Opportunities Funds Commentary

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Trident Investment Management, LLC
Opportunities Funds Commentary
February 28, 2011
UPDATE
Performance Discussion
Markets started 2011 with the same upbeat outlook that characterized the last quarter of 2010. The S&P
500 was up 3.43% in February, the MSCI Europe Index was up 2.6%, and the Nikkei up 3.83%. The
month’s performance put these indices up 5.88%, 4.36% and 3.93% up on the year respectively. Bond
markets continued their selloff, with the U.S. 10-year Treasury yield rising 0.06% to end the month at
3.43%. Commodities rallied with gold being up 5.9% and WTI crude up 5.18% on the month. The U.S.
dollar weakened against most of its trading partners with the U.S. Dollar Index falling 1.08%. The credit
markets continued to tighten in February with most credit spreads trading at or close to the narrowest levels
in two years (all figures in U.S. dollars).
Our funds suffered in January and were flat in February. Our long positions in fixed-income options in
Norway and Australia hurt performance mainly due to a continued decline in rate volatility and higher
yields. Our foreign exchange positions, which are mostly in the pegged currencies such as the Chinese
Renminbi, also suffered as markets concluded that no change in Chinese FX policy was imminent.
Even our U.S. curve steepener options hurt performance as markets increasingly began to price in a U.S.
economic recovery with rate hikes to come from the Fed. We profited from our positions in gold and Japan,
but not enough to compensate for our losses.
We have started to add to some of our key positions in the last few weeks. Many of the options in our fund
are now at levels that represent very little downside going forward. The credit markets moreover, appear
to have disconnected totally from reality to the point where we now see truly compelling opportunity for
profit. Markets today appear much as they did in late 2006. It is hard to imagine that the crisis years of 2007
and 2008 have been virtually forgotten, especially when the fundamentals that caused the crisis have yet
to be addressed.
1. The Looming Macro Challenges of 2011
We enter 2011 with market participants considerably more bullish about global growth than they were in
2010. Sentiment indicators relating both to markets and the real economy suggest that both consumers and
businesses are more constructive. The market euphoria of the last few months is nevertheless at odds with
the global economic and political situation.
1.1 The Challenges for the Developed Economies
Economic conditions in the developed world are hardly robust. U.S. growth, despite record stimulus, is
anemic at best, with unemployment still about 9%. With the exception of Germany, the countries of the
European Union have seen tepid growth, with significant austerity to come in 2011. The sovereign credit
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spreads of the peripheral Euro countries such as Greece, Ireland, Portugal and Spain are near their widest
levels, and even the spreads of the core European countries, while lower, are at their widest levels. Japan
has started to slow and the country has not managed to recover to the output levels of 2007. The U.K. has
experienced a stagflationary outcome with weak growth and continued high inflation that is close to 4%.
While numerous observers could well argue that the developed world’s economic performance is overall
quite reasonable, one should remember that this has come at the expense of record stimulus. Almost all
the developed countries are running enormous fiscal deficits with interest rates at all-time lows. While
some countries, primarily in Europe, are being forced by markets to rein in their deficits, most have not
addressed the issue. The U.S. government, in particular, continues to believe that fiscal deficits are not a
near-term problem at all, and has no immediate plans (or for that matter, longer-term measures) to rein in
expenditure or raise taxes. The Japanese government is equally at sea where it comes to fiscal policy with
debt issuance already at levels that do not allow for domestic savings alone to fund its continued deficits.
The developed economies, with the exception of perhaps Germany, cannot sustain their current growth
rates without continued stimulus. Yet, not much more stimulus seems possible in the developed world.
Rates can only go up from current levels, and markets are already beginning to balk at the huge financing
needs engendered by continued fiscal deficits. Even worse, there has been rampant inflation in most
commodities which is finally beginning to flow through into inflation in the developed countries making
the ultra-easy monetary policy increasingly questionable.
1.2 The Developing World’s Inflationary Problem
The developing world is facing a twin problem of high inflation and an increasingly unsustainable growth
model. We have had big increases in commodity prices, especially those for energy and food. Oil prices,
already above $100 per barrel, could soon hit or surpass the high levels of 2008. Food prices are already at
all time highs, even though rice prices, which are perhaps the most important for most Asian consumers,
remain well below the levels attained in 2008.
