Opportunities Funds Commentary

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Trident Investment Management, LLC
Opportunities Funds Commentary
MONTHLY UPDATE
July 31, 2010
2010
Performance Discussion
July was a month that reversed the trends of May and June. Global equity markets were very strong with the
S&P 500 up 6.9%, the MSCI Europe Index up 4.9% and the Nikkei up 1.7%. Gold was down 4.9% ending
at $1,181 an ounce, but oil was up 4.4% to end at $78.95 a barrel. The fixed-income markets rallied
especially in the U.S. where the 10-year Treasury yield fell three basis points to end at 2.9%. The credit
markets tightened fractionally on the month (all figures in U.S. dollars).
Our funds suffered in July giving back much of the gain achieved in the prior two months. Our
performance was hurt primarily by our long positions in gold and shorts in equity indices. Our yield curve
steepeners helped, though this improvement was offset by some losses in credit. The fixed income
positions in Australia and Norway also suffered marginally. We have not changed our positioning
significantly in response to the market action in July. The economic data increasingly suggest that a global
economic slowdown has already started making the euphoric rise in equities that much more untenable.
Market Outlook and Portfolio Strategy
The news in July was largely about corporate earnings where the majority of companies reporting in the
U.S. appeared to have beaten analyst earnings estimates. Unfortunately, most companies achieved these
earnings through continued cost cutting, especially since top line growth is running at under 6% year on
year for the second quarter. Such low growth is rather surprising given how bad the second quarter of 2009
was and how much government stimulus has been thrown at the economy since then. Conditions in the
financial sector, which is still the largest single sector in the U.S. market, were particularly unpleasant and
may prove a harbinger of things to come. The financial companies as a group saw dramatic declines in
lending activity, net interest margins, and trading profits with overall revenue declines in many cases being
over 10%. However, most firms in the sector beat earnings estimates by cutting back dramatically on
provisioning against bad loans, despite increases in the levels of the same. They all believe that the
economy is strongly on the mend, despite their unwillingness to lend, and use this view to justify their
lower loss provisions.
The second quarter earnings reports might be signaling a legitimate improvement in the overall economic
climate. However, the positive signals from earnings have to be weighed against the economic data
releases over the last few weeks which suggest that both the U.S. economy and world economies may have
started a double-dip recession. The U.S. data have been particularly worrisome. Payrolls, initial claims,
retail sales, credit growth, home sales, and numerous other indicators signal a renewed economic decline.
Data coming from Japan are also proving much softer suggesting not only that the economy there is
getting weaker but that the weakness may have started even earlier, as previously reported data is revised
downwards. Even the perennially hot Chinese economy is showing signs of flagging, with its housing
market now in a confirmed downturn, and its consumer sector once more lagging its export sector in
growth. The only economic bright spot of late has been Germany where there has been a significant
increase in exports and business sentiment thanks perhaps to the weak euro of the past few months. While
Germany’s performance is certainly encouraging, the same cannot be said for the European Union (EU)
where the data have been mixed. Given the fiscal austerity measures that are in place across the EU, it is
unlikely that the region will prove a reliable locomotive for global growth.
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The pundits of Wall Street predictably touted the benign corporate results as justification for a continued
bullish outlook. The poor economic news was increasingly interpreted as a positive – many market
observers believe that any pause in growth will be dealt with by a second round of quantitative easing
(QE) by the Federal Reserve that would prove good for asset prices. In fact, the issue of additional
quantitative easing by the Federal Reserve has dominated the media and investor thinking over the last
several weeks. The advocates for QE have been out in force making this policy seem the panacea for all
the economic travails the U.S. faces. It should be noted that the Fed has already conducted over $1.5
trillion in QE starting March 2009 through March 2010. While this had little to no effect on the real
economy, it did work to drive markets up. Anticipating a repeat of events, markets reacted positively to the
likelihood of more QE with both fixed income and equity markets rallying in the face of poor economic
news. We consider the policy of quantitative easing in greater detail below and analyze what impact it will
have on the global economy and markets, especially if continued ad infinitum as many of the pundits
recommend.
What is Quantitative Easing?
The central bank of a country conducts monetary policy using a range of tools at its disposal. First, it sets
official interest rates, that represent levels at which it is willing to lend to the banking system. Next, it sets
reserve requirements for various classes of deposits that can be changed as needed to affect credit creation.
