Opportunities Funds Commentary
Transcription
Opportunities Funds Commentary
2 Queen Street East, Twentieth Floor Toronto, Ontario M5C 3G7 www.ci.com Telephone: 416-364-1145 Toll Free: 1-800-268-9374 Facsimile: 416-364-6299 Trident Investment Management, LLC Opportunities Funds Commentary UPDATE December 31, 2010 Peformance Discussion 2010 ended on a euphoric note for global equity markets. In November and December, the S&P 500 Index was up an amazing 6.7%, the MSCI Europe Index was up 3.84% and the Nikkei was up 11.25%. Emerging market equities also rallied, with the MSCI Emerging Markets Index up 3.82% over the period. Bond markets globally sold off in tandem with the improved sentiment in equities with 10 year U.S. Treasury yields rising 0.694% to end at 3.295%. Credit spreads tightened in the U.S., although not in Europe, with the U.S. Investment Grade Index finishing close to its tightest levels for the year. Commodities rallied too with gold rising 4.51% to end at $1420.78 an ounce and oil rallying 10.33% to end at $91.38 a barrel. The U.S. dollar, in this atmosphere of euphoria, was broadly stable (all figures in U.S. dollars). Our funds suffered over the last two months of 2010. Our long positions in fixed income in Australia, Norway and South Korea significantly hurt performance since rates in these markets backed up more than comparable U.S. rates. Our long-fixed income positions were almost all taken through options, and the improvement in sentiment resulted in bigger losses than we had expected due to a substantial decline in volatility. The credit tightening also hurt our performance, as did the relative stability, if not strength of the U.S. dollar. Our U.S. curve steepeners were the only positions that helped our performance, but unfortunately our gains here were not sufficient to offset our losses. 1. An Analysis of 2010 2010 proved a disappointing year for us. On the one hand, most of the serious problems that are more than apparent now in the global economy surfaced over the year much as we had expected. Yet, markets decided for the most part to ignore these issues and instead focus on the policy responses which promised some prospect of near-term stability. We ended 2010 with the same global imbalances and problems of 2009, except that most of them have gotten much larger. Even worse, policymakers have considerably less flexibility today because of the flawed measures they have taken so far. Yet, the eternally optimistic markets are projecting a rosy future. The silver lining now, as we see it, is that it is a good time to be betting against the consensus. Entering 2010, the biggest single problem in the developed world was a crushing load of sovereign debt. The debt to GDP ratios for the U.S., the U.K., most of Europe and Japan (which has still not recovered from its 1990 real estate bust) were all at levels that suggested that much of the debt was unpayable barring drastic action such as an outright default or inflation through money printing. Unfortunately, we leave 2010 with the developed world having taken on more debt over the course of the year and rendering itself even more vulnerable. Europe and the U.K. however, have come to terms with the fact that current debt levels are unsustainable and that a period of austerity if not perhaps a new fiscal and/or economic framework may be needed. The U.S. refuses to even acknowledge that uncontrolled increases in debt are a problem. In fact, numerous influential policymakers in the U.S. are calling for even more deficit expenditure to boost growth, along with more money printing to keep rates low – a recipe that has inevitably led to hyperinflation wherever it has been tried. 2010 DEC UPDATE The other big issue entering 2010 was the unbalanced nature of global trade. The Chinese, as the largest exporters in the world, have an economy where consumption represented less than 40% of GDP, a record low for any country, especially one with a large base of poor consumers. The U.S., which has been steadily losing jobs to outsourcing, has an economy with consumption representing about 71% of GDP. Given that the 2007-2008 crisis exposed the flaws of an economic growth model driven by leveraged consumption, one could have reasonably expected that the U.S. would have taken some effort to reorient its economy away from consumption. The Chinese, seeing their exposure to the leveraged U.S. consumer could have also been expected to take measures to deal with their unbalanced economy. Instead, what we observed in 2010 was a determined effort by both parties to continue with their dance of death. The policies pursued globally in 2010 reflected the unfortunate reality of governments pandering to their domestic constituencies while refusing to acknowledge the inherently global nature of their problems. The markets would arguably have been the only objective arbiters of government policy. However, the world’s largest markets were increasingly manipulated by the authorities so that they are now testaments to the power of governments rather than an outsider’s assessment of reality. This has been brought home starkly in 2010 in ways that we explore in greater detail. Most