IceCap Asset Management: "Eruption"

Submitted by Keith Decker of IceCap Asset Management

Similar to volcanic lava flows, financial contagions start slowly at first and then end by destroying many things in its path. Inbetween the beginning and the ending, is a baffling experience that can only be understood from afar. Once the eruption begins, people everywhere want to look, see and feel this infrequent experience.

Yet by the end, few actually recognise how the crisis spreads before subtly engulfing everything in its path and ending in a full-on, blow-out contagion. The financial lava flow has started.

Emerging market bonds and currencies are already experiencing the scorching effect of a capital outflows. Next up will be the European experience.

The culmination of the end of ECB money printing, the end of Angela Merkel's grip on power, and the end of strict German austerity policies will see the financial lava flow first through Italy, then Spain and then before you realise it - France too. From there, the contagion spreads far and wide. Few bond markets will be spared and few interest rate sensitive equities will be safe.

All investors, including pension funds, bank owned mutual funds and individual investors have a tremendous opportunity - anticipate and proactively embrace the financial lava, or do nothing and claim ignorance.

We know which action we are taking.

It Happened

Well, it has happened. IceCap made a significant strategy change to our portfolios – we INCREASED our allocation to equities. Those that know us well, are fully aware of our cautious, meticulous, and OBJECTIVE approach to managing clients’ hard earned wealth.

Those that are just getting to know us, will come to understand, embrace and look forward to hearing, and reading our rationale for our long-term view, and how it reconciles with short-term market fluctuations. Whereas descriptions and announcements of strategy changes will be included in our IceCap Global Outlook, clients benefit from these changes immediately in their portfolios.

When we make a strategy change it is always based upon objective decisions driven by data dependent analysis – we check subjectivity at the door.

One thing we are very proud of here at IceCap is that we have unequivocally demonstrated an ability to change our mind, change our view and most importantly, change our portfolio strategies. In other words – we do not stick our heads in the sand. We never dig in our heels, and it would be absolutely shocking if we ever refused to entertain the thought that maybe our strategy, outlook and perspective is wrong.

Back in 2011, our portfolios held a 20% allocation to gold bullion. The reasons for holding gold were astonishingly clear, and when prices tipped $2000/oz, these reasons seemed even more clear. For those that remember, gold hit the $2000 ceiling and started a sharp, excruciating and painful decline to $1280 levels.

Recognizing trend and technical support levels were broken we quickly sold all of our positions with the last sale at $1648. Even though the fundamental reasons for holding gold had not changed – the technical/market reasons for holding gold had changed.

We share this with you to demonstrate that although all investment managers have long-term views on various markets, many do not have the ability, or the inclination to re-wire their brains and produce independent thoughts to enact significant change. Unfortunately, “same-old-same-old” actually is a very popular investment philosophy. But not at IceCap.

We haven’t been back into gold since. Yet we have a very clear vision as to how the gold re-entry path will look, and until the time when markets guide us in that direction, we’ll sit on the sidelines. During the same time frame (2011-2012) our portfolios were positioned to protect client capital from the potential of a sharp decline in equity markets.

Again, the fundamental reasons for expecting this event to occur were quite strong – and today, many bearish managers continue to shout and scream the same fundamental reasons as to why stocks should collapse. But they haven’t.

Back around that time, our thinking and perspective changed to better understand not why stock markets were avoiding collapse, but instead to understanding why they were going higher.

Now, there is a subtle difference in what we just said. And our approach to solving the riddle was to change our perspective. Instead of beginning with a thesis that all bad things in the world eventually create a crisis, which is then always reflected in a stock market crash – we took a different perspective. And this perspective led us to understand two crucially important things:

  1. the risks in the world today are not in equity markets – instead they are in sovereign debt markets;
  2. the reason few have correctly diagnosed this disease, is due to no one in our (limited) lifetime ever having the displeasure of experiencing a crisis in government bond markets.

Put another way, all the bads that we experienced over the past 50 years have always been a result of excess largess from companies and individuals.

And every single time, governments and central banks have come running to the rescue of financial markets.

