Opportunities Funds Commentary

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Trident Investment Management, LLC
Opportunities Funds Commentary
UPDATE
June 30, 2014
Performance discussion
In the second quarter of 2014, markets got back into euphoric mood. The S&P 500, MSCI Europe and Nikkei
indexes were all up 4.7%, 2.6% and 2.3% respectively. Rather surprisingly, fixed-income markets also rallied with
equities, with the German 10-year bond (the Bund) rallying 0.32% to end at 1.25% for the quarter. Gold was
volatile, but nevertheless finished up 3.4% on the quarter at $1,327/oz. The U.S. dollar was mixed over the period.
It strengthened against the euro by 0.6%, but weakened against both the Canadian dollar and the yen by 3.6%
and 1.8%. Credit spreads in the developed world continued their inexorable tightening, reaching levels that we
last saw in early 2007.
We clawed back some of our losses from the first quarter during this period. Our long fixed-income positions
contributed the lion’s share of our gains. Our long equity position in Japan also helped. Our primary loser was our
net short position in credit. On the portfolio front, we have steadily been increasing our fixed-income exposure
over the quarter, and may even boost it further. We have also increased our short positions in credit though on a
net basis, our exposure has not changed much because we have also increased our exposure to some developing
country corporate and quasi-sovereign credit. We expect significant market reversals in the second half of this year
and are scaling up our book to make sure we can profit significantly.
Market outlook and portfolio strategy
We have been arguing for a while now that growth in the global economy is neither particularly good nor
accelerating. While the fixed-income markets have begun to discount the view that things may not be improving,
the equity and credit markets remain optimistic about the future. Thus, the S&P 500 Index is at all-time highs,
most European bourses are also at record levels, and spreads in many credit markets are close to what even the
bulls would concede were the misguided levels of 2006-2007. The implied volatilities, as reflected by options
prices, in many markets besides are hitting new lows.
1. Explaining the bullish view
The rampant bullishness can be attributed to a combination of factors. First, policymakers have intervened directly
in some markets to fix prices at levels that might not otherwise have prevailed. The Bank of Japan’s program of
Quantitative Easing (QE) for example, has resulted in the country having the lowest 10-year bond yields in the
world at 0.60%, despite it being the most indebted. The U.S. Federal Reserve’s QE has kept U.S. rates very low
as well, even though unlike Japan, much of the U.S.’ borrowing is done overseas and foreigners seem increasingly
unwilling to purchase its bonds at the rates being offered. The U.S. mortgage market remains active though banks
have substantially curtailed their real estate lending, primarily due to the direct intervention of the various U.S.
housing finance agencies that collectively now guarantee almost 85% of all new mortgages.
Next, market sentiment has changed decisively for the better because of the interventionist policies of the last few
years. We consider this effect below in greater detail.1.1 Manipulating risk and reward
Consider an investor who contemplates an investment of $1 with probabilities p and (1-p) of getting returns
g (g > 0, a gain) and h (-1 <= h < 0, a loss) respectively. The investor gets an expected value which is:
Expected Value = p(1+g) + (1-p)(1+h) where 0 <= p <= 1, g > 0 and -1 <= h < 0
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UPDATE
If our risk neutral investor (who is willing to take any fair gamble) is to be indifferent between investing or not,
the expected value above should be $1, implying zero returns. At the point of indifference, g and h should satisfy
the following equality:
g = h(p-1)/p
What this means is that the higher the probability of success, the smaller the upside the investor expects in a
successful scenario. In fact, when the probability of success is very high, the investor becomes virtually oblivious
to his potential losses. Again, if the potential loss is very small, our investor will chase even investments that offer
a low probability of success and relatively low upside because there is no risk to investing.
The developed world’s central banks have successfully convinced markets with their repeated interventions that
the probability of a loss and the magnitude of a potential loss are both low. In Europe for example, most market
participants would acknowledge that the prospects for Greece, Portugal, Ireland and possibly also Spain and Italy
are bleak. Yet they are more than willing to purchase the debt of these countries, assuming little risk of default,
because they are convinced that the European Central Bank (ECB) will both prevent and, in the worst case, limit
any potential losses they might sustain. Again, most U.S. investors would agree that with the current high degree
of bond issuance by the Treasury, rates could spike much higher were the Fed to stop its purchases and normalize
interest rates. Yet, they are sanguine that the Fed will simply not permit such an outcome.