The developing world has been hit hard by these price increases since food and energy (unlike for the
developed world) make up a substantial part of their domestic Consumer Price Index calculation. For
example, food and energy together make up only about 10% of the US CPI while in India they make up
about 50%. The price increases for basic materials have meant a huge hit to overall living standards in the
developing countries.
The rises in inflation have prompted most developing countries to tighten monetary policy with some
resorting to direct price controls or increased subsidies for critical commodities. The Chinese, who are
already experiencing a huge bubble in real estate, have now had to contend with soaring food prices and
a sharply higher rate of inflation. Chinese policymakers have tightened credit already and are attempting
the difficult task of engineering a soft landing in real estate while lowering inflation. Brazil has engaged
in repeated rate hikes even as it tries to quell the rampant appreciation of its currency. Most developing
countries are fighting a losing battle so far against rising prices.
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1.3 Inflation and Political Change
UPDATE
The impact of higher commodity prices in the developing world has been felt most acutely by some of the
poorest sectors of their populations. Many developing countries import much of their food and energy and
the rise in global costs of the same have meant an immediate hit to the most vulnerable. This in turn is
leading to social unrest as the masses hold their political leadership to account for their misery.
The overthrow of Hosni Mubarak, until a few days ago the President of Egypt, resulted largely from
popular discontent with the country’s economic conditions bringing simmering political tensions to a boil.
The Mubarak government, a strong U.S. ally in the region, was a dictatorial regime that suppressed most
dissent. The Egyptian armed forces, which had deep ties to the U.S., were staunch supporters of Mubarak.
In fact, Mubarak rose through the armed forces in his position of leadership. He was a former commander
of the Egyptian Air Force and the Deputy Minister of Defense before becoming Vice President in 1975,
and then President after the assassination of Anwar Sadat in 1981. Yet, a largely peaceful revolution by the
masses managed to unseat Mubarak in just 18 days, with the army deserting him almost as soon the level
of popular rage became apparent. Egypt today is in a limbo – the army is in control, but the leadership
transition that will take place is still in the making.
The revolutionary success of the Egyptian masses has incited other popular uprisings across the Middle
East where most governments are not democratically chosen and are generally out of touch with the
people. Conflicts of varying intensities are raging in Libya, Yemen, Bahrain, Tunisia and Algeria. Libya
is in a state of civil war with violence only likely to increase in the near future. Even the Saudi Arabian
monarchy may soon face popular protests.
Some of the recently affected countries, such as Libya, Bahrain and Saudi Arabia, do not face the problems
with the inflationary erosion of living standards that most other developing markets currently do. In fact,
these nations benefit from high oil prices and in per capita GDP terms are already quite wealthy. Bahrain,
for example, has a nominal GDP per capita of almost $20,000 -- hardly developing country levels. Yet,
events in Egypt have served to catalyze the political frustrations of the populations of these countries into
actual protests against their regimes. The continued success of these popular movements could beget even
more uprisings in other countries where the governments are out of touch with the populations. In fact,
the Chinese government appreciates this risk and has responded very quickly and with disproportionate
intensity to limit any nascent dissident movements.
The tensions which have so far been primarily in the Middle East have served to disrupt oil supplies in a
world which may already be running up against supply constraints. Saudi Arabia claims to have adequate
excess capacity in oil production to deal with the current loss of Libyan supply. However, any problems
with Saudi production could well result in a major rise in oil prices which could compromise the fragile
global economic outlook.
2. U.S. Monetary Policy and Commodity Inflation
A significant driver for the commodity market tensions is undoubtedly the quantitative easing of the U.S.
Federal Reserve. A number of influential economists and Fed Chairman Ben Bernanke himself have argued
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that the commodity price rises have been from a combination of strong global demand along with supply
disruptions. However, the role of the Fed in creating commodity inflation can be understood when we consider
the mechanics of quantitative easing (QE) coupled with the reserve currency status of the U.S. dollar.
When the Fed engages in QE, it is contributing to driving up financial asset prices which could have a nearterm positive effect on consumption. This could come about first because higher asset prices might create
greater confidence about the future and prompt more spending. Next it is also likely that consumers might
feel wealthier and consume more from their assets. The latter effect only works in the short run because
an economy wide increase in asset prices ultimately does not have any benefit, being a classic example of
the so-called “money illusion.” Even worse, such an asset price increase could prove counterproductive in
that asset-poor consumers are effectively being taxed to pay for the wealth increases of the asset rich cohort,
which in turn could generate non-obvious changes, and not necessarily increases, in overall consumption
for the economy.