Which have culminated in the rather odd and peculiar situation the world finds itself in today. One turned upside down by zero and negative interest rates. One pushed offsides by preventing bad banks from going under. And one dominated by 180 degree turns in the political arenas. From our perspective, it is crystal clear that the majority of investors, are completely uneducated towards the current global financial environment.

In some ways, you can’t blame them. After all, for many, their informational world is completely monopolized by domineering media, big banks, and perhaps, most harmful of all – social values which force and expect you to behave, eat, sleep and breath “correctly.”

And this brings us to today and our latest decision to increase equities.

We’ve been very transparent and very consistent with our view that we expect the US Dollar and equities to go higher due primarily to a growing crisis in bond markets. We’ve also been very transparent and very consistent with our view that corrections will occur and unless serious technical support has been broken, we’ll continue with our holdings and strategies.

As an investor, you are well aware that equity markets declined sharply in January 2018 and have largely remained range-bound ever since. In our February 2018 IceCap Global Outlook we wrote that none of our models were indicating a serious downturn was unfolding and it was very likely that the bottom has been reached and if it was confirmed by our research – we would add to our equity positions.

Well, over the last few weeks our models did in fact turn positive which provided us with a green light to do exactly as we indicated – buy more stocks.

As a global investment manager, we absolutely reserve the right (and expectation) to change our views and strategies.
At this point in time, our market view remains completely on track.

This means that anyone who is bearish on stocks, bearish on the US Dollar and believes the bond markets will provide safe footing are about to be hit with a major dose of reality.


A few years ago, I had a conversation that not only caused my head to turn and eyebrows to rise, but it also confirmed my suspicions towards the pension investment industry. And the conversation was with an 8 year old kid.

Me: “How’s your Dad these days?”

Kid: “Great. Did you know he’s a pension lawyer and pension lawyers can charge higher rates than other lawyers.”

Me: “Well, it is a faceless client”

Kid: <now bored and leaves>

As we know, kids do say the darndest things. And we also know, kids know very little about the pension investment industry.

Hence, when I hear the pronouncement about various vendors being able to charge higher fees to pension funds, it only further affirms the inherent dangers and risks within the pension industry. And it is all due to culture.

Culture is everywhere. It’s in countries. It’s in specific regions of countries. It’s in languages. And it’s in organizations, industries and companies too. As well, culture is never right or wrong – it is what it is.

Yet, recognizing culture and objectively understanding the pros and cons within a culture is absolutely vital to correctly (and objectively) developing a projection of what will happen.

Although many investors do not have significant direct exposure to the pension industry – especially Defined Benefit Pension plans, everyone has indirect exposures as to how these extraordinarily large pools of money are invested.

The best way to understand how and why, you will be affected by the pension industry’s culture, look no further than the “greater fool theory”. The greater fool theory is quite simple – it means the price of something is determined not by its intrinsic value, but rather by the irrational beliefs and expectations of other buyers.

Because we do not live in a risk-free financial world, the moment the pension industry was born, sharp people with sharp pencils and sharp calculators came out of the wood work. After all, when you’re dealing with pension monies, you’re talking about a pool of money that is suppose to last for a very, very long time.

And when you combine a very long time period with a very large number of other moving parts – it has been decided that a very large number of smart people need to be involved to ensure monies are always available to meet retirement payment commitments.

And whenever you have a large group of people bandied together, with the same cause and with the same training and pedigrees – you get group-think, and this is bad, very bad.

This is where culture comes into play. And those who know culture, knows it is extremely difficult to change, move or alter.

And understanding this culture will help you see exactly why the bond market is going to completely blindside the majority of pension plans and turn those happy retirement years into ones of bitter resentment towards those entrusted with keeping everything in-line.

Yes – these are harsh words but they are absolutely needed to be heard, read and then re-heard and re-read. The best way to explain why the culture of the investment industry will prevent itself from seeing beyond its nose, is to understand how it is structured.

To start with, the pension fund is created by an employer for its employees and the employer is either a company or a government entity.

Next, you must completely understand there is always a risk that the pension assets (investments) will not be enough to make all of the promised future pension payments. And, all of this shortfall (deficit) must be made up by the company/government entity.

