by EUR 80 billion of capital. The remaining EUR 620 billion will be you guessed it, borrowed. To clarify, the bailout fund which was created to bailout countries who had too much debt, is being created by using even more debt. And mind you, its not even a little debt. If fully used, the ESM will be leveraged 875x of original paid in capital. Granted, maybe the ESM wont borrow any money and simply do new capital calls from the Euro-zone countries. Yet, theres only one ironic concern with this idea no euro country has the money available and they too will have to borrow. Either way, the ESM is a levered bailout machine. Next, look no further than Ireland, Portugal, Greece, Spain, Cyprus (and soon enough Slovenia). Each of these countries are receiving bailouts in one form or another yet according to the structure of the ESM, each is also expected to contribute to the bailout fund. Now, even Brussels admits its tricky when you have to contribute to a fund to bailout yourself so they reluctantly decided that recipient countries would not have to contribute after all. Of course, the

Merkels coalition

Source: bundestag.de

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April 2013
Fingers and toes

Achtung Baby
German economy as well. To really put the slowdown into perspective, simply ponder the following release from the usually balanced Markit Economics team: While March saw severe and painful downturns persisting in Italy and Spain, a stronger rate of decline was recorded in France and growth almost stalled in Germany, which suggests that the only source of bright light in an otherwise gloomy region has once again begun to fade. Chris Williamson, Chief Economist. In addition to having to explain away the upcoming recession, Merkel and Brussels will also be doing their best to put out any smaller fires before they spread out of control. To identify the heat on this map, keep an eye on Italys political deadlock, Italys Monte Paschi Bank scandal, Greek protestors, Spanish protestors, the Cyprus government, anyone in Slovenia as well as 89 year old and former Portuguese Prime Minister Mario Soares who announced The desire to please chancellor Merkel is ruining the country. In short, if something doesnt happen between now and September 22 we would be wordless. Naturally, this wave of economic and societal discontent leads to political change. And what originally started as fringe parties, has now evolved into the True Finns in Finland, Syriza in Greece, the Five Star Movement in Italy and now the Alternative for Germany (AfD). The AfD is new. So new, that theyve yet to officially register for the

Noteworthy of course is Ms. Merkels CDU/CSU/FDP coalition consisting of 330 seats. Like every country, German politics has its own nuances, tides and waves that are beyond boring to most outsiders, and at first glance Merkels coalition appears to have a cushion to pull off another win. Yet, what isnt appreciated by many but certainly known to Ms. Merkel is the growing anti-Euro wave creeping across the Euro-zone that has landed smack in the middle of Berlin. Up to now, all Euroskeptic parties originated in the European countries that were forced to accept various forms of austerity. It turns out excessive debt loads, higher and higher taxes, combined with a transfer of political power to Brussels, is actually not popular amongst some people. In fact, these policies have become so unpopular that more and more people are starting to believe that perhaps the Euro isnt such a good deal after all. Currently, Merkel and her followers are crossing every finger and toe hoping that there are no further crisiss prior to the September 22, 2013 election. Every time another bailout is required, or increased systemic stress from distressed banks, or thousands of Greeks, Spaniards, Portuguese, or Italians marching in protest, the popularity of Euro-skeptic parties increases. Unfortunately for the incumbents, Chart 1 (next page) shows the economic slowdown enveloping the old World is about to swarm the

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April 2013
Sharp decline

Achtung Baby
21 months in recession

Chart 1: Markit Eurozone Composite PMI

Starting to be dragged lower

Depressing

Source: Markit Economics, IceCap Asset Management Limited

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April 2013
Atlas might shrug