By keeping rates low, policymakers have also permitted higher returns from leveraged investing. Their promises to
continue this for an indefinite, but long, time period has emboldened leveraged investors, fresh with their recent
gains, to project significant returns looking forward.
The world’s monetary authorities thus, have engaged in policies that are largely geared to manipulating investor
perceptions. On the one hand they have reduced the perceived probability of large losses by their virtual
guarantee of permanent bailouts. And by promising low rates forever, they have increased the potential gains
to leveraged investing.
1.2 Investor sentiment and market pricing
Central banks, all said and done, are still not 100% of market activity globally. While they can influence perceptions,
they cannot indefinitely prop up prices, especially because market participants are likely to consider reality as well
in their investment decisions. However, by intervening repeatedly and in huge size to change investor perceptions
over the last few years, they have essentially succeeded in divorcing the markets completely from reality. And Wall
Street and its press minions, whose livelihood depends on the health of the markets, are only too happy to tout an
alternate reality suggested by these manipulated market prices, whatever the true reality might be.
The main problem of course, is that the perceived “reality” above does not exist. In fact, what markets are now
doing is pricing the efficacy of central bank intervention because that is the only thing that matters. The actual
state of the economy, profits and efficiency that a traditional free market is supposed to worry about are all largely
irrelevant. Thus, markets today are no longer free in any sense of the word. In fact, the constant barrage of
economic news and analysis from the Wall Street shills should be viewed simply as propaganda to hoodwink the
public who are increasingly disconnected from the market reality.
1.3 How does this end?
The problem with a happy alternate reality is that unless actual reality catches up with the hope, the markets
become even more disconnected from the fundamentals. The more the divergence, the more the intervention
needed from the authorities to keep the dream going. Thus, paradoxically, market manipulation by policymakers
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often begets even more manipulation, making it potentially impossible to revert to a truly free system again. When
participants eventually understand what is happening, a crisis is certain to ensue. And the longer such action is
carried on, the worse the ultimate crisis is likely to be.
UPDATE
In a more benign situation when reality does catch up with expectations, the market outlook may not be much more
pleasant. In such a situation, the monetary authorities almost certainly have to scale back on their interventions if
they are to restore market freedom and have any vestigial credibility left. This process will mean the disappearance
of free leverage and the policymaker put, and thus the re-pricing of risk and return by market participants. The
resulting market correction could well serve to worsen market sentiment and possibly also overall economic
conditions, forcing the authorities to return to their manipulation.
Put simply, market manipulation by policymakers can be likened to an addictive drug. It does provide a quick high
in the short run but it takes more and more of the medicine to keep the euphoria going. And the withdrawal, no
matter how well done, is going to be painful.
2. Where is the opportunity?
There is no doubt today that reality is not catching up with market hopes. The Fed’s QE has yet to create sustainable
growth. The U.S. still has huge fiscal deficits and would also have high unemployment had it not been for a
dramatic decline in the labor force participation rate. And the debt it has racked up over the last few years means it
has much less fiscal flexibility. The Eurozone continues to have high unemployment, large fiscal deficits and weak
growth, with debt levels among many member countries being unsustainably high. The Chinese bubble machine
may have started to go into reverse as credit concerns mount in the country and unbridled investment is curtailed.
As such, the chasm between reality and market perceptions for the future is widening.
At the same time, market sentiment is resoundingly bullish. Fully 100% of the economist shysters on Wall Street
believe that strong growth for 2014 is assured. The equity markets are celebrating with a new crew of technology
companies which lack (positive) earnings or sales, fleecing the public in a repeat of 1999. The credit markets
are even more joyful with spreads at levels that we did not believe would prevail for a few decades. Subprime,
covenant-light and pay-in-kind toxic bonds are all back, and gracing the portfolios of most retirement funds that are
already woefully underfunded to begin with. Nothing is ever expected to go wrong in the world again.
