Opportunities Funds Commentary

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Trident Investment Management, LLC
Opportunities Funds Commentary
UPDATE
April 30, 2015
Performance review
Entering 2015, we had expected growth to be weak and monetary policy to remain easy across most regions of
the world. As such, we had significant long positions in fixed income anticipating a substantial decline in interest
rates. We also believed that these easy monetary conditions would keep asset markets buoyant, especially in Japan
where equity valuations were relatively low. We expected that the credit markets, especially for junk investments,
were too rich because they were anticipating a strong growth environment which we felt would be unlikely.
Accordingly, we were net short credit with the majority of our short positions being in junk bonds. Our shorts
were partially offset by long positions in higher-grade credit, primarily in the developing countries. Finally, we
anticipated that the currencies of the countries whose central banks were engaged in quantitative easing (QE)
would weaken. Therefore, we were short both the yen and the euro against a selected group of currencies that we
felt would perform much better.
Over the first four months of 2015, our fixed income and equity bets contributed positively to our performance.
Our fixed-income positions made up most of our performance with our longs in South Korea and Australia being
the largest contributors. Our long position in Japanese equities (net of hedges established in the U.S. equity
market) also helped our performance materially. Our currency positions also worked for us with euro weakness
against most currencies driving the gains. Our credit book hurt performance as junk bonds remained firm, even
as developing country credits widened. However, our credit losses were small in comparison to our gains in fixed
income and equities.
Starting in April, we cut back on our overall risk exposure. We believed that some global bond markets were at
levels that suggested little future upside. Accordingly, we trimmed our fixed-income exposure which had become
considerable due to many of our options going into the money. We also moved to protect our equity gains in part
by reducing our overall long exposure, and also by purchasing market puts both in Japan and the U.S. We have
changed our currency positioning but have only marginally scaled down our overall exposure. We have trimmed
some of our short exposure to the yen, but have increased our longs in the Norwegian and Swedish krone against
the euro and the U.S. dollar.
We expect turmoil in the markets over the next several months. We believe that participants are much too sanguine
about global economic prospects and are convinced that any risks are minimal thanks to the omnipotence of
global central bankers. The level of complacency is such that the relatively bleak economic news of late has been
ignored with markets continuing to diverge further from reality.
We believe that this policymaker-engineered market euphoria will end more painfully than most participants
expect. We take up our reasons for this in greater detail below and then discuss the type of adjustment we anticipate.
Finally, we consider just how we are positioned in our portfolios to profit from this transition.
We have made a few small portfolio changes in 2015. We have cashed in some of our fixed-income positions that
were very profitable but we still maintain a considerable level of overall fixed-income long exposure. We have
also taken profits on many of our winning currency positions and reduced our net exposure here. We have been
adding slowly to our credit bets because we feel strongly that the euphoria in credit will soon fade and that our
positions will pay off handsomely. We have not changed our equity exposure to a meaningful degree.
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Market outlook and portfolio strategy
UPDATE
In prior communications we have discussed at length the reasons for the weak global growth that we have
experienced in the years following the crisis of 2007-2008. Briefly, the collapse that occurred during the crisis
was engendered by a long period of over-investment that was induced by easy credit and a perception of reduced
risk. Both these factors could be traced back to policymakers who kept rates too low even as they suggested the
existence of a safety net (the so-called Fed “put”) for bad investment.
The policy of QE, initiated by the U.S. Federal Reserve in 2009 and since emulated by the Bank of Japan, the
European Central Bank (ECB) and the Swedish central bank, essentially force feeds credit back into the economy
and as such represents an attempt to reignite an investment boom in a world that is already awash in excess
capacity. However, final consumer demand has proved relatively weak in the post 2009 period because consumer
incomes, especially in the developed world, have simply not increased in real terms. Government demand has
failed to be a locomotive for growth because most developed country governments are already labouring with
high deficits even with record low rates. Not surprisingly, faced with weakness in final demand, real, productive
investment in plants, equipment and labour has failed to take off.
