IceCap Asset Management: The Invisible Zombie

Submitted by Keith Dicker of IceCap Asset Management

“I’ll show you who I am”

And with that one line - the world of invisibility was born.

The 1933 blockbuster film, “The Invisible Man” launched a genre that would span decades, producing many enjoyable and many unenjoyable movies of things and people we can’t see. Next up was “The Invisible Man Returns”, followed by “The Invisible Man’s Revenge”, “The Invisible Boy”, “The Invisible Mom”, “The Invisible Mom 2”, and let’s not forget the Chevy Chase classic “Memoirs of an Invisible Man.”

Through the humour, terror, and mystery, the one thing that was constant throughout these stories was - consistency.

The consistency was in the way the story was told, the path it took and the usual predictable ending.

Unseen and definitely unappreciated by most investors today, the global financial world is missing an important factor that is crucial to keeping the world humming along in a predictable pattern. A pattern that rewards success, punishes failure and then sets the scene to begin the cycle all over again.

This missing factor is none other than the Invisible Hand.

Unfortunately, the Invisible Hand is hard to see. It’s never discussed by the media, big banks, and certainly never discussed by the central banks - after all, they’re the ones who caused it to go missing in the first place.

As you sit back to enjoy and appreciate this latest edition of the IceCap Global Outlook, we ask you to use your vision to see and understand why today’s markets have been displaced, and what happens with the next great story - The Return of the Invisible Hand.

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The Recession

Since 1967, the United States has experienced 7 different recessions. And since 1967, the Survey of Professional Forecasters collectively, have predicted exactly zero recessions.

This 0% batting average can be interpreted two ways:

1) Collectively, this group isn’t very good at their job.

2) Forecasting or predicting recessions is next to impossible.

Yet, the beat goes on.

Recessions can be measured in different ways. The Professional Forecasters focus on a collective decline in industrial production, employment, real personal income and sales. A more common definition used by the big box banks and mainstream media is two consecutive quarters of negative GDP growth.

Meanwhile the most popular definition of a recession is when YOU lose your job.

What we do know, is that a normal economy moves in a cycle where there are highs and lows.

The highs are the good times. While the lows are the bad times.

Good times are followed by bad times

To illustrate the typical economic cycle, consider the below chart. What’s really neat about the business cycle is that over time, it flows in a logical and somewhat predictable direction.

When the good times roll, they really roll. Yet eventually, momentum runs out of the economy and the good times gradually slow to a point where good times turn into bad times. But then, slowly the bad times end, and a recovery and the beginning of the next good times begins again.

Of course, to be more technical, the global economy is simply a function of changes in money supply and demand for credit.

Yet, everyone who has ever studied economics eventually comes to the same realization - the economy absolutely moves in ebbs and flows, and eventually it is always guided by an invisible hand.

Now, those with an interest in economics are quick to recognize this “Invisible Hand” as the discovery by Scottish economist Adam Smith, as a way to describe how an economy will function if governments left people alone to buy and sell freely amongst themselves.

If left alone, the prices of most goods and services would be determined by what people are willing (or able ) to pay. As an example, if all pizzerias are charging $20 for a pie eventually someone will enter the market and make the equivalent quality pizza and charge $15.

This enterprising pizzeria will take customers away from everyone else, until they too decrease their prices to match the  $15. Alternatively, another new pizzeria might look at this market and determine they can make a significantly better pie and charge $25. This enterprising pizzeria will take customers away from everyone else until they begin to match the higher quality.

This movement of people making and eating pizza is being guided by an invisible hand - and it works.

Now, let’s consider what happens to the invisible hand if our dear governments saw what was happening and for whatever reason declared by law that no pizza could ever be sold for more than $10.

In this case, several things happen.

For starters, the pizzerias will have to find ways to reduce their costs to compensate for the lost revenues per pizza sold.Some will succeed but by only using even lower quality ingredients. Others will simply take a bow and close up shop.

What happens next, is similar to what is happening in the financial world today.

Now, as governments eat pizza like everyone else, eventually they realize that the quality of pizza has deteriorated and there are less pizzerias than what previously existed.

