Opportunities Funds Commentary

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UPDATE
Trident Investment Management, LLC
Opportunities Funds Commentary
October 31, 2011
Performance Discussion
Equity markets had one of the best months since October of 1974. The S&P 500 was up 10.93%, the
MSCI Europe was up 10.36% and the Nikkei index was up 3.31%. Bonds sold off as the U.S. 10-year
Treasury yield rose 0.20% to end at 2.11% and virtually all other bond markets following suit. Credit
spreads came in with the overall euphoria, and the U.S. dollar also came under pressure with a 3.08%
depreciation on the month. Commodities rallied as gold and oil rose 5.60% and 8.92% respectively (all
figures in U.S. dollars).
Our funds had a difficult October giving back a significant portion of the gains from the previous two
months. Our fixed-income positions in Australia and Norway were the primary losers in our portfolios.
Our losses on these positions were partially mitigated by our gains on gold and our U.S. yield curve
steepeners. Despite the market euphoria, the news flow over the month remained negative and suggested
that the underlying conditions had become considerably worse. We remain convinced that more market
turmoil will follow. As such, we have trimmed some of our outsize positions to control our risk, but still
have substantial exposure to our core themes. Given the inherent optionality in our portfolio, we expect
that our exposure will increase if markets move in our favour.
Market Outlook and Strategy
The economic situation in the problem countries of Europe deteriorated considerably over October.
Markets reacted negatively to the worsening climate, as Italy became the newest victim of the debt crisis.
European leaders agreed on yet another plan to halt the raging crisis, and expectations of such an outcome
triggered a huge market rally. The actual plan was much as the Roman poet Horace envisioned when he
wrote Parturient montes, nascetur ridiculus mus or the mountain labored and brought forth a mouse. It
seems like Europe and its politicians have not changed much in two millennia.
The European plan, while long on hope and short on detail, nevertheless acknowledged several issues in
a bow to reality. Specifically, policymakers concluded that:
-A significant write-down of Greek debt was inevitable. A “voluntary” reduction of 50% of the face
value on Greek bonds for private investors was agreed upon.
-European banks needed more capital due to the financial conditions in Europe. The European
banking regulators, in conjunction with the governments, decided that the banks needed about €100
billion in additional capital.
-The European Financial Stability Fund (EFSF) needed more firepower since its effective resources of
€440 billion were inadequate to halt the crisis. It was decided that the EFSF would be leveraged either
by providing first loss insurance on government debt, or by purchasing the equity tranche of a Special
Purpose Vehicle (SPV) which in turn would leverage itself to buy sovereign debt. Using these methods,
the effective purchasing power of the EFSF would be boosted to about €1 trillion if not more.
2011
OCT
UPDATE
-Austerity measures and/or structural adjustments were essential in countries that were to receive EFSF
aid. To that end, recipients of aid such as Greece were exhorted to implement agreed-upon plans, and
potential beneficiaries such as Italy were required to come up with reforms to address market concerns.
There are several problems with the European plan:
-A 50% voluntary reduction of debt for Greece does not solve the problem. About 60% of Greek
debt is held by the European Central Bank, the International Monetary Fund and by Greek banks
themselves. No write-downs were to be allowed for the first two holders, and the Greek banks needed
to be recapitalized from their losses anyway by the sovereign. As such, the effective debt reduction for
Greece would only be about 20% of GDP, a paltry amount, given its princely 175% debt to GDP ratio.
Even with future aid, strong growth and austerity, the Greek debt to GDP ratio was expected to reach
120% of GDP in 2020 – a level that today is already a crisis point for Italy.
-The funds available even with a leveraged EFSF are not enough to serve as a credible backstop to the
crisis-plagued countries. Of the funds to be raised by the EFSF, only €210 billion is guaranteed by
Germany, with another €230 billion backed by other nominally AAA rated countries such as France.
Even worse, about half of the €440 billion to be raised has already been promised as aid to countries
such as Greece, leaving only about €200 billion available to be leveraged up. Yet, just the funding
needs of Italy and Spain alone over the next two years total more than €500 billion.
-The EFSF has to raise funds from the public markets and possibly the banks themselves without
any outright support by the European Central bank. As such, it will have to rely on already skittish
investors to provide funds for a complex vehicle which in turn will be used to relieve the fears of these
very same investors!