Finally, it engages in open market operations where it can affect the amount of high-powered money in
the financial system by the purchase or sale typically of high quality financial assets such as government
bills and bonds. In normal circumstances these are all the measures that a central bank should need. In
situations where interest rates are already close to zero and/or the banking system is unable to extend
credit, any small-scale open market operations have little to no effect on the money supply. In such cases,
a central bank can purchase large quantities of financial or other assets in an attempt to achieve a desired
level of growth in the money supply and/or credit. The explicit willingness to commit to such purchases
to boost money supply is what is generally referred to as quantitative easing.
The Case for QE
The argument for QE is that the policy can stave off imminent deflation because the central bank can
commit to increasing the money supply by enough to force up the economy-wide price level. Simple logic
dictates that if a central bank were to print currency on a gargantuan scale, eventually there will be too
much in the way of money chasing too few goods which will lead inevitably to inflation. The promise of
future inflation could bring about an increase in current consumption as consumers rush to purchase at
the lower prices today. Moreover, the increased amount of money in the economy will help stabilize or
increase current asset prices which in turn could spur more consumption as consumers feel wealthier.
Thus, successful QE should have a strong positive impact on consumption. The expectation of higher
demand from consumption with ultra-low interest rates could also work to spur investment. In fact, if real
rates are kept low to negative due to QE, and the economic environment can be expected to improve, it
makes sense for the private sector to invest aggressively to lock in the attractive financing provided. So, the
effect on investment from QE should also be positive. Again, any debt taken on by the government at low
rates to engender growth will become less burdensome as both growth and inflation pick up. This should
result in great future flexibility for government budgets and possibly more expenditure. And finally, the
potential depreciation in the currency that might be forced by a dramatic increase in the money supply
could spur exports and further fuel growth. Thus, all components of GDP might be affected positively by
a policy of QE resulting in both a strong increase in growth along with an acceptable level of inflation.
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The most optimistic QE advocates would argue that the central bank might have to engage in very little
in the way of actual asset purchases or money creation. If the bank can convince the public that it will
increase inflation to a target level in the future, its commitment itself might engender all of the above
desirable effects.
The Argument Against QE
The bullish results from QE could all of course come to pass. However, there are a number of potential
pitfalls with the policy that are rarely highlighted. In fact, the costs from a failure of this policy are so high
and the odds of its success so low that a strong case can be made against undertaking it at all in the first place.
The first major objection to QE comes from an understanding of the practical reality of what the policy
actually entails. A unit of a country’s currency has an associated purchasing power in terms of goods. In
the gold standard days, this purchasing power was defined in terms of an amount of gold. With fiat
currency there is no such backing, but holders of the currency nevertheless benchmark their currency
and financial asset holdings to various baskets of goods. Thus, purchasers of longer-dated bonds (which
are promises to pay currency units out in the future) have to consider the expected level of inflation over
the term of their holding as a measure of how much their purchasing power will be eroded over time. The
interest rate they require will compensate them for the inflation loss in purchasing power, while providing
them a real return over inflation for the risk they take. When a central bank engages in QE, it is acting to
reduce the purchasing power of the currency unit by driving up asset prices, and if it is unable to do so,
the entire policy cannot work! As such, quantitative easing is nothing but a new buzzword for the oldfashioned policy of currency debasement.
A deliberate policy of debasement by a country is tantamount to expropriation from the holders of its
currency. So, QE should be viewed simply as a mechanism to execute a “soft” default on obligations. It is
unlikely that a country will be forgiven by its creditors if it were to undertake such a policy. In fact, creditors
will suffer whether or not the policy works with their pain being greater, the more effective the measures
prove. While QE thus might prove a short-term fix for economic problems, it should make it much more
expensive and difficult for the country to continue borrowing, especially from foreign creditors.
Another important problem with QE comes from the fact that there is a fundamental inconsistency with
its implementation that makes its failure virtually certain. The main task of most central banks in the
world (and especially the European Central Bank) is to maintain the currency’s purchasing power and
ensure price stability. In fact, even the Fed is charged with this task though its charter has a number of
additional and confusing objectives. Thus, when a central bank engages in QE it is explicitly acting
against its fundamental charter and destroying its credibility. The more the central bank convinces the
public that it is serious about debasement, the better the results from the policy will be. Yet, when the
primary, if not only, policy guardian for a fiat currency does the opposite of what it is expected to do,
holders of the currency (and associated financial assets) have no incentive to hold it because they are
faced with little to no upside but huge downside. The central bank, which is working to undermine its
own reliability in the short-term, cannot reasonably expect the public to believe in its future rectitude.
