Opportunities Funds Commentary

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UPDATE
Trident Investment Management, LLC
Opportunities Funds Commentary
March 31, 2012
Performance Discussion
The bullish tone in equity and credit markets from January 2012 continued through March. In the first
quarter, the S&P 500 Index was up 12%, the MSCI Europe Index was up 7.12% and the Nikkei was up
19.26%, making it one of the best for equities in recent memory. The credit markets also rallied with
spreads on 5-year U.S. investment-grade credit tightening 0.29%. Fixed income sold off globally with rates
on the U.S. 10-year Treasury rising 0.14% to end at 2.21%. Commodities were strong with gold rising
6.69% to end at $1,668 an ounce, and oil rising 4.24% to end at $103.02 a barrel. The U.S. dollar was
relatively quiet on the quarter, with the U.S. Dollar Index depreciating 1.47% (all figures in U.S. dollars).
Our funds suffered both in February and March, largely because of the selloffs in both fixed income and in
gold. Our long positions in fixed income in both Norway and Australia took losses as rates in both markets
saw increases in sympathy with the U.S., despite domestic economic conditions that were favourable for
declines. Gold was down about 4% and the miners, a whopping 12% over the two months hurting our long
positions. Even our defensive long equity investments hurt, dramatically underperforming the main indices.
Our credit book, while largely quiet, did little to help performance. Our short positions in U.S. rates, taken
with curve steepener options, were the only gainers in our portfolio. Unfortunately, these gains did little to
mitigate our overall losses. In short, virtually everything that could go wrong in our portfolio over the last two
months, did. Viewed in this context, our losses, while painful, have been relatively limited.
We made only minor adjustments to our portfolio over the last two months. Most of the changes were
in fixed income where the scale of the recent selloff has been such that we have found it advantageous
to initiate some bond positions while trimming others, which offered relatively less upside. We have also
started adding to our overall long duration exposure given the drift up in rates. In gold, we had trimmed
some of our long exposure entering February and are not looking to increase our position as stability
returns to the market. The gold miners in particular, have suffered much more than the fall in gold
prices would have predicted and offer exceptional value at current levels. The huge market moves we are
observing are symptomatic of illiquidity and we believe that conditions are only going to get worse going
forward. Our fundamental outlook has only been reinforced by the facts and we remain convinced about
our core positions.
Market Outlook and Strategy2011 Review
The market optimism, which was triggered in January by the European Central Bank’s Long Term
Repurchase Operation gained more traction over the first quarter as participants began to believe that
global growth was going to accelerate with the U.S. once again proving the locomotive for growth. The
markets were helped in this view by data on U.S. payrolls that suggested that the U.S. economy was once
again creating jobs. The payroll data were reinforced by declining weekly initial unemployment claims
which moved down to levels that indicated, finally, a sustainable and normal economic recovery.
The U.S. employment data were among the only positive outliers in what would otherwise have been
a rather dismal global economic report. Most countries in Europe weakened, with those in Southern
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Europe exhibiting big declines in activity. The Japanese data also suggested economic weakness with
the country showing a worrying deterioration in trade posting its first significant trade deficit in years.
Growth in most emerging countries was anemic at best. Conditions in China also weakened with inflation
remaining stubbornly high, even as growth decelerated from the frenetic 9+% pace of 2011 to levels closer
to 8%. In short, the coordinated growth slowdown we had long expected appears to have materialized in
over 80% of the economic data we monitor with the labor data from the U.S. sounding the major note of
discord.
The U.S. payroll statistics, which the markets chose to pay disproportionate attention to, have generally
been good coincident indicators of, rather than forecasters for, the state of the U.S. economy. The relatively
strong payroll numbers recently observed suggest that the U.S. economy must be growing at a rate of close
to 3% -- a level that is inconsistent with the rest of the data so far available. We believe that the U.S. jobs
data has been grossly distorted of late because of unusual weather patterns which have served to create a
better economic picture than is actually the case.
