Opportunities Funds Commentary

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UPDATE
Trident Investment Management, LLC
Opportunities Funds Commentary
December 31, 2012
Performance Discussion
Markets ended 2012 on a positive note. Equity markets were strong with the S&P 500 Index up 13.4%
on the year, the MSCI Europe Index up 13.4% and the Nikkei up 22.9%. Despite robust equity market
performance, bond yields plumbed record lows with the 10-year U.S. Treasury yield ending at 1.76%, a
decline of 0.12% on the year. Even more, rates in Switzerland, Denmark and Germany went negative
with the 2-year rates trading in these countries from -0.09% to -0.20%. Given the low rates, credit markets
were euphoric with yield spreads on speculative bond metrics like the U.S. High Yield Bond Index hitting
multi-year lows. The U.S. dollar was almost unchanged with the U.S. Dollar Index depreciating a scant
0.5%. Gold and oil were both up. Gold was up 5.9% and WTI Crude was up 13.0% on the year (all figures
in U.S. dollars).
Our funds finished the year virtually flat after fees. The biggest winners in our portfolio were our long
positions in fixed income in Norway, Australia and South Korea. Another contributor was our long position
in Japanese equities, which generated most of our gains over the last quarter. We also benefited, albeit much
less, from our long gold position. While we had reasonable gains in the metal itself, much of these were
offset by losses on our small gold stock positions. On the negative side, our credit book hurt the portfolio,
though marginally. We had both longs and shorts in credit but maintained a substantial net short position in
2012. Our losses were largely due to the cost of carrying our net short position. As a group, our credit longs
outperformed our shorts thus limiting our losses from the generalized credit tightening that occurred over
the year. Finally, our equity exposure in the U.S. negatively impacted performance. Our long positions in
defensive U.S. stocks such as consumer staples and utilities underperformed our shorts in U.S. indices and
consumer discretionary stocks.
We entered 2012 forecasting that growth globally was going to be dismal. We had also felt that more monetary
easing measures would do little to change the underlying growth dynamics. Finally, we had believed that the
chances for a crisis would increase the more the global central banks used their monetary tools to deal with
what were fundamentally balance sheet problems caused by the collapse of the credit bubble in 2007-2008.
We were largely correct on our growth forecasts. Global growth proved far weaker in 2012 than most analysts
had expected. In particular, U.S. GDP grew at an estimated 1.8% which was much lower than the 2.5%+
rate many had forecast late in 2011. Europe is in a recession that intensified over 2012. Most other global
economies grew at levels that were much weaker than most had expected.
The slowing growth prompted considerable policy response. The U.S. Federal Reserve increased its
program of Quantitative Easing (QE) from $45 to $85 billion per month. The European Central Bank
(ECB) expressed a willingness to engage in unlimited purchases of bonds of European countries in trouble,
through its so-called Outright Monetary Transactions (OMT) program. The Bank of England continued in
its quantitative easing without let-up. And even Japan, which had some relatively modest bond purchases by
its central bank, has stepped up its monetary efforts.
2012
DEC
UPDATE
Much as we had expected, the global economy did not respond much to the extreme monetary stimuli that
were in force almost everywhere. Growth and unemployment remain stuck at weak levels despite confident
pronouncements by policymakers regarding the efficacy of their actions. However, the world’s central banks
have succeeded in boosting financial asset prices considerably, driving valuations to levels that are completely
out of touch with reality.
Entering the year, we were unwilling to position aggressively in risk assets because we believed that they
provided limited upside and potentially huge downside given economic fundamentals. We could not have
been more mistaken on that front. Markets in 2012 were increasingly perceived as tools of central planning.
Participants set asset prices based on the omnipotence of central bankers to bail out their bad decisions
rather than on any economic facts. With such a backdrop, it was not surprising that the largest gains for
the year were in the most speculative assets. Exotic mortgage bonds, high-yield bonds from quasi-insolvent
companies, and the debt and stock markets of largely bankrupt sovereigns all posted spectacular returns.
Even worse, investors rushed to sell their safest holdings in this mad dash-for-trash. We felt fortunate that
we largely avoided fighting the speculative herd, despite our fundamental views. Even so, we are more than
a little disappointed at our performance – we simply could not find enough quality investments that could
masquerade as rubbish and appeal to the “investors” of 2012.
All said, 2012 still had its share of crisis moments. In the middle of the year there were serious concerns
about a complete default in Europe with a collapse in global growth. Yet, policymakers have managed
another miraculous save, albeit at an even greater cost than in prior years. Unfortunately, they did little to
address the structural problems the world faces and as such, the chances of a crisis have only increased
entering 2013 -- the costs of kicking the can down the road are simply becoming prohibitive.
