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
UPDATE
Trident Investment Management, LLC
Opportunities Funds Commentary
March 31, 2014
Performance discussion
Equity markets were mixed in 2014, with significant volatility in the first quarter. The S&P 500 Index ended
the quarter up 1.7%, though early in February it was down 5.8%. The MSCI Europe Index ended up 1.9%
on the quarter and the Nikkei was down a whopping 9.0%. Equities in the developing world did not do well
either, with the MSCI Emerging Markets Free Index down 0.7%. The fixed-income markets were mixed.
The U.S. 10-Year Treasury rallied 0.31%, but the Three-Year note sold off 0.10%, resulting in a flattening
of the U.S. yield curve. The U.S. dollar remained unchanged against most currencies with the U.S. dollar
index finishing up 0.08%. Credit markets were very strong, especially in Europe, with spreads reaching levels
last seen in late 2006 and early 2007. Finally, commodities were mixed with industrial metals such as copper
down 10.4%, but oil up 3.2% and gold up 6.5%.
Our funds had a rocky first quarter. Most of our losses came from Japanese equities where our long positions
were hurt because of the market’s outsized correction. Our fixed-income positions were flat. Our gains
coming from bets in European fixed-income were offset by losses due to the significant flattening of the U.S.
yield curve and the continued tightening in the developed world’s credit markets.
Our portfolio has changed only marginally over the last several weeks. We had already reduced our risk
exposure entering the year, and a number of hedges we had set up for our Japanese long positions served to
reduce our exposure further. Virtually all our fixed-income exposure is through options and we have been
adding to such exposure. We have also moved slowly to increase our short credit exposure. We have reduced
our already limited long credit exposure to the developing world to the point where we have little emerging
market risk in our books. We have also increased, albeit gradually, our short exposure to junk bonds and
other speculative-grade credits.
Market outlook and portfolio strategy
Our investment approach relies on assessing the amount of return we can expect in a given opportunity and
weighing that in relation to the amount of risk we need to take to achieve such a return. To determine risk and
reward in a prospective investment, we rely on macroeconomic and political analyses along with the valuation
metrics from bottom-up security analysis. Our process is fundamentally driven in that it is based on realistic
estimates and comparative metrics for future valuation. Market psychology is not the primary driver of our
process, even though it does play a role in terms of the tactical expression of our investment themes. That is,
a potential opportunity might be more tactically attractive because market psychology might be moving in
its favour. However, we do not consider investment themes where the macro backdrop and valuations do not
provide an adequate reward to risk tradeoff, no matter what market psychology might dictate.
Markets today are particularly frustrating for us because the fundamentals globally appear to be deteriorating
at an alarming pace, as they have for some time now, but market psychology remains oblivious to them.
Participants blithely assume that the omnipotent central bankers in the developed world will somehow
engineer an outcome where reality catches up with market beliefs rather than the other way around. This
has been the prevailing view, especially in the U.S. where the Federal Reserve’s policies have consistently
failed to generate the expected outcomes, but each year there is a new excuse for failure, along with more
2014
MAR
monetary medicine to create hope. The Fed’s policies have been echoed by the Bank of England and more
recently the Bank of Japan. The European Central Bank (ECB) has proved even more brilliant in that it has
engineered similar hope in the markets without having done anything other than make promises.
UPDATE
We believe that the reality in the global economy is considerably worse than markets are forecasting and,
in fact, significantly worse than even in early 2007. In this difficult environment, global policymakers
are out of fiscal ammunition. They have also used their monetary tools to excess, creating huge market
distortions to the point where these actions are in themselves impeding any sustainable recovery. An
unpleasant reality and policymakers who no longer appear to be in control could set the stage for a period
where markets catch up with poor fundamentals. We believe that such an adjustment is likely to occur
on a much bigger scale than most market participants anticipate and believe that this will provide us with
significant opportunities for profit.
We briefly consider below the global conditions as we see them and then discuss what should be the likely
course of events given the current conditions. Then, we focus on the opportunities so suggested, and identify
those we believe offer the best potential upside for our funds given the risks.
