Submitted from IceCap Asset Management
"The Halftime Show"
For many, the Super Bowl football game is a rather odd event.
To begin with, Americans claim the winner of the big game to be the world champion – despite never defeating the best from Europe, Asia, or Africa. Next, most of the Super Bowl games are duds. Aside from the crowd pleasing 5 victories by the San Francisco 49ers, and the crowd pleasing 5 losses by the New England Patriots – most games are forgettable.
Now, this lack of competitiveness, isn’t necessarily a bad thing. After all, for most people the game is secondary to the entertainment including the commercials and the Halftime Show. The first ever Halftime Show in 1967 featured dogs leaping through hula hoops and catching Frisbees. Everyone agreed it was pretty cool.
In 1974, the Halftime Show scored a huge win when Miss Texas, Judy Mallett, played the fiddle to the 74,000 stomping fans in Houston. THAT was a good time.
Over the years, the Halftime Show developed into something bigger than the game itself, with the more memorable ones featuring wardrobe malfunctions and the ability of the Americans to actually make it rain while legendary rock star Prince sang about rain. And with the possibility of reuniting the Gallagher brothers and Oasis for next year’s final gig – the Halftime Show will cement itself forever as being the greatest show on turf.
As the Halftime Show literally occurs smack dab in the middle of the game – it should signal the mid-point of the big event. Yet, in reality the 2nd half breezes by fairly quickly with the outcome usually well decided and well accepted by everyone glued to their screen.
The irony of course, is that this year as millions prepare to enjoy the big show, millions of investors are simultaneously wondering if financial markets have also reached their very own Halftime Show.
Naturally, with stock markets hitting all time highs, and Bond yields hitting all time lows – very good arguments are made supporting a significant change in direction for each market.
And as life imitates art, it is reasonable to believe that the 2nd half of financial markets will zoom by just as fast as the 2nd half of the Super Bowl. So, to be safe. Buckle up. Strap on your helmet and pads. And get ready for the 2nd half of global financial markets.
It’s a show you won’t want to miss.
The Multiplier Effect: US Tax Cuts
One word – ENORMOUS.
Yes, despite all the growlings and howlings from both political rivals, and sovereign economic rivals – the recently announced American tax cuts are tremendously good for the US economy.
This is good.
And yes, just as proclaimed by many, these very same tax cuts will add significantly to the American debt pile.
This is bad.
Yes it sounds confusing, so let’s take a minute to clarify the good and the bad. Remember – here at IceCap we are not American voters, and we shed our emotions and pause our personal belief systems when assessing geopolitics (something EVERY investment manager should be doing by the way).
First the good. From the most simplest perspective – the more money you have in your pocket the better.
We have yet to meet anyone on this planet who would not accept more money in their pay cheque due to lower taxes. More money means more spending, more savings or faster debt pay downs.
When this is multiplied across all of America, the aggregate amount is very, very large and significant. And, when you next consider the tax savings at the corporate level multiplied across all of America, the aggregate amount is bigger still. The two amounts together create a powerful wave of economic stimulus not only for America, but for the world.
Some argue that the rich people are getting richer, and the wealthy companies are getting wealthier. This is irrelevant. If you are against the tax cuts and disagree, you are always welcome to pay more to the IRS than what is required. Yes, there’s no law saying you can not make extra contributions to the US Treasury.
Any takers? Regardless if the tax savings are spent buying Budweiser, pinot noir, stock buybacks, or yachts – money begins to flow through the system creating a multiplier effect which leads to even more spending and savings. Not convinced? Consider recent comments from the world’s largest investment manager Blackrock Inc.
Also consider that Blackrock is controlled, and managed by Larry Fink who squarely supports the American Democratic Party, and is certainly no fan of President Trump. The Above is captioned from Blackrock’s February 2018 Market Outlook. In other words – if one of the biggest non-supporters of the US President can check his personal political perspective at the door, then maybe your manager should do so too.