The most critical flaw, however, with the European plan is that it operates with the belief that the countries
in the European Union, with the exception of Greece, are solvent and that some austerity in the problem
countries with medium-term help from the stronger nations will solve the problem. Unfortunately,
economic conditions in many of the problem countries in the region suggest a problem of solvency that
cannot be solved simply by austerity. As such, the plan may be committing the stronger nations of Europe
to a futile and large bailout of the weaker countries that might doom the stronger ones themselves. A real
risk thus, is that the end result of the European plan is that Germany begins to look more like Greece than
vice versa. We consider this issue in greater detail below.
1. GDP Growth and the Accumulation of Debt
The dynamics of a country’s debt to GDP ratio depend critically on four variables: the annual growth rate
of GDP g, the nominal interest rate r, and the ratio of debt to GDP D and finally, the fiscal deficit run by
its government f. It can be shown with some algebra that if the entire growth of GDP is used to service
debt, the debt to GDP ratio D’ at the end of a period, given the definitions above is:
D’ = D (1+r)/(1+g) + f/(1+g)
From the equation above, we can see if the government is in fiscal balance (f=0), the debt to GDP ratio
will be stable (D’=D) if g = r, or the growth rate of GDP is the same as the interest rate paid on the debt.
2011
OCT
UPDATE
Intuitively, this means that if the country is not overspending and it generates enough growth to just pay
interest on its debt, it need not take on any new debt. However, even when the country is in fiscal balance,
if its growth rate is below that of the interest rate paid (g<r) it will have to take on new debt that will make
its debt to GDP ratio rise. The larger the debt to GDP ratio D, the more the new debt that has to be taken
on to service interest payments on existing debt and the faster the growth in the debt to GDP ratio becomes.
When the government runs a fiscal deficit to sustain the country’s growth rate (f > 0), the debt dynamics
become unpleasant rather quickly. This is because the fiscal deficit adds directly to the debt to GDP
ratio as can be seen above. Even worse, if such a deficit occurs when the country is in recession (g < 0)
or if the interest rate exceeds the growth rate (g<r) the rise in the debt to GDP ratio can be rather rapid.
More simply, the effect of a fiscal deficit is to add directly to debt, and if the incremental cost of this debt
exceeds the marginal benefit in terms of growth generated, there is a further addition to the country’s
indebtedness. If the country already labors with a high debt to GDP ratio, the debt levels can quickly
become unsustainable.
Thus, a country with a fiscal deficit that also has a high debt to GDP ratio is living very dangerously. It can
run a fiscal deficit and stabilize its debt ratio only if its deficit results in such a dramatic improvement in
its growth rate that the country can both finance its deficit and service the interest on its existing debt. Put
differently, it is impossible for a government to borrow more and reduce its debt ratios unless it invests its
borrowings to generate rates of return much higher than the rate it pays on its debt.
2. The Importance of Debt in Generating Growth
Given the risks inherent in high levels of debt as discussed above, what is remarkable is the degree to which
most of the developed world has relied on debt to generate growth over the last decade. In fact, absent
growth in debt, it is unclear that much of the developed world would have shown any GDP growth at all
over the last decade.
Table 1
U.S.
Japan
Germany
France
Italy
Spain
U.K.
Portugal
Greece
Nominal GDP increase from
2001 to 2010 (%)
Government Debt increase from
2001 to 2010 (%)
% of GDP growth
caused by rise
in debt
45.4
-6.5
22.7
34
27.9
63.7
48.8
33.2
62.3
50.4
56.1
29.3
47.1
41.7
34.8
61
62.2
117
111.01%
NA
129.07%
138.53%
149.46%
54.63%
125.00%
187.35%
187.80%
Table 1 provides GDP and debt data for a few of the world’s major economies. We report in the table the cumulative
nominal growth in GDP from 2001 to 2010 as well as the cumulative increase in government debt as suggested
2011
OCT
UPDATE
by the annual fiscal deficits over the same period. We consider only government debt as reported, ignoring offbalance-sheet items and other guarantees (such as those for Fannie Mae in the U.S.) that should ideally be reported
as debt. We also do not consider private sector debt growth, particularly in the formal and shadow financial sectors
which has been considerable. As such, our figures significantly understate the degree of debt growth.