If the asset price increases due to QE are not ultimately consistent with the fundamentals, a significant
price correction is inevitable. The more prices get divorced from reality, the more their eventual collapse
results in negative economic effects. Thus, where it comes to investment and consumption, the real effects
of QE, outside of trade, are predicated on a near-term improvement in confidence that might foster a selfsustaining investment and consumption boom. Put differently, QE is attempting in real terms, to fool the
people into investing and consuming more in the hope that this action will somehow create an economic
recovery that can continue even when the illusion created by QE is removed. Unfortunately, rates in the
U.S. are already so low that new investment, if viable, would very likely have occurred already. Even worse,
consumption is already at such high levels that a dramatic increase in this is neither likely nor desirable in
the longer-term.
As discussed in many of our previous communications, the real intent of QE is to engineer a dramatic
depreciation of the U.S. dollar against its trading partners. This will mean a real increase in the prices of
imports relative to exports and result ultimately in sharply lower imports along with much higher exports.
This trade improvement will of course benefit the US economy, except that the cost to this will have to be
borne by the U.S.’ trading partners, which is why this policy is aptly known as “beggar-thy-neighbor.”
2.1 One size fits all Monetary Policy
Since the era of floating exchange rates that started in the early 1970’s, much of the world’s monetary system
has operated with a modified Bretton Woods system with the U.S. dollar as the reserve currency. While most
countries do not maintain an explicit peg to the U.S. dollar, many, and in particular, China, operate with
a de facto crawling peg to the currency. With QE, the U.S. is attempting to engineer a major devaluation
of the U.S. dollar. Unfortunately, countries that resist the QE-induced appreciation of their currencies lose
control of their monetary policies. In fact, the more a country’s currency is pegged to the U.S. dollar, the
more it becomes a satellite state of the U.S. with the Fed effectively becoming its central bank.
To understand the loss of monetary policy flexibility with a pegged currency, let us consider a region such
as Hong Kong whose currency is explicitly pegged to the U.S. dollar. If Hong Kong were to raise rates
much above U.S. rates, foreign capital would flow there to exploit the higher rates on offer until rates in
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Hong Kong fell to U.S. levels. The reverse would be true if the region tried to lower rates. One way for
Hong Kong to maintain an independent monetary policy would be for it to impose capital controls to
prevent the flow of foreign money into the region. The other would be for it to accumulate a potentially
unbounded amount of U.S. dollars into its reserves. If neither alternative is palatable, Hong Kong would
have no choice but to live with the settings of U.S. monetary policy, even if they are highly inappropriate
for its own domestic conditions.
The U.S. Fed today is basing its policies of QE on inflation as measured by the U.S. core CPI index.
This measure ignores food and energy prices and almost 50% of this metric is driven by changes in
rents for housing, which are at best improperly measured. Even worse, the U.S. CPI involves hedonic
(quality) adjustments and substitutions in the consumption basket that are all intended to doctor the index
downwards. As such, the core CPI index does not fully reflect even U.S. inflation and is a poor proxy for
global inflation. Also, most of the developed world, and especially the U.S., is still recovering from a huge
housing bubble with over-leveraged borrowers, huge excess housing inventory and high unemployment.
Food in the developed world moreover, makes up a much smaller portion of the consumption basket than
it does in the developing countries. These conditions militate for exceptionally easy monetary policy in the
developed world which has resulted in QE by the Fed.
2.2 The pernicious effects of low real rates
The economic conditions in the developing world are not comparable with those that exist in the developed
countries. Inflation in the developing world generally runs much higher than in developed countries
because of their economic structures and lower level of economic development. Under such conditions, a
developing country pegging its currency to the U.S. dollar is effectively keeping monetary policy too easy.
In fact, we would argue that real rates in many developing countries are negative today, and in many cases
have been for several years, given the high rates of inflation they have experienced. Low or negative real
rates have a host of undesirable consequences.