The reported payroll statistics that markets focus on are adjusted to account for seasonal variations in
hiring and these corrections are calculated using historical data. In the winter months, these seasonal
adjustments are themselves very large in relation to the raw data. Our winter in 2012 was so warm that it
shattered virtually all previous temperature records. Many industries such as construction, facing record
temperatures, started hiring much earlier than they might normally have. As such, the raw data was itself
better than it would ordinarily have been. With seasonal adjustments increasing these figures further
because of a presumed normal winter, it is clear that the payroll figures are suspect, especially given the
other reported data which have been lackluster. The true trend in the economy is likely to reveal itself as
the weather gets warmer and we move to a more normal weather pattern.
All said, the fact remains that the U.S. appears to have created jobs at a much better pace over the last
few months than we might have expected. The real question thus is whether we have finally reached the
stage when we can expect a sustainable U.S. recovery that in turn might result in a more normal global
economic environment. And it is to this issue we turn to below.
1. Is U.S. Growth Sustainable?
Analysts who expect strong growth in the U.S. going forward have some justification for their views. In
particular, U.S. fiscal policy is extremely expansionary with deficits at over 8% of GDP. Monetary policy is
about as stimulative as it can get with rates virtually at zero. In the post-War era, such fiscal and monetary
conditions have inevitably led to rapid economic recoveries if not booms. With this historic backdrop,
analysts remain mystified by the slow pace of U.S. growth which, with all the stimulus, remains mired at
less than 2% overall.
A critical question is whether we have the conditions for reasonable and important sustainable growth in
the U.S., without government support. The amount of U.S. sovereign debt already exceeds 100% of GDP.
Markets could easily start to balk at continued financing of deficits if future growth requires indefinite
and huge deficit expenditure. Even worse, U.S. growth is a critical factor for the rest of the world because
policymakers have done little to alter the underlying dynamics of the world’s economy since 2008. The
fact is that the U.S. still remains the world’s largest consumer by far, with China and Japan depending on
the former’s continued health for their exports. The Japanese economy’s growth for several years has been
almost entirely driven by exports. In China, investments in export manufacturing and real estate have
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UPDATE
been the main drivers of growth. In fact, the consumer sector has declined to just 34% of GDP, a record
low for any economy let alone one as large as China’s. The economy of the European Union, while large, is
also relatively self-contained in terms of overall trade. Moreover, given the continued weakness in Europe,
there is little likelihood of Europe proving the world’s growth engine.
We would argue that there is virtually no hope of sustainable U.S. growth absent continued huge government
stimulus. The U.S. today faces a combination of problems. It has had at least a decade of over-investment
with much of that investment being of poor quality. It has also seen significant over-consumption especially
in relation to income growth. The latter has meant a big increase in household debt as increasingly strapped
consumers relied on borrowing to fund consumption. And the large, persistent trade deficit over the decade
has meant increasing reliance on foreigners to finance consumption and investment.
1.1 Monetary Policy – The root of all evil?
Most of the U.S.’ current problems can be traced to overly easy monetary policy of the Federal Reserve in
the Greenspan and Bernanke eras. From a macro perspective, we would argue that the Fed has consistently
and wrongly targeted a core CPI inflation measure that has grossly understated true inflation in the
economy. Even worse, it has done so in an era where the world has seen a significant decline in the prices
of many manufactured tradeable goods because of the emergence of low-cost China as a manufacturing
powerhouse. By rights, the U.S. which has now become a huge importer from China, should have seen a
period of falling tradeable goods prices and low inflation if not outright deflation. Conducting monetary
policy to achieve a higher rate of inflation (even if it is only 2%) simply means forcing up the prices of nontradeables, such as haircuts and housing, to compensate for the lower cost of Chinese labor.