1. Analysis of global conditions
The global landscape is far from pleasant when looked at without the financial markets being the overriding
concern. In particular:
1) Global growth has been weak since 2009 and is still weak.
2) Debt levels have been rising despite supposed fiscal austerity.
3) Inflation is not increasing in the developed world, even with money printing.
4) The political environment is fluid with the citizens of many countries becoming increasingly restive with
the status quo.
We have discussed the first two points repeatedly in prior letters. Accordingly, we will not belabor them any
more here. We briefly take up the last two points below.
Inflation is low
Highly indebted governments can often resort to the printing press to create inflation and thus reduce the
real value of their debt, relative to their tax revenues. While most developed countries have resorted to such
measures with a vengeance since 2009, the hoped-for inflation has not materialized. High unemployment
and weak incomes have served as a significant damper on inflation in the developed world. Also, the
developing countries have continued to peg or weaken their currencies relative to the U.S. dollar to boost
their export growth at the expense of higher domestic inflation. The cost to the developed world has been
higher unemployment (and thence deficits because of fiscal supports) and low or declining inflation.
The inflation figures in the developed world are becoming increasingly worrisome especially given the high
debt levels with which most of them operate. The Eurozone, which has refrained from true quantitative
easing (QE), is perhaps in the worst situation with inflation declining to just 0.5% per year – a level lower
than Japan’s today. The U.S., even with rising prices for most services such as health care and education, has
inflation as measured by the Personal Consumption Expenditures (PCE) deflator (used by the Fed) of just
1.1%. Even Japan, after a year of aggressive QE and yen depreciation shows inflation of just 1.25%. While
the developed world was quick to criticize Japan for its policies after its real estate bubble collapse in 1991,
2014
MAR
the simple fact is that most of the developed countries appear to be on a Japanese path today, at least where
it comes to inflation.
UPDATE
Political situation is unstable
Income distribution in most of the developed world has become significantly skewed because the thrust
of policy has been to inflate asset prices and not incomes. As such, the wealthiest sectors of the population
have benefited disproportionately because of their asset holdings, even as the vast majority has seen close to
recessionary conditions with no improvements either in income or prospects. In the developing world, by
contrast, the poorer classes have been ravaged by inflation. Thus, the global policy mix today is increasingly
marginalizing the majority. This does not bode well for political stability.
Political risks are already apparent in many of the world’s major economies. In the Eurozone, populations
in the problem countries are extremely restive and there is a high likelihood of radical political change in
countries such as Greece. Even in the U.S., which has been in relatively better economic shape, the political
system enjoys its lowest popularity ratings in several generations.
Policymakers have persisted in their grossly distortionary policies because the structural reforms needed for a
more sustainable growth and income distribution are painful and certain to be unpopular in the near term.
Also, the moneyed classes have all but taken over the policymaking apparatus and have so far prevented any
change to the status quo. The longer these policies are continued however, the more likely it is that growth
will remain weak and the more the chance of a cathartic political change.
2. The likely course of events
We can identify three specific stages in which events might progress given the conditions above. They are:
Zombification
Low inflation and poor growth together do not allow for easy revenue growth for participants in the
economy. Such an environment is typically characterized by overcapacity and as such there is a paucity of
high-return investment opportunity. In this situation, an agent with high debt levels faces a significant real
debt service burden that does not decline, even if revenues do, with falling inflation. In fact, when inflation
keeps declining, the debtor’s available free cash flow goes increasingly to service debt rather than to increase
productive investment (and the latter was a problem already). To the extent the debtor is able to take on more
debt and service an increased debt burden, the problem of under-investment only gets more acute. When
interest payments eat up most of the debtor’s free cash flow, but he/she is nevertheless able to survive and roll
over his/her debt because of the continued availability of credit, he/she is, for all practical purposes, a zombie.
That is, he/she can continue to go through the motions of existence, but cannot function like a living entity
in terms of investment and growth.