While QE has done little to boost true long-term investment or consumer incomes, it has worked wonders for
global asset prices, and especially those for financial assets. In fact, QE as implemented today is tantamount
to officially-induced speculation disguised as monetary policy. Understanding the macro dynamics of QE thus
requires knowledge of the phases in a speculative episode.
1. An analysis of speculation
A speculative scheme or period involves a three stage feedback mechanism which we will term the SpeculationMisallocation-Reinforcement Loop or SMR Loop if only to invent our own acronym. We consider the three
phases below.
1.1 Speculation – a definition
Financial speculation is the purchase of a security or asset primarily for price gains rather than any intrinsic value
or income that it might provide. A speculative buyer cannot hold on to his asset indefinitely because it provides
him no intrinsic value. The entire value in fact comes from the existence of another market participant to whom
he can sell his holding at a higher price. Thus, the more speculators there are in an asset transfer chain, the higher
the prices have to go for everyone to make a profit.
When speculation drives asset prices far above any concept of intrinsic value, we are in a bubble. When the
demand from new buyers wanes or ends, the bubble cannot be sustained and valuations typically collapse back
to reasonable levels.
1.2 Misallocation of capital
Market prices are important mechanisms that signal the importance of various activities in society and represent
the “invisible hand” that ensures efficient resource allocation. Thus, when a commodity’s price rises it causes
a shift in resources to its production. The resources that are shifted obviously come from areas of the economy
where relative prices are lower, and the longer the higher prices persist, the more will be the diversion.
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UPDATE
When a price rise occurs due to real scarcity, the shift in productive capacity is efficient in that it is both necessary
and desirable for society. However, the same shift will occur even if prices are driven far above fundamentals just
by speculation. In such a situation, society produces more of the product/service in question than is desirable which
means that the net result is economically inefficient. Thus speculation can grossly distort investment patterns and
lead to mal-investment – the more prices are divorced from fundamentals and the longer this divergence persists,
the greater will be the scale of capital misallocation.
1.3 Reinforcement
With speculation and a characteristic supply response as suggested above, speculators face two problems. First,
with new supply, prices will tend to drop rather than rise and so demand has to increase to take up the additional
quantity offered to keep prices stable. Yet for speculators to make a profit, the prices also have to rise, which means
that the overall price has to rise across this new larger quantity of supplied product. Thus, the more the speculation
in a market, the more it needs fresh capital to keep it going. And the longer the speculation continues, the more the
supply response and the greater the capital needed as well. Bubbles simply cannot keep inflating therefore without
reinforcement in the form of fresh capital entering the market.
Most purely private sector induced bubbles are relatively short-lived because new buyers can be found only for so
long. However, when a bubble has the official support of the government, it can be made to continue much longer
and, not surprisingly, wreak far more havoc on the economy.
2. Quantitative easing is speculation
The Fed’s very low interest rates and lack of proper banking supervision were the primary contributors first to the
technology bubble of 1999-2000 and then the real estate bubble from 2003-2006. These actions ultimately led
to the complete collapse of the U.S., if not the global, financial system in 2007-2008 and to the launch of QE in
2009. While the first QE might have been essential to calm markets and forestall a global panic, the Fed repeatedly
continued this policy in the years following to promote growth and reduce unemployment. While the Fed has
recently scaled back its direct QE intervention, the Bank of Japan and the ECB have entered the fray and currently
provide more new net funding every month to the global markets than the Fed did in 2009.
Post 2009, when the initial crisis panic had subsided, the global savings available for investment were ample, while
the opportunities for the same were relatively meager given the bubble that had preceded the period. As such, even
in early 2010 sovereign bond yields were extremely low and reflected the relative lack of reasonable private sector
investment alternatives. What was clearly essential was a prolonged period of structural adjustment in the global
economy to work off the investment and credit excesses of the earlier part of the decade.
In 2010, the Fed launched its second QE while promising to keep short-term rates low for the foreseeable future.