Our figures above compare the cumulative growth of GDP from 2001 to 2010 with the increase in the
stock of debt. GDP however is a flow measure that values annual output. As such, our figures understate
the true impact on GDP of the debt incurred. That is, an increase in GDP from 2001 to 2010 due to
higher debt results in a higher baseline GDP for 2002 and every other intervening year. Our GDP growth
numbers above reflect only the increase in 2010 GDP relative to 2001 rather than the cumulative effects
of intervening years. When the cumulative effects on GDP of the entire period are considered, the GDP
increase is much higher. Put differently, an increase in spending funded by more borrowing has significant
multiplier effects over time. For purposes of our analysis, we can ignore these effects simply because the
intent here is to consider the role of debt in generating GDP growth.
In the U.S., cumulative GDP from 2001 to 2010 has increased by about 46%, even as the fiscal obligations of
the sovereign have risen by 50% (of 2001 GDP) over the same period. While this means only a small increase in
the government debt/GDP ratio, what is startling is the fact that all of US growth since 2001 has come from the
assumption of more government debt. The figures are even worse for the other developed economies. Economic
powerhouse Germany has seen a cumulative 23% increase in GDP from 2001 but has suffered a 29% increase in
debt. France has seen a 47% increase in debt to generate just 34% in GDP over the period. Japan has seen almost
a 7% contraction in nominal GDP even as its debt has increased a whopping 56%! And, not surprisingly, Greece
has seen a 117% increase in debt but just a 62% increase in GDP. In fact, the only sovereign that seems to have
increased debt productively is Spain which has seen a 64% increase in cumulative GDP since 2001 but only a
35% increase in debt. And even this is questionable because Spain has seen explosive growth in private sector
debt over the period suggesting that debt was responsible for most of its growth anyway.
What is obvious from our figures above is that much of the growth in the developed world over the last
decade has simply come from increased debt. The vaunted productivity stories, efficiency gains and the like
all mask an inexorable trend of rising debt. A country can certainly take on debt outright and “boost” GDP
by simply paying its citizens to engage in menial labor, with the increased debt having a leveraged impact
on GDP thanks to multiplier effects. However, when all GDP growth comes from new debt issuance, there
is a continued rise in the debt to GDP ratio to the point where it becomes obvious to markets that the levels
of debt are unsustainable. In such a situation, the interest rates demanded on debt increase and require
higher and higher growth rates in the country just to ensure the debt can be serviced. And if the debt needs
to be paid down, the multiplier effects work in reverse slowing growth precisely at the time when markets
are most skittish. We have very likely reached such a situation in the developed world.
3. Addressing the Problem of Too Much Debt
The choices facing the indebted developed countries are exceptionally unpleasant. From our analysis of debt
dynamics and growth rates, it is clear that any stabilization of debt levels requires significant austerity. However,
austerity itself is going to present another set of tradeoffs. Given that virtually all the growth so far has come
from more debt, any reduction in deficits could well mean a collapse in growth and a further increase in debt
to GDP ratios. So, austerity of any kind could exacerbate the problems the countries already face.
2011
OCT
UPDATE
Taking on more debt instead of austerity is not a better choice. More debt, even if taken to generate growth,
simply cannot be serviced unless truly exceptional growth rates in GDP are achieved – something that
most of the developed world has been unable to do over the last decade. With markets balking at funding
further increases in debt, especially in Europe, it is not clear that increasing debt to generate growth is even
possible. The only way to do so appears to be having the central bank resort to outright monetization by
purchasing all the debt issued. Yet, this approach, given current conditions, is unlikely to result in strong
growth. Thus, more debt will ultimately be needed to service the existing debt making the entire debt
market a gigantic Ponzi scheme. Unfortunately, ending such a Ponzi scheme will require austerity, which
is the choice that is currently proving so unpalatable.
There is perhaps also a third alternative that countries can adopt that involves both austerity and
monetization. Specifically, a country could commit to making the sacrifices needed to bring runaway
debt under control. Such a plan will likely be viewed as unsustainable by the bond markets given current
conditions, and this in turn, by driving up interest rates, could actually make it untenable. Put differently,
it is rational for individual market participants to sell their bond holdings first and then wait for conditions
to improve, except that by doing so, they will guarantee that rates rise and economic conditions worsen.