This is where the risk part comes into play, and this is also where and why all of the consultants, actuaries, pension lawyers, investment committees, trustees and board of directors enter the picture.

As you’ll agree, the future is sometimes tricky to predict – especially when you’re dealing with how long people live, how healthy they remain while living, and financial market returns.

Yet, the number 1 item that affects all of the above is actually NOT that hard to predict – long-term interest rates.

Yes, long-term interest rates directly or indirectly drives all of the above factors including health and longevity (medical research and discoveries are significantly impacted by funding available which in return is affected by long-term rates).

Therefore, simply understanding where long-term rates are going is really the key to solving the looming pension crisis. And as we’ve detailed in our previous IceCap Global Outlook publications, long-term interest rates are on the verge of exploding higher which will create significant losses for everything affected by long-term interest rates – including pension funds.

The reason for this is twofold.

First, practically all pension funds hold anywhere between 15% to 100% of their investment assets in bonds and/or other investments directly affected by interest rates. The vast majority of the professional investment management industry theorizes that the future cannot be predicted.

The investment industry also lectures that stock markets produce higher returns and than bond markets, and stock markets also contain greater risk than bond markets.

And since pension funds are suppose to be professionally and conservatively managed – they will always err on the side of caution and therefore hold a combination of stocks and bonds.

Which presents us with the voila moment!

The preferred mandate for pension funds (as well as the most common strategy for most individual investors) – the balanced fund, or a similar version of the same including life cycle funds, and target dated funds.

The key part here is that the culture of the industry whole-heartedly believes that the future cannot be predicted.

Naturally, there’s a little bit of truths and untruths in this statements. Yes, the future is difficult to predict – especially during a mid-cycle period. No, the future is not difficult to predict – especially during an end-cycle period.

Today, in the land of interest rates – we’ve reached the end of the mother-of-all interest rates cycles.

And because the pension industry is so tightly wound and wrapped-up in its culture, the majority of those fiduciaries are unable to see the future.

It simply isn’t in their genes, and chromosomes and it certainly isn’t reflected in the most important make-up of all – their assumptions for the expected long-term rate of return and the discount rate for liabilities.

Let’s start first with the Rate of Return Assumption. This number is provided to pension funds by actuaries and it is simply a number used to smooth out return expectations over the life of a pension fund.

The error with these numbers is that it is using past performance to predict future performance.
As any investor will tell you – this is the first disclaimer stamped all over any performance data from every investment fund.
But not the pension fund.

The error with this expected return number lies in the assumption used for fixed income returns. As fixed income returns are completely dependent upon the directional movement of long-term interest rates, historical data from the past 36 years has completely skewed the average performance returns for the bond market.

Chart below shows the historical yield of the US 10-year Treasury Bond, which is the proxy for global bond markets.
Put simply, when long-term interests are increasing (red line 1960 to 1982), bond funds are horrible investments.

The opposite is also true. From 1982 to 2018, long-term interest rates (green line) declined, creating the most incredible period ever for bond market returns. And this simple observation, creates another voila moment.

Virtually everyone working within the industry today either worked during this green arrow period or were trained by mentors who worked during this green arrow period. In other words – all everyone has ever known is a period of declining long-term interest rates.

This unintentional happenstance is going to produce a lot of angst.

Today, long-term interest rates are at 3%. Which means, the only way possible for bond strategies to return greater than 3% is for long-term interest rates to remain at 3% or lower forever. We can assure you this will not happen. And anyone who is using bond return estimates greater than 3% will be disappointed.

To demonstrate that there are pension groups that have been blinded by culture, spend a few minutes with the table on the next page. This public data is from one of Canada’s largest private sector pension funds and shows the expected long-term rate of returns. There are several items that jump off the page, with the most significant being:

1) The 55.2% allocation to Nominal Bonds
2) The +3.4% expected return from Nominal Bond strategies

IceCap can assure you that there is zero probability of this pension fund’s nominal bond strategies producing a return  +3.4% or greater. In fact, as long-term rates surge higher, the assets in this pension plan will decline -20% or more.

When this occurs, the culture of the pension industry reveals itself with board room whispers and proclamations that “no one saw this coming.”

We are telling you that it is coming.

Read on in the full presentation below (link)