The rigged markets of today are hard to navigate for any clear-thinking investor who refuses to recognize the
alternate reality of the policymakers. Actual reality is not pleasant and potential returns are unlikely to be high in
going with the market consensus. Yet, the only reason that the perceived risks are even lower is due to the perpetual
put that so far the policymakers have been willing to provide. As such, markets could be rocked by two possible
changes. First, even with policymakers continuing to support markets, a variety of factors could change market
sentiment and make participants much more skeptical about the efficacy of intervention. Next, policy itself could
change and force a re-pricing of the markets’ perceptions of risk. And worst of all, both policy and sentiment could
change at the same time, and in a direction contrary to the bullish consensus.
The most important questions we face as investors are just what could cause changes in policy and/or sentiment
and the market effects of such changes. We consider some parallels from history to help us consider these questions
and then move to our positioning.
2.1 Changes in sentiment
Investor sentiment can change dramatically, often without obvious catalysts, and result in large market moves. The
most recent example of this was the collapse in the Nikkei index in Japan from May to June 2013. The index fell
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UPDATE
from a high of 15,627 to 12,445, a fall of 20.6% from peak to trough. Over the period, Japan was still engaged in
QE, and in fact had just started it, global equity sentiment was still strong given the U.S.’ good performance over
the period, and Japanese corporate earnings were improving significantly. Yet, a near-term stampede for the exits
among panicked investors led to the selloff. Again, drawing from 2013, the bond markets in the Eurozone sold off
heavily from May to September. German bund rates, for example, rose from 1.16% to 2.04%, a rise of 0.88%, and
this despite the fact that Eurozone growth numbers did not even suggest a recovery, let alone a strong one. These
sentiment-driven moves have largely since been reversed: the Nikkei has risen significantly from its June 2013 lows
and the Euro fixed-income markets have retraced most of their losses from 2013. Thus, a change in sentiment
that is not accompanied by a change in fundamentals and/or policy may often reverse, even though the near-term
adjustment might be painful.
2.2 Changes in policy
A shift in the underlying reality or policy however, will typically have lasting effects. In fact, sentiment cannot
divorce itself from such a change for very long. Thus, a rise in U.S. interest rates in 2006 ultimately caused a collapse
in the housing bubble, much as an earlier U.S. rate hike in 2000 caused a collapse in the technology bubble.
The rate hikes in Germany post-reunification in 1990 directly led to the strains in the European (exchange) Rate
Mechanism and ultimately the summary ejection of Britain from the system and the devaluation of the Spanish
peseta. The simple fact is that a policy shift has real consequences that ultimately take hold.
When policy and sentiment change together in a direction contrary to market thinking, we typically have an
amplified response. Leading up to 1997, Thailand had a pegged exchange rate, a buoyant real estate market,
elevated rates of inflation and a trade deficit. Most market participants believed that a small devaluation could get
that country back on track. When the country did devalue in July 1997, the net effect was not just a Thai crisis, but
an Asia-wide crisis with wholesale bank failures and corporate defaults. What might have been a small crisis in a
relatively small economy morphed into a global problem whose aftermath we are still dealing with in some ways.
We believe the current global environment is prone to both a reversal of policy and independently a change
in sentiment as well. In some areas of the world, policy supports for the market are slowly being withdrawn. In
others, market sentiment may be changing with even bigger reversals in thinking possible. With the increasing
interconnectedness of the global markets, we have a virtual smorgasbord of potential risks that could quickly alter
the status quo.
We consider below some of the policy changes and drivers of market sentiment that might potentially catalyze
a big shift in markets over the next several months. We then look at the best investment opportunities and our
portfolio positioning.
3. An analysis of reality
Monetary policy has provided the key policy support for asset markets. Participants believe that the central banks
will remain in unconventional easing mode until the economy has reached escape velocity. However, what they
fail to consider is that a number of central banks have already started to withdraw some of these policy crutches with
ample warning of their desire to further reduce them. In particular:
- The U.S. Federal Reserve continues its tapering and will have ended its QE at the current pace of withdrawal
by October.
- The Bank of England ended its own QE program in 2012.
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- The Chinese government has started to tighten credit. The state banks have been directed to be more careful
about new lending, and the shadow finance system made up of trusts and other unconventional products has
started to contract.
UPDATE
- Many developing countries have already tightened credit. Brazil started raising rates in 2013, as did India.