As well, there are countless other company specific data points all supporting the same effect – people everywhere are receiving back more money due to the Trump Tax Cuts.
Now, it’s also rather important to understand the significance of these tax cuts from a global perspective. Understand that America is a pretty big butterfly – and now that it’s flapping its enormous economic wings, the effect will absolutely be felt around the world.
For starters, and to really gauge the effect of the US tax cuts, simply listen to the response from America’s economic competitors and you’ll find never ending cries of unfairness.
* * *
Go to where the puck will be
President Trump may be many things. But make no mistake, he is a business person who understands the art of a competitive advantage.
The rest of the world (and especially Europe, and Canada) pushes higher taxes on individuals and businesses as a way to pay for high-cost, government welfare states. Since all multi-national companies are profit seekers, establishing various business centers in low cost jurisdictions has always been (and always will be) a rational business strategy.
And, depending upon your perspective, it gets better (or worse). Not only is America lowering taxes; it is also lowering the source of the biggest corporate headaches and grief in the real world - bureaucracy and regulations. And considering the European Union is the undisputed champion of rules, regulations and policies – the mere thought of operating in a jurisdiction with less (instead of more) is enough to make even the French take notice.
It should be clear that the call for lower taxes and less regulatory/bureaucracy demands, is at the very least forcing companies to have meetings and discussions about possibly relocating or making capital investments in America.
While Europe & Canada are really worried about being less competitive, China has a completely different reason to worry. China runs an enormous trade surplus with the United States.
This means China sells more stuff to Americans than what Americans sell to the Chinese. And years of doing this means China has accumulated over $1.2 Trillion in US Treasury Bonds.
Some believe China is on the verge of selling its Treasury holdings, which would cause the USD to decline sharply. These people believe China is fearful of deteriorating American fiscal positions as well as the desire to dethrone the US and become the world’s reserve currency.
This is wrong.
In fact, China fears the exact opposite. The Chinese are incredibly worried that America’s new approach to trade combined with lower taxes and less regulatory hurdles make it a prime destination for foreign capital that will actually siphon even more Chinese private capital out of the country and into America.
This of course would weaken the Yuan, and force China’s central bank to increase interest rates and impose even more strict capital controls.
Anyone who is short USD for Yuan is sitting on a whole lotta risk.
This is great news, unless it isn’t
In addition to the tax cuts, the other point of contention towards America’s new trade policies focuses on protectionism. Effectively, going forward America will now do trade deals that are economically profitable.
While this may sound like a novel concept – the European Union (EU) is especially enraged at this new positioning. In some ways you can’t blame them. After all, for over 100 years America has used economic policies to further promote and advance their foreign policies.
Foreign economic losses to achieve foreign political agenda has become indoctrinated within the American political ideology. For America to now change this approach, is unprecedented and should of course rattle the rest of the world. After all – no one likes change.
Of course, having the EU refer to anyone as being protectionist is perhaps the biggest irony since Alanis Morissette sang about ironies.
Every country in the world engages in protectionism.
The French protect their companies from foreign takeovers. Canada has been protecting and subsidizing Bombardier for years. And then there’s China and their internally promoted “Made in China 2025” industrial policy which clearly encourages domestic over foreign.
The uproar over the paradigm shift in American trade policy is being sold as protectionism – which is branded as being politically incorrect and unacceptable. Whereas in reality, the only bad is from the perspective of non-American companies and nations who will gradually make less money from American trade.
As investors, one should simply accept it is happening and adjust accordingly.
In the end, with American corporate taxes now lower than that demanded in Europe and Asia – investors should expect a flood of business and investors flowing into the United States. Yes this is exciting stuff, yet don’t get too excited.
All of this is great news, unless of course you are heavily invested in bonds, or worse still - you are a bond manager, or a company or country who is heavily dependent upon continuous borrowing to survive.