U.S. observers believed that the U.S. economy in 2010 would be on a strong recovery path. A sustainable recovery appeared imminent at the end of 2009, and the Federal Reserve was expected to end its quantitative easing (QE1) on schedule at the end of March 2010. It was also believed that the Chinese and the developing world in general would perform well as global growth resumed. We believed that QE1 would be totally ineffective in sustaining growth and that the moment it was withdrawn the strains in the U.S. economy would become apparent. While we were not bearish about growth in the emerging markets, we were nevertheless concerned because so much of the bullishness came from the expectation of very strong growth in the developed world. As things played out in 2010, global growth proved slightly weaker than the consensus had expected. The U.S. economy failed to live up to the hype at the start of the year. The European Union (EU) became enmeshed in a sovereign crisis where the solvency of its member states came into question. The region has embarked on a round of fiscal austerity, which has yet to take full effect, but its overall contribution to global growth was still anemic. China, and the emerging countries in general, grew strongly, partially mitigating the relatively weak environment in the developed world. As growth concerns surfaced in mid2010 along with sovereign debt worries, risk aversion increased and markets swooned into August 2010. However, the U.S. Fed rode to the rescue promising yet another round of QE. Even worse, the U.S. announced an extension of the Bush tax cuts with an additional cut in payroll taxes to boot. The additional government expenditures, with money printing, ignited another burst of euphoria notwithstanding the usually dire consequences of such actions. We ended the year thus, with equity markets at their highs and most participants believing that vibrant, consumer-led growth, especially in the U.S., was back. We seem to be stuck in a time warp with the village idiot chorus. Our portfolio in 2010 was positioned to profit from a move to resolve some of the gargantuan problems that the world faced entering the year. We fully expected that the U.S. would print money and spend whatever was necessary on its fruitless attempt to reignite growth, and that the main casualties of its measures would be the dollar and longer-dated U.S. bonds, the former because of the commitment to print money and the 2010 DEC UPDATE latter because of the continued expansion of fiscal deficits. We also believed that the rest of the world would move to letting the U.S. dollar depreciate while making their own painful adjustments to reorient their growth away from U.S. exports. In the latter case, we could not have been more wrong. While there was generalized dollar weakness over the year, the exchange rate that is the linchpin of the global trading system, the Chinese renminbi, barely moved against the dollar. The Chinese economy did not reorient away to consumption, nor did it even slow: we just had more investment in export capacity and real estate, as we did for the last several years. The European problems, which we believed would be instrumental in slowing down global growth and creating conditions for more financial turmoil, appear to be having the effects we expected. Markets nevertheless believe that the European issues will be contained to the periphery, even though Europe is the largest single economic bloc in the world, much like the subprime problems of 2007 were “contained” at first. This has meant a significant sell-off in fixed income in countries like Australia where the problems of the developed world and the country’s own real estate bubble faded in comparison to the booming exports to China. And our credit shorts, which were largely in corporate credits in the U.S. and Europe, were relatively unaffected if not tighter over the course of the year despite the European turmoil. In fact, sovereign credit spreads in Europe have blown out to levels that suggest that sovereign default is highly likely across much of Europe, even as corporate credit spreads (even in Europe) suggest that this problem is unlikely to affect the companies in question at all. So we have the anomalous situation now where an AAA rated bond like that of France trades with a wider credit spread than a BBB+ bond issued by a French company, which in turn trades at an even wider spread than a BBB rated U.S. company. Most of our positions in fixed income and currencies were taken through options. Despite the clear and present risks in much of the fixed income world and the huge gyrations of the bond market from the daily changes in market sentiment regarding future growth, volatility has dropped considerably over 2010 on options. Our biggest winners in 2010 were our long positions in gold and our U.S. curve steepener options. Gold posted a healthy gain over the year albeit with constant wild swings. Our yield curve positions helped our performance but not nearly as much as we had expected. Our steepener options finished in the money for the most part, but since the yield curve remained only as steep at year end as it had