The rationale for these policy changes is varied. The UK and most developing countries are facing significant
inflation, and policy remains too accommodative even today. In the U.S., Fed members have belatedly begun to
realize that more QE may not help much. In China, the government has recognized that they need to re-orient
growth away from investment to consumption spending.
On the positive side of the ledger, Japan continues its QE and is unlikely to reduce or end the program for some time.
The ECB may start its own QE program, though it is far from clear that it can do so under its mandate. ECB officials
moreover, seem to believe that the benefits of QE, if any, are likely to be limited at best in the European context.
Further impetus for policy changes might come from the fact that the current policy mix is simply not working
to deliver growth. Wall Street economists had a rare consensus at the start of 2014 that it would be a year of
3%+ growth. They were correct only perhaps in the magnitude though not in the sign – U.S. first quarter growth
printed at -2.9%, a level that historically has always meant a recession. European growth is flagging despite market
expectations of a pickup.
3.1 The situation in Europe
The primary effect of market manipulation by the authorities has meant a substantial increase in the values of the
assets held mostly by the wealthiest, with no increase in overall incomes. As such, social tensions are increasing,
especially in Europe. The Eurozone now faces a restive electorate in many of the member countries where growth
has been weak. This was perhaps most obvious in the elections to the Euro Parliament that took place in May,
where the anti status-quo groups won some decisive victories. In Greece, the radical left party, Syriza, won the
largest share of the vote. Syriza has campaigned on a platform that abandons the current austerity programs though
not the membership in the Euro bloc. Again, the National Front, a right wing, anti-immigrant party in France,
won a resounding majority in an election that decimated President Hollande’s socialist party. In Spain, Podemos,
a party created in March 2014 by left wing activists, won an amazing 8% of the vote. The political strains should
likely get worse by later this year, especially in November, when the Catalans of Spain vote on a referendum for
self-determination, if not independence.
The recent leadership change in Italy with Matteo Renzi taking power, the popular former mayor of Florence,
is going to create further tension in Europe. On July 1, Italy took on the rotating presidency of the European
Union council. The Renzi government in this position is likely to push for more fiscal easing, putting Italy into a
collision course with Germany. With Eurozone debt and deficit levels already sky high, a fiscal showdown among
policymakers might force the ECB to delay or even abandon its tentative plans for QE.
3.2 Rising global tensions
The other impetus for monetary policy restraint comes from the political tensions that have increased over the
last few months. The civil war raging in Iraq creates considerable uncertainty about future oil supplies from the
country. This conflict has pitted the jihadist Sunni forces of the self-proclaimed Islamic State of Iraq and the
Levant (ISIL) against the Shiite government of Iraq installed by the U.S. A third player in this war is the Kurdish
population in Iraq that has long sought self-determination. The U.S. and Europe find themselves in the unhappy
position of supporting a pro-Iran Shiite government against a militant group with significant Al Qaeda elements,
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UPDATE
supported by Saudi Arabia and the Sunni governments of the Middle East. A complete stoppage of Iraqi oil exports
due to the fighting raging in the country could send oil to over $150 per barrel, sowing the seeds for future inflation.
Easier monetary policy would be unlikely in this context, given the runaway inflation that resulted from a similar
experience in the early 1970s.
The events in Iraq are even more of a concern given the civil war that is raging in the Ukraine. By most objective
accounts, the current conflict was created by the Western powers which overthrew a Russia-leaning government,
replacing it with one that was likely more pro-Western. This move was driven by the naïve belief that a Westleaning Ukraine would be tolerated by a weakened Russia. However, Russia responded strongly to this provocation,
annexing the Ukrainian province of Crimea which had a largely Russian population, and voted to rejoin Russia.
The rest of the Ukraine has now become divided along ethnic lines, with the areas of the country in the East that
have significant Russian populations wanting to rejoin their country of origin. The Ukraine’s collapsing economy
and its inability to pay its foreign creditors has meant even more problems. The Russians have cut off natural gas
supplies to the Ukraine for non-payment and since the country is an important transit point for gas supplies from
Russia to Western Europe, disruptions in supply are highly likely. Coming at a time when oil prices themselves may
be rising due to Iraq, this could make for a toxic cocktail.