Never to let a crisis go to waste, governments next announce they’ll pay each pizzeria $10 per pizza to compensate them for the lost revenues from not being able to charge the original price of $20.

Two things have now happened.

First, government involvement in setting prices has completely distorted the pizza industry. Second, the “invisible hand” has been completely blocked out and unable to keep the market in balance.

Today, the exact same story is playing out in the world of interest rates.

When the financial world blew-up in 2008-09, governments and central banks around the world made a coordinated decision to become involved in uncountable ways to affect the monetary system.

And in its most simplest forms - central banks have decided that instead of letting Adam Smith’s invisible hand determine the correct price of money (ie. interest rates), they would set the price of money. This price of money has ranged from NEGATIVE % across Europe and Japan, to near ZERO % across everywhere else.

This crowding out effect is having two effects on our money world:

One - the economic cycle has been temporarily suspended.

Two - zombie companies and governments now roam the lands.

Recall how on page 5 we showed how a regular economic cycle weaves and bobs over time.

The interference in interest rates by central banks has completely flattened cyclical economic movements and instead has changed the economic cycle to appear as a flat line - one characterized as having no growth and no contractions.

Some might say this is a good thing. After all, it would mean steady eddy economies, one characterized by consistency in everything. Yet, a successful flat-lined economy is one that doesn’t exist now, it hasn’t existed in the past and will not exist in the future.

For those in disagreement, note that this kind of a controlled economy has been tried numerous times over the years. Those that tried include:

  • The Soviet Union (Marxism-Leninism)
  • Germany (Nazi National Socialism)
  • China (Maoism Communism)
  • Cuba (Communism)
  • Venezuela (National Socialism)

Each of these failed states attempted to eliminate the invisible hand from doing what it does best - rewarding economic  success, or put another way, not rewarding economic failure.

Unknown to most today, the global financial system has taken on economic characteristics of socialism/communism. And it is happening right before your eyes in the form of central banks setting interest rates at zero % and negative %, as well as their policies of printing money to help stimulate the economy.

These monetary policies have been ongoing now globally for 10 years and while the creators of these policies hail them as a resounding success - others declare the opposite has happened.

The Invisible Zombie

From an economic perspective, 10 years of zero/negative rates combined with trillions in money printing has only achieved muted economic growth.

  • Europe is unable to achieve consistent growth >1.5%.
  • America is unable to achieve consistent growth >2.5%.
  • Japan is unable to achieve consistent growth >1%.
  • China is unable to achieve consistent “official” growth >6%.

But this attempt to break the invisible hand is also having another far more devasting effect that is never discussed by the big box banks, the mainstream medias and the mutual fund salespeople - 1000s of companies and governments have turned into financial zombies.

From a corporate perspective, the lack of growth is causing many companies the inability to generate enough revenues and profits to not only pay off their debt, but to simply pay the interest on their debt. The only reason they remain alive is due to interest rates being so low, that interest owed can be met by borrowing even more. Once the invisible hand returns (it always does), interest rates will surge higher, making it impossible for most of these companies to operate with their debt loads.

And in case you’re wondering - these borrowings by these zombie companies are actually bonds.

And guess who owns these bonds from these zombie companies - many of the new bond funds like those described on page 3. Put another way, bonds from zombie companies are also known as junk bonds which are wrapped up nice and neat and sold to investors as high yield bonds.

Other forms of bonds at risk include leveraged loans, and private credit. Beware - bond market risk comes in several forms.

The absence of the invisible hand is not only setting up the most conservative investors with unrecoverable future losses, but it’s also wreaking havoc within the sharpest and brightest minds on Wall Street.

As you can imagine - the world of finance is complicated.

There are many markets, in many currencies with all trading in either public or private transactions.

And within each of these many markets, there are many factors that have either a material or immaterial impact on pricing. And to make matters even more confounding, there are times when the material factors are material and other times when these very same factors are immaterial.

However - there is always one factor that plays a significant role in helping market participants (and the invisible hand) determine an appropriate price.

This factor is interest rates.

Read the full report below.