The important thing to note here is that the Fed did not do what normal monetary policy might have suggested
which was to fix short rates even if at zero, and let the markets price longer-term risk. Rather, by purchasing
bonds in the quantities that it did, it increased market prices to levels that had no reasonable basis in fact. By
providing guarantees of future purchases, it made certain that market participants could speculate at will, secure
in the knowledge of a future patsy (the Fed itself) that would bail them out at a profit. By providing them with
zero cost funding, it gave them an opportunity to join in the bond market manipulation. As such, the Fed became
both the primary speculator in the bond market as well as the main reinforcer for speculation. Therefore, while
one can argue the benefits of QE, what is perfectly clear is that it is just old-fashioned speculation dressed up as
monetary policy.
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UPDATE
The misallocation of resources that one might have expected because of QE has been all too obvious because its
scale has been so vast. In the U.S., subprime auto loans are back with official government sponsorship. Student
loans have risen to all-time highs. Corporate borrowing has increased with some of it being used to fund shaky,
unprofitable investment, but most of it going toward buying back stock. The Chinese, insistent on retaining their
peg to the U.S. dollar, launched their own credit intervention in 2009 and continued it post 2010 to counter the
U.S.’ QE. These measures fuelled their already large domestic real estate and investment booms to what can only be
described as epic levels. Most sovereigns took advantage of the low global interest rates to run huge fiscal deficits to
cope with recessionary domestic conditions increasing their debt dramatically in the process. Some of the problem
nations in Europe, which were already bankrupt in 2009, virtually doubled their debt levels in the years following
thanks to QE.
The obvious impact of lower global rates and a rampant investment boom, especially in China, was continued
global deflation, especially for manufactured goods and lower incomes for the higher-paid manufacturing workers
in the developed world. The excess capacity did little to help “normal” corporate profits engendered by increasing
sales and revenues. The supposed improvement in corporate profits since 2009, especially in the developed world,
has come largely from reduced funding costs thanks to Fed intervention and the increased assumption of debt to
buy back shares and boost earnings. The longer the low rates persist, the worse the actual operating conditions for
most companies and the greater their dependence on continued low rates for their earnings.
Considering the economic conditions created by the Fed, the rise in stock markets, especially in the U.S. and
Europe, has been increasingly, if not entirely speculative because earnings and revenues continue to deteriorate
even as stock prices keep rising. Thus, the bond market speculation has in turn triggered a stock market bubble.
The willingness of the credit markets to lend huge amounts to increasingly shaky borrowers at generationally tight
spreads in a desperate search for yield suggests that the credit markets have their own bubble too. All this can be
traced directly back to the Fed, and its able acolytes in the ECB and the Bank of Japan.
The need for constant reinforcement to continue speculation cannot be understated. The markets in 2010 were in
trouble in anticipation of the end of the Fed’s first round of QE. It was clear then that most global economies were
not reviving as expected, and that a number of sovereign borrowers, especially in Europe, were shaky at best. These
inconvenient facts did not stop the Fed which persisted with its QE with increasingly specious rationales until late
2014. By that time, the baton had been firmly passed to the ECB and the Bank of Japan.
The scale of intervention today, despite the Fed’s ending its QE last year, is still massive. Most market participants
rightly believe today that any threat to these bubbles will be met with more monetary intervention. The move to
negative interest rates in Europe across most of the sovereign curve, and the increasing limitations on cash use in the
region are ample testimony to the seriousness of ECB policymakers in this regard as is the continued unwillingness
of the Fed to raise rates in the face of what appears to be low unemployment in the U.S.
So, what we have today is a bubble in most of the developed world and in China across most of the asset markets.
Virtually all the policymakers emphatically tout these policies despite their obvious inefficacy so far when looking
at the facts.
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3. How does this end?
UPDATE
The SMR loop we have discussed can end in one of two ways. The normal way in which it would end would be
a sudden loss of confidence among the market participants about the valuations that prevail, leading to a lack of
fresh capital. This typically would mean a crash as panicked sellers, who believed they could get out at the top,
now try unloading their positions to non-existent buyers. We saw exactly such a situation in 2008 when the rubbish
mortgage instruments that were touted as highly safe proved to be exactly the opposite and their prices collapsed
along with the financial system itself.