at the start of the year, our gains were limited to the so-called “roll-down” in these options, which reflected our gains from the fact that the Fed did not raise rates in 2010 as the markets had expected in 2009 (when we purchased these instruments). A true blow-up in the fixed-income market has not occurred – even with the selloff in December following the U.S. tax cuts, the 10-year treasury remains at yields lower than those that prevailed at the start of 2010. All in all, our poor performance in 2010 can be traced to just one factor – the cost of waiting. We paid out premium on our options which for the most part did not pay off. We lost money on negative carry on corporate credit which remained tight all year. And we are glad we did little to no new positioning on the news relating to the U.S. slowdown and the European turmoil – had we been more aggressive, most of the positions that our logic would have suggested would have been major losers. We leave 2010 amazed at the market action – reality has already started to bite at every level in virtually all of the world’s economies and yet the markets and the Wall Street pundits persist in projecting a rosy outlook that could well be from a parallel universe. Frustrating though 2010 has been, we cannot believe that we are entering 2011 with the level of opportunity that we see today. 2010 DEC 2. The Global Situation in 2011 UPDATE The major issues faced by the world entering 2010 have become much worse over the course of the year so that we enter 2011 with less flexibility and more market risk than before. First, the economic imbalances across economies are very high and have gotten worse over the course of 2010. The world’s main exporter, China, has continued to grow exports with its main export markets being those of the U.S. and the European Union. However, the latter economies have problems with continued consumption. The EU is weighed down by significant unemployment and the potential of further economic weakness due to government austerity. The U.S. also suffers from high joblessness with its consumer facing the added problem of too much debt. Even worse, consumption in the U.S., unlike most of the EU, is already over 70% of GDP suggesting that any consumer slowdown will feed quickly into much weaker growth and higher unemployment. The Chinese economy in sharp contrast to those of its customers, is driven mostly by investment and exports. Consumption in China represents less than 40% of GDP, a percentage that is ridiculously low, especially for a developing country. Even worse, China’s policy of pegging its exchange rate to the U.S. dollar has led to a domestic bubble in real estate and commodities, making its already frugal consumer feel even more impoverished. Many of the exporting economies in Asia share the characteristics of China to some degree, with the almost universal issue being that consumption has been a much smaller portion of GDP than the wealth of these countries would suggest. For long-term, sustainable global growth, we need to resolve the imbalances between the producer and consumer countries in the world. The frugal Asian economies must be induced to consume considerably more as a percentage of GDP and export less, while the more profligate advanced economies of the West need to rein in their consumption and live within their means. Such a transition will require a major reorientation of economic priorities in all the affected countries. Moreover, while this change would be of long-term benefit, it is unlikely to help the economic situation in most countries in the short run. And this brings us to the second major problem the world faces. Getting out of the distorted equilibrium that the world economy is in today will involve significant economic pain. Government policy could help mitigate such pain by assisting the affected sectors because such assistance would lay the foundation for longer-term stability. However, most governments do not have the wherewithal to mitigate the pain of transition because they have expended so much of their resources in sustaining the status quo over the last several years. The lack of financial flexibility in the developed world is particularly visible in the levels of sovereign debt. The debt in most of the advanced industrial nations has reached such huge proportions that one can argue that it is no longer a “safe” investment. Even worse, the developed world is adding to its debt at a staggering pace to the point where any reasonable analysis of the dynamics would suggest a problem with repayment. The table below shows the situation of some of the major countries of the world. 