From an international perspective, the Ukraine conflict has pitted Russia against the Western powers, making
global co-operation to solve problems all but impossible. Russia now actively supports the Shiite government in
Iraq, which is increasingly leaning toward Iran, making a resolution to the crisis in Iraq much harder. Also, the
Western sanctions against Russia, even if limited, have encouraged the latter to actively seek alternative markets
and currency arrangements to sell its oil. Russia is working to create a new global payment system free of the U.S.
dollar and U.S. interference. In this effort, it is finding ready allies among the developing countries that are already
unhappy with the destabilizing inflationary effects that U.S. QE is having on their domestic economies. In fact,
the largest developing nations (Brazil, Russia, India, China and South Africa) have already set up a $100 billion
currency fund (as of September 2013) to limit the wild currency swings they have experienced from the U.S.’
unilateral pursuit of its domestic objectives through monetary policy. More QE, at a time when many of the U.S.’
creditors are actively looking to limit the U.S. dollar’s role, could be the proverbial straw that breaks the camel’s back
and precipitates a dollar crisis as we saw in the 1970s.
With policymakers already starting to lean against the flood of global liquidity, markets become more vulnerable to
shifts in sentiment. And sentiment today is at optimistic extremes by most measures such as credit spreads, equity
valuations and volatility indexes in the developed world. Yet this bullishness is not mirrored to the same degree in
the emerging world.
3.3 Changing investor sentiment
We would argue that sentiment has already changed for the worse in China, which is dealing with a wave of
trust defaults and bad loans. Sentiment is likely to get even worse there as banks are starting to find out that
collateral pledged against their loans has often been re-pledged multiple times, and on top of that, may have even
gone missing. The government in China appears unwilling to undertake a bailout of all the trusts, fearing the
resumption of even more speculative activity. But the inevitable result of this is going to be a longer-term slowdown
in commodity imports from China as its real-estate boom cools and its growth rate approaches more normal levels,
let alone a recession.
The effects of China are already being felt in some of its major trading partners. Commodity exporters Australia and
Brazil are feeling this in the pricing of their goods. Australia in particular is experiencing a significant slowdown in
its commodity industry, which was the primary driver of its investment boom over the last few years. Yet a prolonged
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Chinese slowdown, which seems increasingly likely, will have wider ranging effects. Exports of intermediates from
other Asian countries to China, as well as sales of finished, higher technology products from Korea, Germany and
Japan are all likely to be affected. The once-in-a-generation boom in China is being replaced by an equivalent bust.
UPDATE
Even most developed market investors, for all their euphoria, are curiously mixed on their outlooks. On the one
hand, stock markets are hitting record highs, but the bond markets suggest a return to recession in Europe and a
lack of confidence with the economy in the U.S. Japan saw exceptional GDP growth in the first quarter as well as a
significant pickup in inflation. Yet, Japan’s equity market is among the worst performing in the developed world and
there has been no rush to stampede out of even its 10-year government bonds, which yield a paltry 0.60%.
While sentiment may be changing slowly for now, there is a clear risk that a more abrupt reversal in thinking could
occur. Numerous factors suggest that such a change could produce significant market dislocations. In particular,
equity trading volumes are much lower today than a few years ago and a large percentage of this volume is made
up of high-frequency robot trading. Fixed-income trading volume has declined, with large markets such as the
Japanese government bond market going untraded for several days in the quarter. While investors remain euphoric,
Wall Street houses remain unwilling to warehouse risk for any length of time or provide much liquidity. A big shift
in investor psychology in this environment could quickly cause markets to spiral out of control without aggressive
official support. Yet most equity investors in the U.S. and Europe remain convinced that they can ride this equity
bubble and exit at the top without problems. Conditions like these typically precipitate market crashes. No doubt
when one does occur, the mantra will be that no one could have seen it coming.
4. Portfolio positioning
Turning to the portfolio now, we believe the trends for the next several months are clear:
- Growth will most likely be much weaker than even current lowered expectations for 2014. Additional monetary
support for a slowing economy is unlikely in the U.S., but might occur in Japan and possibly also in Europe.
- Eurozone tensions are likely to resurface, and this time in the political dimension. Italy will likely seek fiscal
expansion for the region, putting it (along with Spain, Greece, Ireland and possibly even France) in conflict
with Germany and other healthier nations.