Unfortunately, the net result then could well be a total exodus from the currency followed by
hyperinflation, as the public moves to hold any hard asset in preference to the currency. The costs of such
an outcome are likely to be so immense that few, if any, central banks would risk this, whatever be the
purported benefits.
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2010
Finally, while QE is often presented as a monetary policy alternative to be conducted by the central bank, it
is de facto, a fiscal choice with important normative and fairness issues that are best dealt with by legislation.
When the central bank commits to purchasing large quantities of government debt, it is in effect transferring
wealth from the savers in the economy to the government, which is able to borrow at lower rates. This
represents a significant tax on the country’s savers and, as such, should be viewed as a fiscal matter for its
elected leadership. After all, in most democracies, a significant new tax will create plenty of debate regarding
its incidence and its beneficiaries. When the central bank starts purchasing instruments other than
government securities such as mortgages and corporate debt, the wealth redistribution it creates is even more
significant. Such transfers fall firmly in the realm of fiscal policy. There is no reason that a central bank, which
is typically run by unelected officials, should be allowed to make decisions regarding such redistributions,
especially if they are made without legislative oversight and accountability. We would argue that a true tax
imposed by the fiscal authorities would be a much more transparent and democratic choice. Unfortunately,
those who call for QE know that a full and informed public understanding of the consequences of the policy
would make it inherently unacceptable. In some ways, QE represents crony capitalism at its finest.
To summarize, the main problems with QE are first that it is a disguised form of debt default through the
currency with its attendant consequences. Next, it puts the central bank in an untenable situation that
should make a hyperinflationary currency collapse the most likely outcome. And finally, it is an odious
form of wealth redistribution that should ideally be undertaken in the open with electoral support. This
is something that is unlikely to occur in practice, which is why disguising the same as “quantitative
easing” (which does sound much better) is so much more palatable.
The Quantitative Easing Experience
Our experience with quantitative easing has been mixed overall. The Bank of Japan (BOJ) on March 19,
2001 was the first major central bank to undertake a policy of QE. It should be noted that Japan at that time
had already been suffering from deflation for almost a decade. The BOJ in its QE program increased its target
for current-account balances (reserves) of commercial banks held at the BOJ to levels far higher than their
required reserve levels. It also committed to maintaining the policy until inflation, as measured by the CPI,
stopped declining and registered a zero or positive increase year on year. The policy was lifted on March 9,
2006, and over this time period the BOJ increased its target levels for the current account balances nine times.
The objective of this policy was to flood banks with reserves which meant in essence that rates would fall to
zero. To implement its QE policy, the BOJ purchased longer-dated Japanese government bonds.
The Japanese experience with this policy of QE was mixed. There is no doubt that banks, firms that needed
financing, and the government, all benefited from this. However, it is not clear whether the policy contributed
to any pickup in economic activity. In fact, the economic recovery that followed was led primarily by exports,
even though the yen actually appreciated slightly over the period against the U.S. dollar. An improvement in
economic conditions in the country’s trading partners was perhaps most responsible for Japan’s recovery.
From our perspective, the Japanese policy should correctly be perceived as “QE light”. The Bank of Japan
historically has been a very conservative central bank and their QE program was not entirely of the kind we
discussed above. In particular, the BOJ committed to keeping a level of excess reserves in the banking system
but made no attempt to devalue the currency, commit to future increased purchases of other types of assets
if deflation did not end, or adopt other unconventional policies that most U.S. observers were urging on the
country. Given, in particular, that the BOJ did not try to debase its currency, their QE was more like an
extended commitment to zero rates which predictably had little effect given the country’s problems.
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Turning to the U.S., we would argue that the Fed’s program of QE started earlier than March 18, 2009
when it was officially announced. In 2008, the Fed already moved to expand its balance sheet significantly
by guaranteeing much of the toxic debt in the banking system’s books. While this was not perceived as
QE, this nevertheless represented a transfer of wealth from the public to the affected institutions,
something far out of the realm of monetary policy. The fact that these guarantees were undertaken by an
institution that did not then have any legislative oversight and refuses, even today, to agree to a full audit
of its activities is almost unconscionable given the scale involved. The actual QE program, as announced
in 2009, involved the purchase of over $1.5 trillion of Fannie Mae and Freddie Mac guaranteed
mortgages as well as Treasuries and it came to an end on March 31, 2010. The net result of the Fed’s
actions was a dramatic expansion in its balance sheet to over $2 trillion from just $500 billion in 2007. In
addition, there has been a huge increase in the Fed’s off balance-sheet guarantees with some estimates
putting these backstops at over $10 trillion.