Achtung Baby
happens. Yet, the swiftness of this sell-off in gold bullion was particularly worrisome. To put the decline into perspective, it has been calculated that the swiftness and volatility of such a move in gold only occurs every 4,767 years a rare event indeed. From another perspective, in 2002 global equity markets declined 30%, but this was over a 10-month period. Painful, yes but there were no jolting -15% declines over 2 days. Mathematically, the -30% decline should have felt twice as bad when compared to a -15% decline. However, when the decline is spread out over a longer period, people become somewhat desensitized to the loss. As such the psychological damage from the gold experience feels worse. More importantly however, when financial markets experience significant and rapid price changes, you know something is afoot. In our opinion the primary reason for the sell-off is attributed to gold being used in just about every hedge, carry, and pair trade known to mankind. Its been no secret that since the central banks began printing money, many investors have been LONG GOLD and SHORT YEN/EUR/Treasuries/Oil to name a few. Considering gold was trading in a weak technical range, for the fireworks to begin all it needed was a single very large seller and off she went. Also of significance was the impact of margins. When trading in any type of commodity or currency, investors typically only need to pay about 5% of the actual amount due. The other 95% is in effect borrowed and when there are significant moves in the underlying

upcoming election. Yet, despite this non-official status, recent polls have up to 24% of voters considering voting for the party. To achieve this level of relevance in such a short time is nothing short of epic (theres that word again). Even more troubling to Ms. Merkel is the composition of the AfD. No comedians, no billionaire party animals and certainly no one wearing a pirate hat. In fact, to the naked eye the AfD contains no one of interest to the courts, People Magazine or Brussels. The founders are a bunch of business people, academics and everyday average people. In addition, practically all of their policies are similar to the current main stream parties. Yet, the only real difference between the AfD and Merkel, is that she wants to keep the Euro in order to save Europe, while the AfD wants to get rid of the Euro to save Europe. No ands, ifs or buts with this one. We have no idea what will happen. We do know that should Europe experience no further crisiss between now and the German election, the election should be a non-event. However, should anything occur to mix the pot, the odds of a Euro break-up increases significantly. Every 4,767 years During April 12-15, 2013 gold bullion declined from $1,559 to $1,328. This $231 or 14.8% decline was significant for several reasons. For starters, all financial markets experience significant declines it

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April 2013
QE5?

Achtung Baby
most people everywhere in the World are experiencing a higher real cost of living. Yes, prices of some goods and services such as healthcare and education are rising, while other costs are rather flattish. Yet, the impact of higher taxes and austerity is not included in normal inflation calculations and this is a shame, because failure to recognise the social and political risk resulting from this tax inflation is sure to cause more socioeconomic and geopolitical stress as the days pass along. All of which brings us to the next big market surprise. The Next Big Market Surprise The next move by the US Federal Reserve will be to INCREASE their money printing program. Yes, various members of the FED have recently hinted that they are discussing the whens and hows of reducing their addiction to their printing money schemes. However, the deflationary wave enveloping the globe simply cannot be ignored. The combination of the steady decline in commodities, developing recessions in Britain, and Europe, as well as declining growth in Australia, Brazil, Russia, Canada and Asia are economic cries for help. Yes despite the central banks of the World printing trillions of Dollars, Yen, Pounds, Euros and Swissies the much feared deflationary trap continues. Of course, maybe the central banks and governments could simply admit defeat, and cleanse the World of the much maligned bad debt

investment, the buyer has to contribute more money to maintain margin otherwise his margin is called and his position is forcefully liquidated. And this is when the golden snowball really stated to roll. The really important point to understand is that today global financial markets are all interconnected. Commodities are connected to stocks, stocks are connected to bonds, bonds are connected currencies, currencies are connected to interest rates, interest rates are connected to central bankers, central bankers are connected to gold, and everything is connected to inflation and deflation. Sadly, pretty well all investors today are ignoring the signals and messages produced by the central banks and their money printing ways. Most want to believe that the World has returned to the typical business cycle and the reaction by stocks and bonds simply represents a normal investment experience. We know this message is falling on deaf ears, yet it is a message that warrants repeating. It is fact, the major central banks are all trying to out-print each other with the hope that their currency will fall, business profits will rise, employment will rise and the glory days will return. Yet, the overwhelming tide of sluggish economic growth is telling in simple terms, the World is increasingly becoming caught in a deflationary trap and the window to escape is getting smaller and smaller. Yet, although the global economy is caught in a deflationary trap,