By preventing the bankruptcy of inefficient borrowers, the problem of mal-investment and/or excess capacity
in the industry/economy is prolonged. Then, even entities without debt will simply not invest because the
inefficient borrowers by the continued profitless survival depress returns for all companies in the industry.
As such, a policy that permits such debtors to survive could mean the zombification of entire sectors of the
economy. We would argue that the primary thrust of policy in most of the developed world today, except
paradoxically in Japan (which did the same in 1991, though not today), is towards perpetuating zombies with
easy credit and explicit market intervention. We believe that these policies have been in operation in some
form in the U.S. since the Long Term Capital Management debacle in 1998, but they have been applied
even more zealously since 2009 on a global basis.
2014
MAR
UPDATE
Examples of the destruction wrought by these policies are legion. The developed world’s banking system has
rampant excess capacity and is woefully insolvent. Policymakers have resorted to keeping large swathes of this
inherently predatory financial system alive with huge amounts of zero cost financing at the expense of the
public at large. The corrosive effect of this is felt in the depressed returns earned by savers in the economy
and in the continued “financialization” of economic activity at the expense of actual productive enterprise.
Numerous high-yield companies in both the U.S. and Europe are nothing other than Ponzi debt repositories.
They are in industries with excess capacity and face both declining revenues and free cash flow. Many of them
would have likely failed even without the crisis of 2007-2008. Yet, many of these very companies were taken
private in the period following 2009 and loaded up with even more debt that permitted their managements
and private equity masters to pay themselves handsomely. These firms are now being offered to the public
through Initial Public Offerings that our venal bankers are only too happy to market. In fact, such is the
voracious appetite for junk that these undead companies have been able to raise financing through pay-in-kind
bonds where debt service can automatically be capitalized into more debt as needed.
The problem of zombification is not confined to the corporate sector. On the sovereign front, the logic applies
equally well. A sovereign debtor whose revenues are limited either by weak growth and/or high tax rates can
take on more debt only when its benefits are truly compelling in terms of potential returns. If not, the increase
in debt will simply eat into the tax revenues leaving less for providing other services. If the debt burden exceeds
100% of GDP, the problem becomes more acute – the uncertainty regarding the sovereign’s taxation policies
might itself serve as an impediment to productive investment. Unfortunately, the longer a sovereign rolls over
its debt to pretend that conditions are somehow normal, the worse the overall situation gets and the greater will
be the uncertainty. Put differently, the more debt the country takes on, the less effective its ultimate growth
impact will be and the less sustainable its debt situation becomes.
Most of the problem Eurozone countries today are effectively debt zombies thanks to the ECB’s promises to
support their debt. Greece simply cannot invest or grow with debt/GDP at 178% and unemployment over
25%. Nor can Portugal, Ireland and perhaps even Spain or Italy, all of which have high debt ratios, weak
growth and high unemployment. The Euro authorities’ willingness to load up these countries with even more
debt in the pretence of an organic recovery as such is doomed to failure.
Default and/or structural change
When faced with economic zombification, the only way to stimulate real investment growth is to permit the
destructive part of capitalism to function. Inefficient borrowers should be starved of debt finance and allowed
to fail. The capacity reductions and industrial cleansing that this will entail will permit the resumption of
genuine growth, albeit with near-term pain.
In a corporate context, the free markets (if they are permitted to function) already have the mechanisms to
resolve a debt problem. When debt levels reach a stage where the prospect of repayment seems remote, a debtor
needs to restructure and come up with a plan that will maximize his debt payment capacity, while minimizing
his payments. A so-called Chapter 11 bankruptcy restructuring in the U.S. allows such adjustments to occur
under the direction of a judicial supervisor who takes into account the various interest groups that need to be
paid, with the overriding intent being to maximize the value of the enterprise for all parties.