The first effect of overly low real rates is over-investment fueled by cheap credit. Easy U.S. monetary policy
since 2003 prompted investment booms in much of the developing world. The Chinese, in particular,
have invested and continue to invest in their export industries, even though they already have considerable
excess capacity. The second effect of easy money is to encourage speculation in assets. The Chinese
situation again serves as an excellent example of this problem. China reduced bank deposit rates to very
low levels in 2004 to help bail out their failing banks. With high domestic Chinese inflation since then,
real rates were negative, forcing savers to turn to real assets to hedge against their losses from inflation.
The huge bubble in Chinese real estate can be traced directly to the easy stance of monetary policy. An
initial rise in home prices coupled with negative real rates begat a construction boom and self-reinforcing
speculation. Even worse, Chinese banks were essentially assured in 2004 that they would not have to suffer
the consequences of their irresponsible investments and have since taken the lead in speculating in real
estate and other hard assets.
Since the crisis of 2007-2008, most of the developed countries have made the same monetary and banking
mistakes that China made in 2004 when it dealt with its banks. With QE the US is forcing money on the banks,
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with policymakers leaving no doubt that they will act to protect their largest financial institutions (which were
and still are the largest global speculators) from suffering the true losses of any bad investments they may make.
Free money, with guaranteed protection against losses has led to speculation on a global scale. Even worse,
with QE the Fed has provided an intellectual endorsement of speculation because its stated belief that high
and rising asset prices in the short-term will somehow generate sustainable economic growth.
2.3 Low global inflation not achievable with current policy
With QE and pegged exchange rates, the world is experiencing the high inflation that Bernanke had wanted
to create in the U.S. Asset inflation is visible the world over, albeit from relatively depressed levels in the
developed world. The continued strength in housing and construction in China in particular, have driven up
the prices of the basic commodities that serve as raw materials for their investment boom. Even worse, to the
extent that countries realize that these commodities will be in demand, they have been willing to build large
stocks of the same given that the financing is virtually free and given too that future price rises are virtually
certain as long as the U.S. is on its path of inflating asset prices. In fact, any hard asset whose future demand
is assured has proved to be a target for stockpiling and has experienced huge price increases. Thus, while QE
may not be the only cause of the huge rise in asset prices, it is no doubt a major contributing factor.
Viewed with this lens, the huge increase in food prices over 2010 is at least partly because of the Fed’s QE
policy. While the initial rise in prices was attributable to weather-related supply disruptions, the continued
huge increases are at least in part because countries have erred on the side of building larger precautionary
stockpiles.
The longer the developing countries continue with pegging to or shadowing of the U.S. dollar, the worse
their inflation will become. To the extent that inflation leads often to significant wealth transfers from the
asset-poor classes to the asset-rich wealthy groups of society, we might see most of these countries facing
significant problems with social unrest much as we have seen in the Middle East. Even worse, attempts
to rein in inflation with tight fiscal policies will likely slow growth in these countries while providing no
offsetting growth boost to the developed world. The only sensible choice for the developing world is to
abandon the link to the US dollar and let the U.S. achieve its goal of creating inflation with a sharply
devalued currency.
3. Outlook
Our belief is that the world in 2011 is facing a difficult combination of weak growth, seriously unbalanced
macro policies, and a wave of political turmoil that could result in more global disruptions and volatility.
The deterioration in global conditions appears to have accelerated over the last several weeks. This is
hardly an environment where risk concerns can be brushed away.
It is highly likely that we will have a significant U.S. dollar crisis this year. The likelihood of this has
increased significantly for two reasons. First, the Fed remains aggressively committed to QE even as most
central banks have at least acknowledged the recent sharp rises in inflation and the need to tighten policy.
Next, the rises in commodity, and especially food, prices have begun to extract a heavy toll on social stability
in the emerging markets. The reason the U.S. continues its QE is because the Fed perceives it as being its
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only policy option. Unfortunately, QE puts the rest of the world, and especially the developing world, in
an impossible situation if maintaining a stable exchange rate with the U.S. dollar is a priority. However,
a significant dollar depreciation against other world currencies would solve most of these problems and
might prove the best global policy alternative.
We have yet to operate in a world where the U.S. dollar has lost its hegemonic status. The Fed is forcing the
U.S. dollar to abdicate its royal role, but rather surprisingly, the currency’s global constituents are refusing
to allow this. If history is any guide, unwilling kings cannot be expected to perform their duties. We expect
considerable turmoil when markets begin to understand the scale of the change that is taking place in the
world’s monetary system.