To avoid this outcome, policymakers could use aggressive monetary policy, if not outright monetization,
to stabilize the bond markets and prevent a near-term rise in rates so that policy is given a chance to work.
There is ample precedent for central banks to act to prevent panics, and even the most conservative of
central banks can rationalize such action as long as it is accompanied by genuine austerity.
The U.S. and the U.K. have embraced the monetization route. While the U.K. is at least making an attempt
at austerity, its efforts so far have been relatively limited. Most U.S. policymakers, in sharp contrast, have
failed to even acknowledge the need for austerity. While the recent debt ceiling discussions require that the
government embark on austerity automatically to the tune of $1.2 trillion starting in 2013, most members
of Congress have yet to come to terms with the draconian fiscal adjustment that will ultimately be needed.
Even worse, given that 2012 is an election year, there is a continued attempt to convince skeptical voters
that more austerity will not affect them and that growth in the U.S. should continue.
The European Union, unlike its Ponzi-minded brethren, is refusing to take significant monetary action to stem
the ongoing crisis, relying instead on promises of greater austerity. Germany, the strongest economy in the EU,
is unwilling to commit to huge fiscal transfers to indebted member nations and does not want unbounded
monetization of debt either. It has so far pushed for fiscal adjustment to solve the debt crisis in Europe, a move that
is not surprising given that it is among the largest creditors in Europe as well. The austerity being contemplated
in many of the EU’s members now virtually guarantees a region-wide, if not global, recession. Given the
high unemployment rates across much of the EU moreover, populations have become restive, punishing the
politicians who implement the unpopular fiscal austerity measures. While it is commendable that the EU is
moving to address the fundamental debt problem it faces, markets have responded negatively, driving rates and
credit spreads across the periphery to new highs. In this context, strong action by the European Central Bank
is desirable, if not essential. Such action may not take the route of outright monetization, but could certainly
involve a dramatic cut in interest rates, possibly to zero in the short end. Unfortunately, the ECB has resisted
pre-emptive action, although in practice it has been forced to respond anyway. By lending to the peripheral
countries to offset capital flight from them, and also by buying their bonds, it has acted very aggressively given its
limited mandate. We believe that more decisive ECB announcements, with the first step being a significant cut
in interest rates, might prove a more effective weapon to halt the Euro wide contagion that is occurring.
2011
OCT
UPDATE
4. Investment Implications and Positioning
The world appears to be poised on the brink of something very significant. Growth is faltering everywhere
as the limits of debt accumulation and monetary policy are being reached. Austerity, while perhaps the
right alternative, is being discredited thanks to the situation in Europe. There is no consensus on what
needs to be done, even as markets gyrate wildly in fear. We anticipate a near-term crisis with considerable
uncertainty on the ramifications of the same.
We continue to believe that the two best investments we can make today are in the bonds/swaps of countries
that are fiscally beyond reproach. We highlight Norway, Australia, Sweden, Canada and South Korea as
members of this list. Most of these countries have interest rates that are higher than much less solvent
nations such as the U.K., suggesting that a major bond market rally might be in the offing for them. Gold
has corrected significantly over the last several weeks after hitting a high of over $1,900 an ounce. Given
the prospect for continued turmoil and increased monetization, we believe that the metal offers excellent
upside with $2,000 being a near-term target, and levels much higher being suggested if the problems are not
resolved quickly.
We have never seen markets this turbulent. Most of the developed world appears insolvent with the banks
there being in even worse shape. Growth is anemic and worsening and a significant credit crunch is
building. Political tensions are rising in the industrialized world thanks to austerity, and in much of the
developing world due to a combination of slowing growth and high commodity prices. And investors
for the most part still believe that good times are around the corner, especially in the U.S. We have long
warned about such turmoil and have positioned our portfolios as best we could for such a situation. Reality
is sinking in and it is something that we welcome and markets dread.
Performance Summary at October 31, 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)
-3.6%
2.5%
4.4%
-0.1%
-2.2%
1.2%
21.2%
10.9%
2.6%
10.8%
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)
-3.6%
2.2%
4.0%
-0.2%
1.0%
23.0%
9.5%
17.4%
2.4%
17.9%
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.
2011
OCT