The Fed’s policies to fight the deflationary effects of Asian competition served to boost incomes and demand
in the short-run. However, they led to an illusion of permanent prosperity which in turn fostered leverage
and over-consumption. However, the long-term results of the Fed’s policies have been disastrous. The
boosts to growth only served to erode competitiveness as U.S. wages were driven up even further relative to
those in countries such as China. Also, the huge rise in the price of housing resulted in explosive growth in
homebuilding, much of which is now recognized as mal-investment on a huge scale. The 2007-2008 crisis
should rightly be perceived as the culmination of a decade or more of bad monetary policies.
The question before us today though is whether the aggressive fiscal and monetary actions by the U.S.
government and the Fed can engineer a sustainable U.S. recovery. Since 2008, U.S. policymakers have
assumed that a “normal” recovery can somehow be engineered for the private sector, with short-term
government and monetary support. The expectation is that once private agents, and particularly the
banks, begin to participate in the recovery, the government can withdraw its supports, albeit over a period
of time.
The policymaker position, which is also embraced by the academic community, is not without merit.
Some fiscal support with automatic stabilizers can provide a floor for economic activity in the short run.
With low interest rates, falling labor costs and the opportunities presented by the supposedly dynamic U.S.
economy, one could expect an investment boom along with rising asset prices as the future prospects of the
U.S. economy are discounted. This could lead to increasing consumption making for a virtuous cycle of
growth. Of course, the government in this environment would see an automatic increase in tax revenues
and a reduction in deficits, feeding further into this virtuous cycle.
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UPDATE
What is perhaps most surprising is why this beneficial loop has not started already with the amount of
stimulus already committed. One might argue that housing remains depressed and that since the residence
is the primary asset for most U.S. families, the increase in wealth and hence consumption has simply not
occurred. Yet, it is hard to understand why investment has not increased substantially especially given the
purportedly “cash-rich” corporate sector in the U.S.
We believe that the above happy consensus outcome is highly unlikely. The Fed’s policies over the last
decade have so badly distorted the capital allocation process that any return to economic normality is likely
to be impossible. We discuss our reasons for this in greater detail below. We first consider the technical details
relating to the transmission of monetary policy into the real economy by the banks. Then we discuss the real
economic effects of the Fed’s prior policies from a micro capital-allocation perspective. Our fundamental
conclusion is that we are firmly on the path of permanent bailouts and government life support with a
cathartic systemic reset ultimately being necessary for a return to normality.
1.2 Monetary Policy and the Real Economy
A pedagogic triumph for a teacher of macroeconomics is demonstrating the multiplier effect on the money
supply from the injection of high-powered (or central bank created) money in the world of fractional reserve
banking. If banks have a reserve requirement of 20% it means they are required to keep that percentage of
every deposit made with them as a combination of vault cash and deposits at the Fed which together make
up their reserves. From this, using some algebra, it can be shown that the money supply expands about $500
for every $100 of new money created by the Fed giving us a money multiplier of 5. The Fed can affect the
amount of high-powered money by so-called open market operations where it buys and sells bonds to inject
or remove high-powered money respectively. By extension, thus, the Fed can control the flow of credit in
the system.
The model of the banking system above is far removed from today’s reality. To start with, reserve requirements
have been virtually zero in the U.S. banking system since the mid 1990’s. Banks are required to keep reserves
only against a narrow class of “transaction” deposits with most firms able to meet this requirement just with
vault cash that they need for day to day customer liquidity needs. As such, the reserve requirements are not
a constraint to credit creation – in fact, the banking system as a whole has operated from the 1990’s with
significant excess reserves.