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April 2013
Apologies to Marc Faber

Achtung Baby
the World has a head start in the latest round of currency devaluation schemes. As all markets and financial phenomena are interconnected, investors should also consider what happens next with the Australian Dollar. The AUD has skyrocketed 80% since the dark days of 2009, yet for the past 2 years the currency has become the epitome of stability. Since money never sleeps, expect a breakout move at some time soon. Chart 2 (next page) shows the AUD is poised to break out of a narrowing technical trend, and when you consider the recent disconnect between commodity prices and AUD, the break in trend is likely to be on the downside. Our Strategy Despite volatile, headline producing moves, global stock markets continue to tread water and have traded flattish since the end of January. During this time, we have waited patiently for sentiment and technical measures to lead the way to a re-entry point. Yet, various sentiment indicators still signal downside risk, while the combination of fewer and fewer stocks making new highs, combined with weakening emerging markets are signals for investors to remain cautious. As all financial markets have corrections the time between such downturns vary. Yet, it is worrying that it has been 100 days since American stocks have declined -5%, 382 days since a 10% correction and 1,031 days since a market drop of over 20%. The message is loud

that clogs the system. Yes there would be losses, especially for banks, insurance companies and pension funds yet, just think about all of the fresh, clean, crisp capital waiting on the financial sideline. Instead of a very deep and long lasting depression as warned by current leaders, the World and its economy would actually recovery a whole lot quicker with no can left to kick down the road. Alas, this ripping off the band-aid approach is extremely unlikely, which therefore always leaves the default option more of the same. But, will it really be the same? While rumours of Ben Bernanke registering his 401K plan may induce cheers from all Austrian economists, we caution that his replacement could actually be even more liberal with the printing press. Now apologies to our dear friend Marc Faber, but Janet Yellen actually has the potential to print so much money that it would make Ben Bernankes view on monetary expansion look closer to that of Marc Faber.s view. Yes, Ms. Yellen really has the potential to become a star in the global quantitative easing league. Meanwhile, British everywhere should be preparing for their re-entry into the money printing twilight zone. You are now merely days away from the arrival of Mark Carney and those thinking he will simply continue with his unassuming, conservative Canadian-way should think again. Mr. Carney wasnt hired to ramp up a moral suasion strategy, instead one should expect a new and very aggressive Bank of England. After all, UK growth has completely stalled and the rest of

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April 2013
Chart 2: Aussie Dollar

Achtung Baby

AUD inflection point approaching

It is unusual for AUD to disconnect from commodity prices

Source: TheShortSideOfLong.blogspot.com

Copyright 2012 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at www.ndr.com/copyright.html. For data vendor disclaimers refer to ww.ndr.com/vendorinfo/.

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Source: Markit Economics, IceCap Asset Management Limited

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April 2013
Dont forget the bond market

Achtung Baby
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 to contact: John Corney at johncorney@IceCapAssetManagement.com or Keith Dicker at keithdicker@IceCapAssetManagement.com. Thank you for sharing your time with us.

and clear a correction is due. However, unless a significant crisis develops, the downturn should be with the -5% to -10% range. Gold has recovered from the low on Monday, and is now down -7% (vs -14%) from pre-crash levels. The bounce is welcomed, yet we have to recognise that many support levels have been broken which causes us to be concerned about the potential for more corrections. We remain holders of gold, but we have reduced our holdings. Whereas most personal investors and media pay little attention to bond markets, it really has become the most fascinating market in town. It has always been our view that longer-term rates will spike up, but this will only occur within a country that is experiencing financial stress. The global deflationary wave will remain supportive of lower rates, at the same time, investors must also acknowledge that the demand from private investors as well as that from money printing programs, ensures current demand is enough to meet all new supply of bonds coming to the market. Of course, should the German election really heat up, market sentiment, technicals and fundamentals will become less and less important. And to this we caution a very big achtung baby!

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