Outlook for 2013
We enter 2013 with an outlook similar to 2012. First, we believe that global growth will prove anemic, even
relative to the poor numbers recorded in 2012. Next, we expect policymakers to engage in more heroic
measures in the developed world to boost growth. However, we feel that the limits of monetary policy have
largely been reached especially in the U.S. and U.K. and possibly also in the EU, so that additional easing in
these regions should have little to no effect. We expect that the deteriorating economic conditions in these
safe-haven areas could lead to more political tensions and increase their perceived risk. This in turn could
finally prompt a much-needed global realignment where the countries of Asia and the developing world
de-peg their currencies from their Western trading partners and adopt policies that foster domestic growth in
preference to exports.
The problem of growth is the main issue that preoccupies all policymakers today. In our highly-indebted
world, weak growth and deflation are recipes for default. We discuss the growth issue in detail below and
then consider where the best investment opportunities exist for 2013 given the policy responses we expect.
1. The Problem of Growth
The one overriding economic concern for 2013 will prove to be growth. Entering the year, most of the largest
developed countries in the world are slowing down or mired in recession. Even worse, there are few policy
levers left to move economies out of this stasis.
2012
DEC
1.1 The Crisis in the European Union (EU)
UPDATE
In the EU, most economic indicators continued to weaken into the end of 2012. The problem countries of
Greece, Portugal, Spain and Italy showed few signs of emerging from the recession that has gripped them for
the last several years. The Greek economy remains in a depression and has so far avoided total default and
collapse only because of continued aid from the EU. Yet, this aid comes with significant austerity requirements
that the country’s dysfunctional government seems incapable of imposing on its already suffering population.
Thus, significant uncertainties exist as to the continuation of foreign aid and thence the viability of the current
government. As such, an autonomous pickup in private consumption or investment is unlikely. At best what
we can expect in Greece is some stabilization at huge cost to the EU, but little real growth.
The situation in Spain, in some ways, is more dire than in Greece. The Spanish economy is stuck in a
punishing recession that has already exposed domestic political strains in the form of increasing demands for
greater regional autonomy or even outright secession (as in Catalonia). The Spanish government has avoided
asking the EU for adequate aid to deal with its economic and banking crisis fearing the repercussions in terms
of lost sovereignty for such help. Yet, such a loss in economic freedom was an essential precondition for the
ECB’s support of the Spanish bond market through its OMT program. The decline in Spanish credit spreads
after the ECB’s OMT announcements thus represent a hope that Spain will voluntarily relinquish its internal
decision-making to EU authorities. We feel this will not happen barring a major crisis, which might soon be
forthcoming on the growth front as the economy slips further.
In Italy, conditions have taken a turn for the worse. The country’s economy is weak and the political
environment fractious. Parliamentary elections in the country, now scheduled for late February, are unlikely
to produce a strong government. The current technocrat Prime Minister, Mario Monti, enjoys little political
support. Former leader Berlusconi has re-emerged as a political force after being expected to leave politics
further confusing the electorate. The Five Star Party of Beppe Grillo has gained popular support while
running on an anti-Euro platform. In short, Italian politics remain as confused as ever with no party willing to
tackle the structural reforms necessary to put the country’s finances on a sound footing. It is unlikely, however,
that markets will take kindly to a return to business as usual in the country, especially given the poor growth
results delivered so far.
The more alarming problem for the EU is the economic weakness in the core. France had already started
slowing early in 2012, and the tax-raising policies of President Hollande have only served to depress confidence
further. The huge increases in taxes on the rich have led several high-profile, wealthy French citizens to
seek refuge in more tax-friendly domiciles. Private sector sentiment continues to be depressed in France and
the government is unlikely to provide further stimulus. Conditions in Germany are also getting worse. The
German economy proved the most resilient in the EU through much of 2012, holding up remarkably well
through the first half. However, even Germany has slipped into outright recession in the last quarter of 2012
leaving Europe with no growth locomotives.
EU bulls, however, have some cause to celebrate. The OMT program has managed to bring credit spreads for
Spain and Italy down from their lofty levels of August 2012 making their debts much more sustainable. This
has been achieved simply by the promise of OMT rather than actual buying by the ECB. The improvement
in sentiment appears to have reversed the outflow of deposits from the troubled nations of Southern Europe.
The so-called TARGET2 balances over the last two months of 2012 actually declined by almost 100 billion
suggesting an equivalent inflow to the troubled nations.