On the sovereign front, things are much less clear cut. A sovereign default does not entail the enslavement of
the defaulting country’s people or the immediate seizure of its assets. Rather it is a negotiated restructuring
where the country in question can often dictate what it is prepared to do in the context of what it might lose
were it to treat its creditors unfairly. Typically, a sovereign default involves painful domestic structural and
government reform, but with the benefit of sharply lowered payments as the debt gets written down to levels
2014
MAR
that become manageable. When done cooperatively with help from other sovereigns that trade with our
defaulting country, the whole process can be handled effectively, as long as it is done in an environment
where the political authorities retain the necessary domestic authority and credibility.
UPDATE
Unfortunately, this should have been the adjustment that most of the developed world should have undergone
post 2008. Fiscal resources should have been applied to dealing with the growth fallouts from such restructuring
rather than prolonging the zombification phase.
Systemic failure
When multiple corporate debtors default at the same time, we could have a market breakdown because of a
total aversion to risk among the lenders. This is akin to what happened in 2008 with the default of Lehman
Brothers. While the firm itself may not have had enough borrowings to compromise lenders, the uncertainty
coming from the prospect of cascading defaults caused a complete breakdown in the U.S. financial system.
Stabilizing the situation required substantial injections of capital from the U.S. government as well as
extraordinary measures from the Fed.
On the sovereign front, default can lead to similar system-wide effects. The first default on debt by Mexico in
1982, on its $80 billion of debt, led to a cascading sequence of defaults by 26 more nations whose borrowings
totaled $239 billion. This in turn, resulted in financial distress across most of the developed world as numerous
banks suffered huge losses and very likely exacerbated the recessionary conditions in the world.
The sovereign situation today is no different and, in some ways, much worse than what prevailed in 1982.
Numerous nations in the developed world are teetering on the brink of default. Greece, Portugal, Ireland
and perhaps even Spain and Italy are in considerable economic distress with huge debt levels. A default by
even tiny Greece might trigger a cascading sequence of defaults that might ultimately break the Eurozone
apart. Again, China is currently seeing its domestic trust market experience its “Lehman moment.” Were this
to snowball into a more serious credit revulsion in the country, it could have seismic implications for global
credit at large, potentially triggering a 2008 style crisis. Japan is struggling with colossal debt levels and is
printing money at a frenetic pace. Any loss of confidence in the nation could slaughter the yen and prompt a
disorderly, global exchange rate adjustment.
On the corporate front, the situation is equally dire. The largest financial firms have become even larger
since 2008. They have gone from being “too big to fail” to “too big to save,” even with the full resources of the
sovereigns. The pre-2007 era was characterized by hope and fraudulent but vibrant real-estate lending. The
post-2008 period is one of cynicism and zombification – the developed world’s economies are static and many
firms are in trouble, but free money ensures that the undead live on. If the credit spigot were to be turned off,
it could quickly bring about numerous corporate bankruptcies and a total credit market breakdown.
The policy mix in the developed world since 2009 of refusing to accept reality has meant that many corporate
and sovereign borrowers today are debt zombies that need to restructure. Had the world undergone such a
restructuring in 2008, it would have likely involved mostly the corporate, and specifically the financial sector.
Most sovereigns then, except perhaps Greece and Portugal, were in relative good fiscal health. As such, the
pain such an adjustment would have entailed could have been minimized with appropriately tailored fiscal
policy. Unfortunately, the primary result of prolonging the adjustment is that a number of sovereigns have
joined the zombie club. Any restructuring today will almost certainly involve more entities both corporate
and sovereign, and as such, is much more likely to result in a systemic breakdown. By avoiding near-term
pain, policymakers have dramatically increased the risk of a financial catastrophe.
2014
MAR
3. Is everything priced in by markets?
UPDATE
Human beings operate with a psychological crutch referred to as the normalcy bias when faced with a potential
disaster. The normalcy bias is a tendency we have to systematically underestimate both the probability and
the scale of a potential disaster when it is of a type that we have never experienced. The logic behind such
thinking is that since such a disaster has never occurred, it will never occur either. Our history allows us to
persist with this justification even when the current evidence, viewed dispassionately, might suggest a more
extreme outcome. In fact, the normalcy bias causes us to dismiss bad news or, even worse, interpret it as good
news because our belief structure is so deeply set up for the benign outcome that we are conditioned to expect.