With no limit to credit creation from reserve requirements, the banks technically can create an infinite
amount of credit. However, they do not because the laws of supply and demand come into play. Consider a
profit-maximizing banking institution that gets $100 of deposits at a cost of 2% per annum. If 1% of the loans
it makes default with no money recovered, it has to be able to both recover its losses from the remaining
loans and pay its depositors the required 2%. This means effectively that the bank must make $102 from $99
of net repaid principal which means it will have to charge an interest rate of about 3.0%. If the Fed were to
set borrowing rates at 2% (and for our example, they would do that by paying interest on reserves at 2%), they
would have to accept the fact that credit would expand in the economy to the point where all investment
opportunities yielding 3.0% or more would be funded.
Banks however, have to contend with another constraint on credit creation and that is the need to meet
their capital requirements. When a bank makes a loan, it is required to assess a certain capital charge
against the loan depending on the riskiness of the borrower. That is, it is required to make the loan with
some percentage of its own money (capital) as opposed to borrowed money (deposits and other market
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borrowings.) With a uniform capital requirement of say 10%, the banking system would be limited to credit
creation of $100 for every $10 of capital it had at the start. However, banks can certainly raise more capital
from the markets. If capital can be raised at a cost of 20% per annum, representing an 18% spread over the
deposit rates of 2% assumed above, then the bank’s cost of funding for a loan rises to 3.8%. With this cost of
funding, it can be shown that any opportunity that yields over 4.85% will be funded by our banks.
The bottom line is that given our modern system of banking, the only constraints to the growth of the
banking system’s balance sheet are the risk-adjusted returns to lending as they relate to the costs of funding.
The existence of a transparent mechanism for the pricing of loans, recognition of defaults and appropriate
risk charges assigned to bank capital are all critical factors in determining just how much credit gets created
in the real economy. Put differently, the Fed can set the price for money in the form of the interest rate,
but it has to accept the fact that any investment opportunities whose risk-adjusted return exceeds the banks’
cost of funding will in fact be exploited. The only way the Fed can ensure efficient allocation given its rate
decisions thus, will be to allow for the market mechanisms to work without impediment at the micro level
in loan pricing and bank funding.
The problem for the real economy comes when policymakers interfere with the market mechanisms that
allow for the automatic limiting of the credit creation process. If the monetary authorities attempt to finetune every small decline in the economy with rate cuts and easier policy, the borrowers in the economy
closest to failure could see their lives extended. This will make the banks view such borrowers as being
much safer than they actually are. When the Fed comes to the rescue of the banks in every minor crisis,
the capital erosion that should otherwise have occurred does not. This then creates the perception in the
capital markets that banks are much safer than the risks they are taking would suggest. Paradoxically, this
leads to even more capital for the banks and makes them get larger even though they are actually more
risky. Also, the rate cuts that accompany every one of these crisis periods serve to depress deposit rates each
time ensuring that banks’ costs of funds are lowered further making them expand lending even more. Thus,
the net result of policymakers bailing out banks during periods of crisis is to make them larger and more
risky. The only way to avoid such an outcome is to accompany bailouts with much tighter controls and/
or regulation for the banks. This would have the effect of significantly boosting their costs of funding and
limiting their future growth.
1.3 Fed Policy – A History of Incompetence
Given our analysis above, what becomes very clear is that the Fed has done everything in its power to make the
U.S. banking system riskier and larger over the years. The Greenspan Fed repeatedly worked to bail out banks
when they had to suffer the consequences of their poor lending decisions. In 1998, for example, the Fed and
Treasury engineered a bailout of the major lenders to Long Term Capital Management by forcing a collective
loan to the failing entity. Even worse, the Fed cut rates thus taxing savers to pay for the mistakes of their banks.
These policies were in large measure responsible for the technology, media and telecommunications bubble
for which the banks were once again the leading facilitators. The collapse of this in late 2000 led to more easy
policy with housing becoming the focus especially after 9/11. In the gargantuan housing bubble that followed,
the banks were once again the leading actors. With the collapse of 2007-2008, easy monetary policy came
back with a vengeance with the Fed lending trillions of dollars to the banks even as it engaged in so called
quantitative easing to drive up inflation via the route of asset prices.