Serious investors ask serious questions
The tax cuts are not the panacea for all wrongs in the world. In fact, the entire act merely provides the world with one final sugar high, delaying the inevitable – a crisis in the bond market. The Debt Machine Critics of the Trump Tax cuts focus on the expectation for the American debt pile to increase further and therefore causing a debt crisis for the country.
This view is correct. Yet, the irony here is that these very same critics of America’s debt balances are either quite ignorant of the debt balances of other countries, or worse still – they choose to ignore it. Despite anyone’s personal view of the world, they must understand, accept, and acknowledge that the entire planet runs off the same yield curve.
What we mean by this is that all global interest rates are a function of US interest rates. When interest rates are established in Europe, Asia, South America, and anywhere else that borrows – the market interest rate is established as a spread (higher or lower) relative to interest rates offered in the US Treasury bond market.
Next up – know that sovereign debt levels are compared to each other on a relative basis. In other words, America’s debt balances may be bad, horrible, disastrous or whatnot, but they are actually less bad, not as horrible, and slightly less disastrous than other country’s.
Sadly, those who are bearish on the USD, ignore or have completely forgotten that the Americans have another incredible advantage over all other countries. With the USD dominating world trade and world debt issuance, the United States Treasury has a never ending private sector AND public sector demand for all bonds that it issues.
No other country or currency bloc has this advantage. Put another way, when discussing sovereign debt levels, the most important fact to know is how countries are funding their borrowing. In other words – if a country is borrowing all the time, someone else is lending all the time. Since we already know who is borrowing, serious investors should naturally be asking - who is lending? Knowing the answer to this question should shine light on why the USD is not headed towards zero (well, not yet anyway – other currencies go there first, thereby causing USD to eventually surge).
In many ways, the absolute level of interest rates are irrelevant. What is relevant is that investors are lined up to lend money to these supposedly dead-beat borrowers. And this is where the USD dooms day hoopla is confused.
Today around the world, there is an enormous demand for USD and American debt.
In fact, the demand is so large – the real fear in the world is that there isn’t enough of USD to spread around.
A recent study by Ilzetzki, Reinhart, and Rogoff shows 60% of all countries in the world use USD as their anchor currency. And better still, this 60% equals over 70% of the global economy.
The amazing thing about this data point, is that it is occurring during a period where the American dominance over global GDP is shrinking. Think about that for a moment. And of even more significance is the fact that #2 in the world is not even close.
In other words – the last days of the USD dominating the world’s financial landscape can only occur if both the global demand for USD ends AND if there is a reasonable substitute. Ironically, it is the world’s reliance upon USD and USD issued debt that will eventually cause the USD to lose its reserve status.
This will occur – but first other currencies and sovereign debt will enter crisis first.
As of writing – the New England Patriots have a better chance of coming back to win the big game, than the USD dominance coming to an end any time soon This isn’t to say USD won’t bounce around in the short-term – all financial markets do this from time to time.
But it is to say – those who are so painfully focussed every minute of the day on high-lighting any real or perceived flaws in America’s economy, its politics, or its social make-up is looking in the wrong place. To further demonstrate the relative dominance of America consider the following chart which details how global businesses view the United States relative to China.
This is a survey of 1,300 chief executives from the private sector who always seek to maximize their firm’s profits. Considering all of the negativity surrounding America over the last year, these survey results should grab your attention.
Putting it Together
To square the peg, investors must make the connection that all of this borrowing by countries, individuals and companies, is achieved by selling bonds.
And it is the buyers of these bonds that are unknowingly sitting on top of the most explosive financial crisis to hit in our lifetime. The biggest worry and concern in the money world today isn’t tax cuts, trade wars or even the current stock market jitters.
Instead, the greatest worry that few even know exists is the slowdown of money printing by the world’s central banks.
In America, the Federal Reserve has already stopped printing money, and in fact now, it is actually reducing the bonds and MBS it acquired over the last 9 years.