The second possible outcome is one that is perhaps unique to current conditions and that would be a total market
breakdown. When the largest buyer in a speculative market is the government itself or one of its agencies, another
way for the speculation to end is for the government to purchase so much that it owns virtually all of the market
and all trading effectively ceases. Individuals in this context might have already lost confidence but prices may
nevertheless remain elevated because of the government buyer and there is no more effective price mechanism
left. We would argue that both the ECB and the Bank of Japan have created such an environment, with the yields
on both European and Japanese debt being totally divorced from any classical metrics for solvency. The same is
likely true of the debt of many of the local governments in China which is held mostly by the state-owned banks
themselves.
When there is such market breakdown, the ramifications of the sovereign’s actions on other markets and its
domestic politics become extremely important. When monetary authorities manipulate bond prices up they affect
the stock and currency markets as well. A loss of public confidence in bonds, even if not reflected in officially
manipulated prices, could lead to a similar loss of confidence in stocks, currencies, credit or other markets. As
such, the government should be prepared to act to support the speculative prices in all of these markets as needed
which might prove a legally and politically impossible task. Thus, if there is a sudden decline in the Eurozone
equity markets, the ECB is unlikely to intervene to support prices given its mandate. Again, if the Bank of Japan’s
purchase of bonds were to backfire with a dramatic and uncontrolled decline in the yen, the institution will find it
impossible to intervene directly given its need to support the bond market.
Equally important is the prospect that the domestic political climate might change sufficiently to the point where
the government is simply unable to support the speculative market as it intended. Thus, a Greek debt default that
could impose significant losses on the ECB might force the Eurozone nations to limit QE activities. An exodus of
funds from the banking system due to overly low or negative rates might force the ending of these policies.
The ending of an SMR loop, no matter how it happens, is likely to prove extremely painful because the entire
cycle of speculation goes into reverse. On one hand, the price adjustment is itself painful imposing heavy losses on
participants. When the whole nation is actively involved in speculation, the costs are likely to be that much higher.
Next, the misallocation of resources will end and while this might be beneficial in the long run, in the near term it
will surely be painful. The pain will come first because of a direct reduction in investment activity and next because
the capacity built during the period of speculation will lead to excess inventories and bankruptcies in the industries
involved. The reinforcement unfortunately goes into reverse too as sellers proliferate and buyers leave the market.
Once this Humpty Dumpty falls, there is no putting him back together again.
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4. Near-term catalysts for change
UPDATE
We would argue that today markets are extraordinarily fragile because there are a number of near-term catalysts that
might force an end to the speculative excesses of the last several years.
First, the Fed has ended its QE and may even raise rates soon. As such, the U.S. buyer of last resort has left the bond
market and is doing so when the economy appears to be stalling. While continued weakness in the U.S. economy
and a Fed that is unwilling to ease more might result in the bond market remaining stable, the same is unlikely to
be true with the equity market whose valuations are predicated on a strong second half recovery.
Next, the European Union is staring at the prospect of a Greek debt default and potentially huge losses. Even
worse, a Greek default and/or exit from the Eurozone might create more Euro wide contagion and the need for
intervention at a scale that neither the ECB nor any of the Eurozone countries can manage.
Finally the Chinese economy appears to be slowing markedly with growth rates very likely being closer to 5%
rather than 7%. Moreover, there seems to be considerable capital flight from China based on concerns about the
domestic real estate and credit markets, to the point where there appears to be a credit crunch induced by this loss
of high powered money. The Chinese central bank has responded to the induced tightening by cutting reserve
requirements but has so far resisted a more aggressive monetary push perhaps in fear of causing more capital flight.
A decisive response by the Chinese to deal with their current problems would be to engineer a maxi-devaluation of
the Chinese renminbi against the currencies of its trading partners. This would have the double effect of providing
an export boost as well as halting capital flight. While this might benefit China, there is a high likelihood that it will
bring about a trade war and plunge the world into a deflationary crisis.