All said, at least for now, markets seem to be oblivious to the risks. Equity markets globally are close to
recent highs and the pundits are convinced that more strong returns can be expected. Bond yields, while
they have risen recently, are still at very low levels, especially given rampant global commodity inflation.
Options volatility is close to the halcyon days of late 2007 even though the range of economic outcomes
today has become harder to predict. The credit markets are particularly interesting in this regard, and are
worth discussing in more detail.
The markets for corporate credit are euphoric today with spreads on investment grade companies close to
the very tightest levels observed during 2005 and mid 2006, though perhaps not quite at the super-tight
levels that accompanied the height of the CDO boom in early 2007. Yet, the economic environment in
2005 was relatively benign, with global growth strong, unemployment low and commodity prices contained.
Of course, interest rates were much higher then, but the credit spreads reflect corporate risk, and one could
argue that the companies faced much less risk in their operating environments then than they do now.
The credit bulls of today would argue that the tight spreads reflect policy that is much more activist with
governments willing to backstop the economy with a combination of credit and consumer supports.
Even though the tight corporate credit spreads rely on the continued largesse of highly indebted
governments, we have seen a significant increase in the perceived risks of government debt itself. Thus, the
credit spreads of sovereigns such as Greece, Ireland, Portugal and Spain have widened out as markets price
in the prospect of a potential default by these countries. Even the safer countries such as Germany and
France (both rated AAA) have seen their spreads widen virtually to all-time highs. Yet, markets believe that
companies domiciled within these countries are less risky than the sovereigns themselves, despite the fact
that the continued viability of these firms depends largely on the sovereign’s health. Thus, a BBB+ rated
French media company such as Publicis trades at a credit spread on 5 year debt of about 0.65% while the
AAA rated government of France trades at 0.90%. Common sense would suggest that a French sovereign
debt default would prove a much more serious outcome for the credit markets than the bankruptcy of
Lehman Brothers. Yet, markets are valuing corporate credit as though no future risks are likely even though
they still assign France itself a non-negligible probability of default.
The credit mispricings get worse when we consider the spreads across countries. The sovereign external
credit of China (of which it has only about $3 billion of external debt outstanding) is deemed relatively
risky with markets requiring 0.75% a year for five years to insure the same against default. Yet, the U.S.,
which has over $14 trillion in U.S. dollar debt, has its credit default swaps trading just at 0.45%, even
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though China is the country’s biggest creditor. Thus, China which has about $3 trillion in foreign reserves,
which is about 1000 times the total amount of foreign debt it has outstanding, is deemed more risky than
the U.S. which has about 50% of its government debt held by foreigners.
To sum up then, market participants today are willing to assume benign outcomes and omnipotent
policymakers despite overwhelming evidence to the contrary. The folly of such hope was amply demonstrated
in 2008, but the drug of easy money has dulled these memories. Most markets today appear divorced from
fundamentals, with the credit markets perhaps being the most perverse in their outlook. No doubt this
explains why all the quantitative models that rely on efficient markets have proved so ineffective in use.
4. Conclusion
We have taken significant losses in our portfolio from the moves we have had already. Many of our larger
core positions have been written down considerably so there is limited downside risk in our portfolio. Yet
we believe strongly that the potential payoffs remain intact. We are now also seeing incredible opportunities
for huge payoffs while taking very little risk. In fact, our discussion makes clear that we are now able to find
situations in credit where we are effectively being paid to buy options. We have been adding to our portfolio
much more aggressively of late to exploit such mispricings.
The phrase “the gift that keeps on giving” was trademarked in the U.S. in 1925 for the talking machine (the
precursor to the modern day phonograph) and parts thereof. We had never anticipated that this expression
would apply to the ability of markets to spawn crises. 2011 could well be another year of turmoil. We believe
that the coming trauma could be a repeat of 2008 and should hopefully be as much of a gift to our funds.
Performance Summary at February 28, 2011
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)
-2.5%
-6.2%
-5.7%
-6.8%
5.6%
19.1%
11.1%
-1.7%
11.1%
0.0%
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)
-2.3%
-5.8%
-5.3%
6.6%
20.7%
8.7%
17.4%
-1.5%
18.4%
0.1%
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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