The bailouts would not have created the banking behemoths that we have today had the Fed moved to
exercise its very considerable regulatory powers. Yet, former Chairman Greenspan did little on this front
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since he firmly believed that the banks could be “self-regulating,” whatever that might mean. This is an
insane position for the chief regulator of the banking system to take. Even after the systemic collapse
of 2007-2008, the Fed did little to regulate the banks more strongly. In fact, regulations in banks have
actually been loosened if such a thing were even possible! The banks have been spared any need to mark
their doubtful loans to market. The largest firms have not been broken up into smaller, more focused
institutions. The incompetent managements that committed fraud on a huge scale during the mortgage
crisis have suffered no penalties for their felonies. And taxpayer money has been used to fund bonus
payments to the same coterie that caused the crisis.
1.4 The Effects on the Real Economy
The real economic effects of the Fed’s actions can be viewed in the context of our analysis using data for
the U.S. from 2001 to 2005. A study by the Bank for International Settlements estimates the real cost of
equity to U.S. banks at 7.4% for that period, a spread of 5.2% over the real risk free rate estimated at 2.2%.
We can reasonably assume that deposits, which have typically yielded less than short-term Treasuries, also
paid the risk-free rate of 2.2% for that period. With a 10% capital requirement (which is actually far above
the 7% most banks operated with then) we arrive at a real cost of funds to the banking system of 2.72%.
Let us assume aggregate loan losses for that time of 1% of assets per annum -- a number much higher than
what was actually experienced. Using our simple framework above, we calculate that any opportunities in
the economy which yielded 3.76% or more would have been funded. In fact, to the extent that capital is
mobile, there should have been by rights a flood of money out of the U.S. particularly to the developing
world where returns on investment have often been higher.
Over the same period, the U.S. government was funding itself at a real rate of about 2.0% for 10 year debt
(nominal 10 year yields of about 4.3%). When opportunities economy-wide get funded at 3.76% meaning
a risk spread of just 1.76%, there is almost certainly too much investment risk being taken on. The huge
bank loan growth over the period and the creative financing methods adopted to allow lending to even the
worst of borrowers were all reflective of a banking system that had run amok thanks to Fed policies that
encouraged the mispricing of risk.
Thus, we would have to conclude that the U.S., and by extension the global, economy has been
characterized by over-investment on a gargantuan scale over the last several years. This has taken the form
of real estate over-building and speculation as has occurred in the U.S. and much of Southern Europe
and is still occurring in countries such as Australia and Canada. It has also been in manufacturing with
countries such as China developing huge export capacity to deal with the insatiable demand from a hyperinvesting and over-consuming world. And it has occurred in the raw materials arena where demand from
users has stoked a huge increase in the exploitation of resources. In short, hyper-cheap capital fuelled a
global boom unlike anything we have seen in modern times.
1.5 Rebooting the Economy
Our analysis suggests that once the boom comes to an end with a crisis as in 2007-2008, followed by an
echo-crisis like we have in Europe today there is no route back to a “normal” economy. Policymakers
have allowed banks to postpone the true recognition of losses post 2008 and one can safely assume that
the banking system is significantly underwater in most developed countries if the true costs of the bad
loans are factored in. The markets are aware of this and are unwilling to provide risk capital to banks at
advantageous terms. The banks therefore, with regulatory forbearance on capital adequacy, have to rebuild
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capital with earnings. This requires high lending rates which will almost certainly be much higher than
those that prevailed in 2006. Even worse, a weak economy means higher loan risks and so the banks need
to charge higher lending spreads to account for potential losses. Yet the borrowers facing these higher costs
have to contend with rampant excess capacity in many industries necessitating loan forgiveness or at least
dramatically lower rates than even 2006.
Using our framework, what has happened post 2008 is that the cost of funds for banks has gone up
substantially and so real lending rates have increased. Yet, the economy today is much weaker and therefore,
there are far fewer opportunities today that can generate returns comparable to those achievable in 2005.