2010 DEC UPDATE Table 1: Sovereign market vulnerability statistics in % of 2010 GDP Country Net Debt Budget Balance Current Account Balance U.S.A. 66 -11.1 -2.7 Germany 59 -4.5 4.9 France 74 -8.0 -1.9 Japan 121 -9.6 2.8 UK 69 -10.2 -1.1 Italy 99 -5.1 -3.2 Spain 54 -9.3 -5.5 Greece 110 -7.9 -11.2 Source: Citi Investment Research, “The Debt of Nations”, 7 January 2011 The huge levels of debt put the developed world in a difficult situation. On the one hand, most of the countries need to run large fiscal deficits to manage even anemic growth – for example, the U.S. is running a deficit annually of over 11.1% of GDP to generate just 2.5% GDP growth. Yet, trying to generate growth with deficits means even more debt and a bigger repayment hole, not to mention potentially higher interest rates which in turn could feed into higher indebtedness. In this context, governments need to be especially careful about policy. Any increase in indebtedness has to result in a proportionately greater increase in growth if the debt ratios for the country are to remain stable. That is, the growth generated by the economy by increasing debt should at least offset the interest payments on the increment – if not, we end up in a situation with explosive debt dynamics where more and more debt is taken on just to service existing debt. Yet, most developed countries are taking on debt to maintain current levels of consumption without addressing the huge global imbalances with the developing world at all. That is, scarce resources are being used to fund the least productive activities with no regard for long-term stability. Even an optimist looking at the levels of debt in the developed world would have to conclude that there is a high likelihood of either a hard default or restructuring of payments, or a soft default with the monetization of debt and inflation. It may be possible, with several years of austerity, to perhaps avoid these outcomes and muddle through to a benign resolution, but to do so requires strong leadership and a degree of political will that is lacking in most of the advanced nations. Moreover, significant divergences exist across countries in terms of what needs to be done and these will very likely create significant turmoil in markets in 2011. The current U.S. policymaking consensus believes that the levels of U.S. debt are not a problem. In fact, the latest “compromise” between President Obama and the Republican leadership extended the Bush tax cuts while cutting some payroll taxes in addition. And this is in the face of a restive population that seems unwilling to fund further expenditures by the government, as reflected by the most recent election results in November 2010, where deficit-cutting “Tea-Party” candidates were elected in significant numbers to the legislature. The U.S. Congress today is exceptionally polarized with members of both houses appearing far from compromise even on the most trivial of issues. 2010 DEC UPDATE The bond market’s potential disciplining of the U.S.’ spendthrift leadership has been subverted by the Fed which has engaged in a shameless exercise of monetization of debt with its quantitative easing policies. Fed chairman Bernanke, in an amazing display of intellectual dishonesty, argued recently on national television that the Fed’s QE2 was not the same as printing money, contradicting his own statements of a year ago on the same television program. Even worse, most mainstream U.S. economists argue for even more government largesse while supporting more QE as needed. With this framework, the U.S.’ trading partners are in the hapless position of catering to the country’s voracious import needs, while continuing to accept in payment U.S. dollars, which should soon be in virtually infinite supply given U.S. policymaker leanings. The EU and the U.K., unlike the U.S., have not embraced the idea of continued government expenditure with monetization. In fact, the crisis in peripheral Europe has come about largely because the institutional framework of the EU does not permit the European Central Bank to engage in monetization of the region’s debt, no matter what the benefits of doing so might be. An inability to monetize requires accepting market discipline on debt issuance. Markets have started to balk at funding the large deficits of the countries of peripheral Europe forcing many of these nations into painful fiscal austerity at a time where their economies are already reeling with high unemployment and weak growth. Even worse, it is becoming apparent that such austerity might be futile. Many of the peripheral European nations such as Greece, Portugal and Ireland are essentially insolvent and austerity is only going to prolong the inevitable restructuring of debt. Finally, Japan, the other big player in the developed world, has adopted a policy of simply ignoring its horrific debt levels while continuing to pile on more debt. The government in Japan so far has proved unable to even enunciate a policy framework for dealing with its debt, relying instead on its relatively lessindebted households and corporate sector to continue to finance its borrowing. A major debt crisis that could result in an outright monetization of debt for Japan is highly likely within the next two years. Such an outcome might not prove catastrophic for the country especially if the yen were to weaken because it would feed through into more exports, given the country’s manufacturing prowess, and domestic inflation. Faced with the developed world’s policies, the developing countries are more than concerned. The problem that they collectively face is that their productive output can be purchased by the developed world with paper money that is becoming