5. How do we make money?
We believe that global markets are in for a very rough second half for this year. On the one hand, short-term rates are
much too low both in the U.S. and in Europe if the expected rebound in the global economy for the second half of
2015 were to materialize. If such a rebound were to occur, the Fed would have to raise rates and this in turn could
mean a sharp re-pricing of bonds and an end to the virtually free liquidity that has been available to global markets
for so long. This could affect the global bond markets very negatively, although we believe that the U.S. market
is likely to be the most affected if only because most other regions are in different stages of their economic cycles.
The negative impact of a Fed rate hike, even if only anticipated in by markets through the yield curve, is likely to
be significant to the stock markets and will have to be countered by a large rebound in earnings, which appears
unlikely in the extreme. The U.S. stock market might face the constraints of rising interest rates, a stronger dollar
and minimal to no earnings growth, all at the same time. As such, a sudden loss of confidence is something we
believe is highly likely later this year.
Given the prospect of a U.S. stock and bond market rout, we believe that our best investment alternatives are bond
markets in those countries where rates are still high especially in relation to the economic conditions that are likely
to prevail. As such, we still like the bond markets in Australia, New Zealand and South Korea. The economies in
all these countries are likely to slow down further, even as their official interest rates are much higher than in the
U.S. and Europe.
We also are convinced that the credit markets will see much more turmoil later this year, especially if the Fed
were to raise rates. U.S. and European Union junk bonds in particular trade today at spreads that suggest the best
of times when the exact opposite might be true. The relative spreads of emerging country credits imply a possible
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crisis though these nations are in relatively rude health. Accordingly, we are short U.S. junk credit, even as we have
positions in selective developing country credits. We remain net short credit but expect to be building up our long
emerging credit book when more market concerns surface.
UPDATE
On the equity front, we still believe Japan’s equity market is quite far from bubble territory unlike those in the U.S.
and Europe. As such, we have retained our long bias towards Japan, though we have trimmed even that a little of
late. We have also increased our shorts in the U.S. equity market to hedge against our Japanese equity risk
6. Conclusion
All said, we are rather concerned today about markets in general. There appears to be a lack of liquidity in
most markets and this is even with the ECB and the Bank of Japan still engaging in aggressive QE. The
daily swings in most markets appear to have increased in magnitude, except in U.S. equities where they
have paradoxically hit abnormally low levels. Our concerns have prompted us to take most of our fixedincome exposure with options, as well as continually maintain a large position in purchased put options
against our long equity positions. If the SMR loop ends as other similar episodes have in the past, we believe
that markets are in for a period of volatility that might be unlike anything that we have ever experienced
before. We believe that we are extremely well positioned to profit in such an environment and can hardly
wait for the fireworks to start.
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Performance summary at April 30, 2015
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)
-3.4%
0.1%
10.1%
16.4%
-0.8%
3.8%
1.4%
10.8%
6.1%
8.5%
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)
14.8%
UPDATE
-3.3% -0.1% 9.5% 15.6%3.5% 1.2% 11.2%4.8% 5.7%
Some of the statements contained herein including, without limitation, financial and business prospects and financial outlook may be forwardlooking statements which reflect management’s expectations regarding future plans and intentions, growth, results of operations, performance
and business prospects and opportunities. Words such as “may,” “will,” “should,” “could,” “anticipate,” “believe,” “expect,” “intend,”
“plan,” “potential,” “continue” and similar expressions have been used to identify these forward-looking statements. These statements reflect
management’s current beliefs and are based on information currently available to management. Forward-looking statements involve significant
risks and uncertainties. A number of factors could cause actual results to differ materially from the results discussed in the forward-looking
statements including, but not limited to, changes in general economic and market conditions and other risk factors. Although the forward-looking
statements contained herein are based on what management believes to be reasonable assumptions, we cannot assure that actual results will
be consistent with these forward-looking statements. Investors should not place undue reliance on forward-looking statements. These forwardlooking statements are made as of the date hereof and we assume no obligation to update or revise them to reflect new events or circumstances.
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 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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