Fewer borrowers overall with higher borrowing costs for everyone will result in a significant decline in
lending. The best potential borrowers in such situations are usually cash rich and unwilling to deploy
their cash into real investment given the degree of global over-investment. The poorer quality borrowers
need significant debt relief which is not forthcoming. The longer this situation continues, the more the
economy languishes, and the greater the need for further monetary intervention becomes. Where it comes
to monetary policy, we have reached the end of the rope.
The U.S. and other countries have attempted to address the monetary limitations of today’s environment
with fiscal measures. The deficits run up by most of the developed world since 2009 have been staggering
to say the least. In the short run, fiscal policy does work to stabilize growth. What it cannot do is create
good investment opportunity. In fact, studies have repeatedly shown that government expenditure typically
yields returns far below those achieved by the private sector. And we are already at a stage where the private
sector simply cannot invest profitably on a scale needed to engender recovery given rational pricing of
credit by the banking system. So, the conclusion we draw is that fiscal measures may stabilize the situation
near-term, but will prove ultimately wasteful. With such action in the face of record levels of debt, it is not
surprising that markets have started to worry about the sustainability and repayment of these obligations.
To put things more graphically, the U.S. economy (and much of the developed world’s) could have been
likened at the end of 2008 to a malnourished patient collapsing from exhaustion. Returning such a patient
to health requires a prolonged period of rest and nutrition. The process can be accelerated with medical
help but not by much – the body needs a certain minimum time to recuperate. Policymakers, in treating
the malnourished U.S. patient have been unwilling to give him either food or the time he would need to
recuperate. Rather, they have injected him with massive doses of amphetamines since his main symptom
after all was exhaustion. Not surprisingly, the patient is only getting weaker with every successive drug
dose. And whenever the drugs are stopped, he is all the more ready to collapse.
All things considered then, we live today in a truly bizarre world. We have anemic growth but to generate
it requires colossal amounts of financial amphetamines in the form of fiscal and monetary intervention.
No policymaker in the affected countries can afford to come clean about the nature of the problems for
fear of losing the popular vote. So, we continue with the same imbalances, the same prescriptions and the
same dishonest and incompetent policymakers that have been responsible for the entire recent crisis. And
financial markets rejoice at the continuation of this status quo punishing any attempts to craft workable
solutions that might involve austerity and economic pain. The capitalist Utopia characterized by efficient
markets and resource allocation that many of the world’s countries aspired to, has been replaced in much
of the developed world with a financial kleptocracy whose only function it seems is to redistribute wealth
to itself on an amazing scale.
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The market stability of 2012 thus has been engendered at enormous cost and these costs are only increasing.
The overall system is extremely fragile and crises seem a daily fact of life. What is needed is a wholesale
reorientation of priorities which requires strong, honest leadership. We are unlikely to get either unless we
lurch into a major crisis but that does seems tantalizingly nearer.
2. Conclusion
In a world such as this, one should be very concerned about safety and the ultimate return of capital
because the next step in our current path is outright financial repression. Eventual confiscation of savers’
wealth either through taxation or default is a virtual certainty. The euphoria in the markets of late has
meant that all instruments that are safe, such as gold, Norwegian, Australian and Canadian bonds, and
high-quality stocks have been sold. Market participants are engaged in a mad dash for trash, certain that a
greater fool will pay them higher prices for the same. Novelist Jack Kerouac once said that “Dreaming ties
all mankind together.” He must have been talking about the financial markets.
Performance Summary at March 31, 2012
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)
-1.6%
-3.1%
-7.4%
1.6%
-1.7%
-4.1%
18.1%
10.4%
-3.1%
10.0%
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)
-1.4%
-3.1%
-7.3%
1.3%
-3.9%
19.8%
9.7%
15.3%
-3.1%
17.1%
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.
2012
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