increasingly risky. This is of significant consequence to China, the world’s largest exporter and reserve holder. Were the developing countries to revalue dramatically against the developed world’s currencies, this would create near term pain for their export sectors as well as dramatic paper losses on their reserve holdings. However, to the extent that countries have chosen to peg to the U.S. dollar, they have started to face serious problems with domestic inflation because of huge U.S. dollar inflows from the Fed’s QE2. Any rate increases to quell inflation are in turn leading to even more inflows and domestic inflation – for example, Chinese reserves have increased almost $600 billion in just the last six months of 2010, even as its official inflation (which is grossly understated) exceeded 5% for the year. On a number of levels, we are reaching the point of no return in 2011. Serious questions exist about the ability of the U.S., U.K., Japan and much of peripheral Europe to repay even their existing debt, let alone new debt. The developing world is increasingly aware of this but is yet unwilling to adopt the exchange rate appreciation needed. Any major adjustment in currencies will mean a significant near-term slowdown in 2010 DEC UPDATE growth globally, and possibly higher inflation in the developed world. Yet, postponing these realignments is only serving to make the problems much worse to the point where many of the developing countries could soon face internal unrest due to rising inflation. Muddling through is not a likely outcome for the world in 2011. 3. Market Opportunities for 2011 Markets today, especially in the U.S., are oblivious to most of the risks we have highlighted above. The reason for the insouciance comes from the fact that the Fed has essentially reassured participants that they stand ready with more money printing as and when needed. In particular, Bernanke explicitly stated post QE2 that a rise in the stock market would somehow bring confidence, if not prosperity to the U.S. While the Fed chief also said he was 100% certain that these interventionist policies could be reversed when conditions improved, what has become very apparent is that the Fed will essentially be unable to remove its accommodative stance barring a crisis. In fact, even the slight slowdown that ensued after the end of QE1 caused the panicked Fed to embark on QE2 after consultation with market makers about just how much QE2 needed to be to keep the domestic party going. Not surprisingly, asset prices in the U.S. are now at elevated levels with volatility plumbing the lows of 2007 when subprime was not even a factor. Correlations across asset classes are also at all time highs. This near-term Fed-induced “stability” is in fact anything but that. Zero rates and ample liquidity are driving market participants to ignore facts and embark on a dangerous chase for yield, while encouraging practices in the stock markets reminiscent of the technology bubble days of 1999. Yet this time, we have commodity prices soaring and this in turn is causing real pain to the developing world suggesting that a reckoning is in the offing. The longer markets ignore these realities, the more certain that any adjustment, when it does commence, will be a crash rather than the gradual tradeable decline that participants expect. There are two possible scenarios that we foresee that might upset the happy world of today. One involves a significant currency adjustment (and ultimately economic change) that will move the emerging and developed world closer to the desired long-term equilibrium. The other is a recognition by the markets of the unsustainability of the debt situation in the developed world, which in turn induces a round of sovereign defaults and global debt aversion. We take up both scenarios in more detail below. 3.1 The Currency Adjustment Scenario The continued inflation in food and commodity prices is forcing much of the developing world into a difficult choice. On the one hand, they can tighten policy and face the prospect of increased U.S. dollar inflows and an outcome with more inflation, price controls and the like. Or they can let their currencies appreciate significantly accepting the export sector consequences, and act to boost the domestic consumer economy. Unchecked food inflation is leading to social unrest in some emerging countries and could soon prove destabilizing for many governments in the developing world. There is a strong likelihood that China and many of the other developing nations will revalue their currencies significantly (at least 5-10%) against the developed world and especially the U.S. dollar in 2011. Such a move would help quell domestic commodity inflation given that most commodities are priced in U.S. dollars, even as it would help reduce any risk of deflation in the U.S. 2010 DEC UPDATE The Chinese Yuan – U.S. dollar exchange rate is clearly the linchpin for this scenario and it is very much in the global interest to force a major revaluation by China. While painful in the near-term for China, and especially Chinese exporters, such a policy may not prove as detrimental in the medium term as one might