2012
DEC
UPDATE
Yet, the prospects for Europe this year appear bleak. Austerity drives are in full force through much of Europe.
Rates are already at rock-bottom levels in the core and are unlikely to decline much further. Unemployment
remains stubbornly high and cannot come down much, absent sustainable growth. And finally, economic
conditions should prompt more political turmoil resulting in populist policies in the afflicted nations. This is
in turn should create even more divisions among the nations in the bloc.
1.2 U.S. Prospects
Compared to Europe, the U.S. may appear to be a picture of rude economic health. However, appearances
are deceptive. The simple fact is that for the last several years the U.S. government has been on a spending
binge financed by the printing press of the Federal Reserve. The deficit at close to $1 trillion, is around 7% of
GDP. Over 80% of all U.S. government expenditure moreover, goes to entitlements, employee benefits and
defense – expenses that are unlikely to boost long-term investment and growth. Even with such spending, the
U.S. economy grew at less than 2% in 2012. In fact, the U.S. has managed to rack up colossal deficits since
2009, turning what was a reasonable fiscal position to something that is already unsustainable.
The statistics also underestimate the scope of the fiscal challenge the U.S. faces. In particular, about 6% of
U.S. government expenditure is interest on debt which is likely to increase in the future given the record
low levels of interest rates. Moreover, about 10% of the stock of U.S. debt is held by the Federal Reserve
thanks to its QE. The interest paid on this debt is simply rebated to the Treasury which means that the U.S.
pays a zero interest rate on this portion of the debt. If the Fed were to reduce its holdings of Treasuries to
more normal levels, the government would immediately see an increase in its expenditures of about $70
billion for debt service. In addition, ongoing U.S. deficit levels significantly underestimate the true costs of
the future entitlement spending. The future costs of Medicare and Social Security, assuming these programs
are maintained at current levels, are likely to be staggering. The GAAP version of U.S. government’s financial
situation as reported by the Treasury show a huge annual increase in accrued obligations that have frequently
exceeded 25% of GDP per year over the last several years.
It is critical that the U.S. embark on a plan for longer-term fiscal sustainability. The country has accelerated in
its transition from being the bastion of capitalism and small government, to becoming a full-fledged socialist
state much like the nations of Europe. Yet, this change has not been well understood by the population with
the majority wanting lower taxes and more benefits that they do not pay for. Unfortunately, political aspirants
are only too willing to pander to these conflicting desires. The Republicans promise lower taxes while the
Democrats argue for more benefits. A serious discussion of the tradeoffs needed for a stable fiscal outlook
is something neither party wants to initiate. What we have is political demagoguery at its worst, and total
ineffectiveness where action is needed.
2013 should force all the U.S. fiscal discussions to the forefront. We entered the year hitting our Congressionally
imposed debt ceiling. We also faced the so-called fiscal “cliff” thanks to the expiration of income and payroll
tax cuts as well as a decline in government expenditures mandated by Congress when the last debt-limit
increase was negotiated. Lawmakers were able to agree on a plan to keep some of the income tax cuts in place
for 2013. Yet the expiration of the payroll tax cuts of 2012 and the rise in taxes for those making over $400,000
per year are likely to dampen growth by as much as 1% of GDP. Even worse, there has yet to be any substantive
discussion on spending cuts. U.S. lawmakers are currently trying to find ways to reduce or eliminate the
automatic spending cuts that were to be triggered in the absence of any Congressional agreement to reduce
2012
DEC
spending – these automatic measures were instituted during the last huge increase in the U.S. debt ceiling
to force cuts in the face of lawmaker inaction. Yet, U.S. leaders today are expending energy in trying to undo
their own actions of August 2011 while refusing to discuss the looming fiscal catastrophe the country faces.
UPDATE
The bottom line is that fiscal stimulus for 2013 cannot possibly match the levels of 2012. At best, we expect
government expenditures to be roughly flat with 2012, and at worst considerably less. Given that overall
conditions are not much better in the U.S. entering 2013 compared to the year before, the fiscal drag is
likely to engender weaker growth.
1.3 A Japanese Revival?
The economic situation is perhaps the most interesting today in Japan, where currency strength and a
potential fiscal disaster are creating conditions for major change. Japan’s fiscal situation is dire. Its net debt
to GDP ratio is about 135%+. It has a fiscal deficit of about 10% of GDP. And it continues to be stuck in
a deflationary morass – the worst possible situation for a highly indebted borrower. Even worse, QE in
the U.S. and potential OMT in Europe pressured the yen to appreciate through much of 2012. These
conditions pushed Japan into recession over the latter half of 2012. Corporate Japan also suffered mightily.