- Political changes in some key countries seem imminent. Greece’s current government could fall soon with
Syriza, the radical left being voted in as a replacement. The vote in Catalonia could feed up a constitutional
crisis for Europe.
- Iraq and the Ukraine are unlikely to see peace in the near future. If anything, conditions are ripe for
destabilizing escalation.
With sentiment in many markets reflecting record bullishness, it is clear that market participants are putting a lot
of faith in the world’s policymakers. Yet, most of the developed countries have little policy flexibility. Many of them
(the U.S., UK, Italy, Japan, Greece and Portugal, to name a few) are fiscal basket cases. Few of them have any
monetary flexibility – after all, there is not much one can do to expand on QE done at the current scale.
We believe strongly that the catalysts for monetary policy change and thence market valuations are already at work. Our
portfolio is positioned to profit from the major shifts in market thinking that we believe are imminent. In particular:
- We are long fixed income in South Korea, Norway, Sweden, Canada, Australia and Europe, expecting rates to
fall considerably from current levels. These countries/regions have interest rates that are simply inconsistent
with the world’s current growth outlook. We believe that European rates will soon plumb Japanese depths.
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UPDATE
- We are short credit, especially select high-yield instruments whose spreads have tightened to levels seen in
February 2007. Our significant short credit positions are partially offset by longs in the credits of some global
oil companies and quasi-sovereign developing country entities. We have recently increased our exposure to
Indian credit, in particular, in response to the strong mandate given to Narendra Modi, its dynamic new Prime
Minister.
- We are long Japanese equities and expect to increase this exposure further. Events in Japan are progressing
nicely with the country finally seeing significant inflation. The corporate sector’s earnings are very geared to the
rising prices.
- We are building up a short position in the currencies of the QE countries in the developed world against
those of select developing countries. We expect a significant devaluation of some QE currencies over the
next several months.
- We have reinitiated our long position in gold through options and expect to boost it significantly over the next
few months.
5. Conclusion
Global fundamentals have been deteriorating steadily over the last several months. The decline has not just been
on the economic front. Governments everywhere are getting increasingly shaky with incumbents becoming more
unpopular by the day. Cooperation among the major world powers has become much harder to achieve on a
variety of important areas. And wars are raging on two continents, with either one having the potential to cause
huge swings in the price of energy – the one critical driver of the global industrial economy. With all these negative
developments, equity markets appear to be in the blow-off phase of bullishness. All bad news, however significant,
is typically dismissed as being due to the weather or other unpredictable factors. Happiness is a state of mind and
markets have wanted to be happy so far no matter what the reality. We expect this unreasonable happiness will
soon give way to a prolonged period of extreme depression.
Performance Summary at June 30, 2014
Trident Global Opportunities Fund
1 Mth.
3 Mth.
6 Mth.
1 Yr.
2 Yr.
3 Yr.
5 Yr.
10 Yr.
YTD
Since Inception
(Feb. ‘01)
-0.1%
-4.5%
-8.4%
-2.6%
-0.8%
-3.0%
9.4%
-4.5%
7.9%
0.4%
CI Global Opportunities Fund
1 Mth.
3 Mth.
6 Mth.
1 Yr.
3 Yr.
5 Yr.
10 Yr.
15 Yr. YTD
Since Inception
(Mar. ‘95)
-0.1%
-4.3%
-8.4%
-0.9%
-2.9%
9.3%
7.4%
-4.3%
14.7%
0.4%
Nothing herein should be read to constitute an offer or solicitation by Trident Investment Management, LLC or its principal to provide investment
advisory services to any person or entity. This is not to be construed as a public offering of securities in any jurisdiction of Canada. The offering of
units of the Trident Global Opportunities Fund are made pursuant to the Offering Memorandum only to those investors in jurisdictions of Canada
who meet certain eligibility or minimum purchase requirements. Important information about the Funds, including a statement of the Fund’s
fundamental investment objective, is contained in the Offering Memorandum. Obtain a copy of the Offering Memorandum and read it carefully
before making an investment decision. These Funds are for sophisticated investors only. ®CI Investments and the CI Investments design are
registered trademarks of CI Investments Inc.
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