expect. Many of the goods that China exports involve assembly or manufacturing of imported commodities and intermediates. Since the prices of these inputs are typically set in dollars, a sizeable fraction of the costs faced by the Chinese exporters are also in U.S. dollars. Also, a large fraction of Chinese wages goes to food and shelter. A continued rise in the prices of these necessities that is being engendered by a pegged exchange rate is already leading to demands for wage increases. Thus, while exporters will see a compression in their operating margins due to a yuan revaluation, this should be somewhat mitigated by a reduction in input costs and possibly a reduction in the pressure for wage increases. Managed carefully, a yuan revaluation coupled with tighter domestic credit and targeted fiscal policy to boost consumption, could permit China to reorient its economy away from exports and real-estate investment towards domestic consumption. This will entail near-term pain, but should have huge longer-term benefits. The developed world would face a period of stagflation in this outcome, which is perhaps desirable and maybe even the best one could hope for. The best investment opportunities under this scenario would be to short the currencies and the bonds of the developed world against those of the developing countries. Gold should also do well in this environment. Selected equities, especially in the emerging markets, might perform well over the medium term. 3.2 The Sovereign Debt Crisis Scenario This is perhaps the situation that markets deem most likely currently, but yet the consequences of the same are not fully priced in. Credit Default Swaps for many of the European sovereigns suggest that countries like Greece, Ireland, Portugal and Spain could default very soon on their obligations. Markets, however, believe that such defaults will have little effect either on corporate activity or on global credit. Unfortunately, a true sovereign default will mean a repricing of sovereign risk especially since both the U.S. and Japan share the same debt dynamics of the peripheral Euro nations. As such, a global revulsion to the debt of the riskier sovereigns could develop. While this might not mean more defaults, it might at least force austerity on countries like the U.S. and Japan which can ill afford such measures at the present. This in turn could lead to a significant global slowdown, falling commodity prices and a big deflationary shock as countries like China continue to export their excess capacity into a world that is increasingly unable to consume more. This situation could rapidly spiral into one involving trade wars and mutual recriminations, which will exacerbate the global slowdown. The best investments for this scenario would be the debt and/or the currencies of the highly solvent sovereign nations such as Norway and Australia. Gold is likely to do well in this scenario as well because of the loss of confidence in sovereigns. This environment however, will wreak havoc on equities, credit and most risk assets – after all, leverage even with zero interest rates will prove painful if most investments one can make will lose. 2010 DEC UPDATE Conclusion Our portfolio is positioned to profit from either of the scenarios above. Much of our leverage to these two scenarios is obtained through options that provide a limited and fixed downside, while providing substantially greater upside if we are correct in our views. Given the significant decline in volatility over 2010, most of our options today are priced at levels that prevailed in the halcyon days of early 2007. Some of them in fact have been written down over 70% in 2010. Yet, fundamental conditions have not changed much, suggesting that if markets come around to our viewpoint, our payoffs could be explosive. We enter 2011 sounding the alarm about global imbalances and highly risky policy measures much as we did in 2010. The only difference today is that we are that much closer to the brink, as attested to by the sovereign debt markets in peripheral Europe and the rampant inflation throughout the developing world. Given the rather obvious challenges faced by the world, it is not much of a stretch to anticipate a volatile and difficult 2011, but most market participants are overwhelmingly bullish. The Greek god Apollo gave the Trojan princess Cassandra the gift of prophecy even as he cursed her to live in a world where no one would believe her predictions. Given our views, I can certainly appreciate how Cassandra might have felt in her time. Fortunately, we are much more mercenary than Cassandra and fully expect to profit significantly when our predictions prove correct. Wishing all of you a happy and prosperous 2011. Performance Summary at December 31, 2010 Trident Global Opportunities Fund 1 Mth. 3 Mth. 6 Mth. 1 Yr. 2 Yr. 3 Yr. 5 Yr. 10 Yr. YTD -0.9% -2.0% -3.9% -4.9% -4.3% 9.6% 20.0% N/A -4.9% Since Inception (Feb. ‘01) 11.5% CI Global Opportunities Fund 1 Mth. 3 Mth. 6 Mth. 1 Yr. 3 Yr. 5 Yr. 10 Yr. 15 Yr. YTD -0.8% -1.9% -3.7% -4.7% 9.3% 21.6% 8.2% 18.3% -4.7% Since Inception (Mar. ‘95) 18.7% 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 DEC