The Fed’s actions so far have been much more aggressive than those undertaken by the BOJ. However,
the Fed has arguably accomplished little by these policies, while dramatically increasing the risks to
taxpayers. While it is true that the Fed has driven mortgage rates to record low levels, as things stand today,
any potential homeowner who meets minimal qualifications can still take out a mortgage with its
associated prepayment option at an unbelievably low rate. No private sector institution would lend either
the amounts or at the rates currently prevailing in the markets if its own money were at risk rather than
the government’s. A reasonable question that should be asked is why the Fed should be allowed to
subsidize housing when it is a role so far removed from central banking. Again, while the Fed has ensured
that the banking system is operating with huge excess reserves, it has not been able to arrest the continued
decline in overall bank lending.
Thus, the legacy of the Fed’s policies so far is a bloated central bank balance sheet chock full of rubbish
assets and guarantees, a still somnolent economy, and mounting concerns about the sustainability of the
vestigial economic growth generated so far. Unfortunately, some markets are signaling increasing
concerns about the long-term implications of these measures. In particular, gold, oil and most
commodities remain stubbornly near their recent highs despite anemic global growth. A number of the
global central banks such as India have started to purchase gold in preference to holding dollars. The
Chinese, who have the largest holdings of foreign reserves, appear to have totally stopped their purchases
of U.S. bonds. There is significant unease in the markets.
With these conditions already in place, it is amazing that the pundits are calling for a second round of QE
by the Fed. Markets should really be praying that a second QE does not occur given the tremendous risks
that it would represent. It could mean significant social and political consequences especially since the
biggest beneficiary would still be the incompetent, if not corrupt, financial system rather than the public
overall. Such fiscal transfers through monetary means could well inflame an already restive U.S. electorate.
An outright monetization of the continued huge U.S. fiscal deficits is sure to make huge foreign holders of
U.S. Treasuries worry. If history were to repeat itself, a continuation of QE will end the way it always has–
with a total loss of the Fed’s credibility and a hyperinflationary collapse of the U.S. dollar.
Portfolio Strategy and Conclusion
We have now an economic slowdown that is intensifying with huge U.S. and global fiscal deficits in the
developed world. The U.S. mid-term election in November is likely to result in the Democratic Party
suffering, if not losing control of one or both chambers in Congress. We are entering a difficult phase for
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the U.S. where fiscal expansion could prove much harder to undertake and the temptation for more QE
might become almost overwhelming. But more QE at this juncture could trigger a huge fall in the U.S.
dollar and/or a fall in the U.S. bond market, which might spell doom for the financial markets. In this
situation, it would be impossible to return to the current status quo – a dramatic change in the global
financial architecture would be inevitable and is perhaps even highly desirable.
We have already positioned for many of the likely outcomes with options, which we feel are essential
given the dislocations we expect. There is altogether too much complacency still in the global markets,
but the rude awakening may just be starting.
Performance Summary at July 31, 2010
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)
-1.9%
0.1%
-2.9%
-5.6%
6.2%
26.7%
21.7%
N/A
-2.9%
12.3%
CI Global Opportunities Fund
1 Mth.
3 Mth.
6 Mth.
1 Yr.
2 Yr.
3 Yr.
5 Yr.
10 Yr.
YTD
Since Inception
(Mar. ‘95)
-1.8%
0.0%
-2.8%
-5.4%
7.9%
27.6%
23.2%
7.7%
-2.8%
19.4%
Nothing herein should be read to constitute an offer or solicitation by Trident Investment Management, LLC or its principal to provide investment
advisory services to any person or entity. This is not to be construed as a public offering of securities in any jurisdiction of Canada. The offering of
units of the Trident Global Opportunities Fund are made pursuant to the Offering Memorandum only to those investors in jurisdictions of Canada
who meet certain eligibility or minimum purchase requirements. Important information about the Funds, including a statement of the Fund’s
fundamental investment objective, is contained in the Offering Memorandum. Obtain a copy of the Offering Memorandum and read it carefully
before making an investment decision. These Funds are for sophisticated investors only. ®CI Investments and the CI Investments design are
registered trademarks of CI Investments Inc.
2010
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