Thanks to the strong currency and trade tensions with China arising from the disputed Senkaku/Diaoyu
islands in the East China Sea, most Japanese exporters suffered horrendous losses. The very survival of
many iconic Japanese companies such Sony, Panasonic, and Sharp was called into question in 2012.
In the latter half of 2012, the government of Prime Minster Noda (of the Democratic Party of Japan) called
for more aggressive Bank of Japan (BOJ) action to support the economy and weaken or at least stabilize the
yen. In the election for the Diet, contested in December, the opposition Liberal Democratic Party actually
campaigned on a platform of taking away the BOJ’s independence if it did not work aggressively to create
inflation! The LDP won a super-majority in the Diet that now permits it to pass any legislation it chooses
without opposition support. Even though the party lacks a majority currently in the Upper House, its
margin of support in the Lower House allows it to simply override the Upper House if needed. New Prime
Minister Shinzo Abe takes office with a strong mandate, but with his country facing a fiscal crisis. With his
election there is a palpable air of change in Japan.
Change is perhaps most visible now in the BOJ itself. The institution has been taking in younger members
into its board, virtually all of whom are predisposed to more aggressive monetary action. The two most
recent appointments to the BOJ in July 2012 have proved very dovish and appear to have shifted the
institution’s thinking. In March and April this year, Governor Shirakawa and his two deputies retire, with
their replacements almost certain to be politically savvy, monetary interventionists. The BOJ also seems
to have accepted the fact that its independence might be lost were it not to cooperate more with the
government. As such, it is widely expected to accommodate Abe in adopting a 2% inflation target with a
willingness to work more aggressively to achieve it.
We expect the BOJ to adopt policies that will engender significant domestic asset reflation and thence
more growth, if need be, with gradual yen weakness. We believe a full scale move to weaken the yen might
be met with considerable resistance from Japan’s trading partners given the already depressed state of the
global economy. Unfortunately, even with strong BOJ action, the growth prognosis for Japan is not very
good unless it succeeds in creating a mega-asset bubble in Japan or dramatically weakens the yen.
2012
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UPDATE
1.3 Developing Country Imbalances
There are few, if any, countries in the developing world that can serve as a global growth locomotive.
China still faces significant headwinds from its real estate bust and is unlikely to see its export growth
compensate for this, given anemic conditions in the U.S. and EU. Many other developing nations such as
India and Brazil have an unpleasant combination of high domestic inflation and overly low real interest
rates. While we expect these economies to perform well in 2013, we do not believe that policymakers will
ease policy much fearing a resurgence of inflation. As such, the emerging countries as a group will not be
where we look for the 2013 growth acceleration.
All in all, we enter 2013 much as we did 2012, but with significantly higher fiscal deficits, even lower interest
rates and an increasing sense that the policies of the past are simply not working.
2. Conclusion
To sum up, 2013 promises to be an exciting year. Japan’s new beginning might provide an excellent
uncorrelated investment opportunity that could potentially have huge payoffs. The rest of the world remains
mired in a mess that has not gotten better but for which the policy well has largely run dry. While some of our
views on Japan are becoming more widely shared, we remain in a minority where it comes to our position on
global, and especially U.S., growth. We are convinced of our view on the real economy – the markets simply
cannot handle this truth and it is in this that we perceive the biggest opportunity.
Wishing you all a Happy and Prosperous 2013
Performance Summary at December 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)
-1.1%
1.5%
-0.5%
0.6%
-1.3%
5.9%
11.0%
-0.5%
9.6%
0.1%
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)
-1.1%
1.4%
-0.5%
-1.3%
5.7%
11.4%
13.3%
-0.5%
16.5%
0.1%
Nothing herein should be read to constitute an offer or solicitation by Trident Investment Management, LLC or its principal to provide investment
advisory services to any person or entity. This is not to be construed as a public offering of securities in any jurisdiction of Canada. The offering of
units of the Trident Global Opportunities Fund are made pursuant to the Offering Memorandum only to those investors in jurisdictions of Canada
who meet certain eligibility or minimum purchase requirements. Important information about the Funds, including a statement of the Fund’s
fundamental investment objective, is contained in the Offering Memorandum. Obtain a copy of the Offering Memorandum and read it carefully
before making an investment decision. These Funds are for sophisticated investors only. ®CI Investments and the CI Investments design are
registered trademarks of CI Investments Inc.
2012
DEC