When this is considered, together with the relentless march higher in Fed Funds Rates (over night interest rates), it should be crystal clear why the US is a destination of choice for objective, foreign capital. Europe is a different story. And it’s a story that will not end well.
The big Canadian, American and Australian banks and their legions of mutual fund sales people have all completely dismissed or worse still, missed, the biggest risk story in our financial lifetime.
In some ways, they can be forgiven. After all, their relentless focus on short-term earnings, protecting margins, and meeting regulatory requirements are all to the detriment of actually seeing the risk in front of them – is a sad song that plays over and over again.
They all missed the Tequila crisis, the Asian crisis, the Ruble crisis, the LTCM crisis, the Tech crisis, and the Housing crisis. Expecting them to see, understand and proactively protect their millions of investors exposed to the bond market is perhaps a bit too much to ask.
In the bond world, the bad news today is that long-term interest rates have already begun to leap higher, leaving a wake of losses and despair.
The good news is that IceCap’s forecast for higher long-term rates has been 100% correct. As well, anecdotal evidence shows that an increasingly higher number of other boutique investment managers now share the same view.
Protection against near-certain losses in the bond market is available.
There’s even better news – the current bad spell for the bond market is entirely due to the expectation that inflation will be higher. Our expectation for surging long-term interest rates will come from a re-escalation of the sovereign debt crisis. This recent bad spell for the bond market is a nothing burger.
The real show hasn’t even started.
Yet, to demonstrate just how sensitive bond investors are to rising long-term interest rates, consider the below chart.
The biggest financial crime to ever occur in our lifetime wasn’t the Madoff scandal. Nor was it the scandals from Enron or WorldCom.
Instead, the biggest (alleged) financial crime was the decision by the central banks in USA, Australia, Canada, Britain, Europe, Norway, Switzerland, Sweden, Denmark and Japan to socialise the global debt problem.
To refresh your memory, in response to the 2008 crisis, all central banks lowered interest rates to zero or negative rates with the hope that it would stimulate economic growth.
The financial crime with this scheme, was the negative effect it had on the traditional savers and low risk investors around the world.
Now, nearly 10 years later we are starting to see where the risk lies, and the downside of what is to become.
Global long-term interest rates reached record lows and have now begun to swing higher. The problem with higher long-term interest rates is that they have a significant negative effect on bond strategies and mutual funds.
This chart shows how a mere 0.5% rise in long-term rates affects bond investors and their ability to recapture these losses with interest/coupons received. From the chart you’ll see how a 0.5% increase in long-term rates in America, and Canada will force bond investors to wait over 2 years to recover those losses with interest payments received.
Think about that for a moment. You are a cautious investor, dependent upon bond interest to buy groceries and gas, and then suddenly you realize you just lost 2 years worth of income while invested in supposedly the safest investments in the world.
For France, Sweden, Finland, Austria, Belgium, and the Netherlands the financial crime is even worse. In these countries, a mere 0.5% increase in long-term interest rates means 6 to 9 years to recoup your losses. Yet, this is nothing compared to the devastation awaiting the Germans.
In Germany, the self-proclaimed bastion of conservative investing and financial management, investors here only break even after nearly 12 years of coupon clipping. And all of this assumes long-term rates ONLY increase 0.5% and stay there forever.
Which of course, should lead you to ask – What happens if long-term rates rise more than 0.5%? Two things actually. To start, global losses from bonds will be measured in the TRILLIONS.
To end, and this is the risk few are talking about – countless individuals, companies and worst of all – governments, will have to pay exceedingly more to borrow money from investors.
And that’s if they are able to borrow at all.
In fact, the threat of rising long-term interest rates has already hit markets and headline news.
Due to the medias’ and the big bank mutual fund machines’ obsession with stock markets, one has to look a bit harder for the evidence that is lying before you in plain sight.
More in the complete IceCap presentation (pdf)