The normalcy bias usually results in huge, often avoidable losses in disaster situations simply because planners
refused to consider highly likely outcomes. Witness for example that several hundred victims of Hurricane
Katrina lost their lives because they could not believe that the levees in New Orleans would break simply
because they had not done so in the past. These unfortunates, in fact, could actually see the water levels rising!
On the investment front, few anticipated the decline in U.S. home prices in 2007-2008 and the subsequent
collapse of the U.S. financial system in 2008 for the simple reason that they had had no experience with either
outcome in their past. In fact, most seasoned financial veterans, including our genius policymakers, spent the
2007-2008 period first arguing against a decline in home prices and then against the prospect of even a mild
U.S. recession let alone a global economic and financial crisis.
We would argue that the markets today are operating with the same normalcy bias that characterized the
period leading up to 2007. Since the Fed began its QE in 2009, to be joined shortly after by several other global
central banks, investors have come increasingly to rely on the market distortions engineered by policymakers
rather than focus on the underlying facts. With fundamentals not improving, and arguably getting worse
over the last few years, and the ability of policymakers to continue their interventions becoming increasingly
questionable, we might be setting up for an epic market adjustment that might make even 2008 look like a
relative walk in the park. Yet, markets today do not just ignore such risk – they seem to believe that conditions
are less risky than at any time in recent memory, except perhaps for a brief period in 2006 leading up to the
events of 2007-2008. And it is precisely in this that we perceive substantial opportunity.
4. Investment opportunities
We believe that conditions are such that the Fed is going to continue its tapering this year unless extreme
conditions force it to alter its pace of reduction. China also appears intent in stopping or at least slowing its
runaway credit growth. The ECB is currently talking about unconventional monetary policy (including QE),
but seems unlikely to act aggressively in the near term. The Euro Parliament elections in May, which might
result in a significant boost to the representation of Euro-sceptic parties, could also trigger a sea change in
European attitudes especially in regard to support for extreme actions by the ECB. Japan is the only major
developed country that should keep its monetary spigot wide open, though it is unlikely to increase the pace
of QE in the near term. Thus, we believe that the tide of monetary liquidity is ebbing and with it will come
the recognition of reality as well.
The liquidity injected into the global financial system over the last few years has been so vast that any attempt
to wind it down could lead to potentially catastrophic adjustments. We believe that there is a high likelihood
of the following over the next several months:
1) A sequence of sovereign defaults in the Eurozone with the possible creation of a second Euro bloc of
weaker Eurozone countries.
2014
MAR
2) A huge correction in the leveraged credit markets, where participants finally begin to understand that the
only value in their holdings comes from the prospect of a greater fool who might buy them.
UPDATE
3) A collapse in global growth as a Chinese slowdown takes hold and the Eurozone disintegrates. Most
countries, and especially the U.S., may not be able to avoid this outcome given the woeful state of public
finances. This should result in a collapse of sovereign bond yields with European sovereign bonds, for
example, trading well below 1% on the 10-year maturity.
4) A breakdown in the U.S. dollar-centric world order as the emerging countries, led by Russia, create alternate
payment arrangements to be free from the U.S.’ monetary policy. This could mean a complete decoupling
of emerging markets from the developed world.
5) A currency war as Japan tries to inflate its way out of the global slowdown with a much weaker currency.
This could help Japanese stocks but lead to a huge fall in Japanese government bonds.
The normalcy bias in the markets is more than apparent since the above outcomes are not even remotely
being priced in. Market participants are wildly bullish about the Eurozone as evidenced by the return of
confirmed zombies such as Ireland, Portugal and Greece to the bond markets. Credit spreads are at levels that
we have never seen except during the wildly speculative period of 2006. Most observers expect rates to trend
up the world over since growth has supposedly resumed in force everywhere. The U.S. is still perceived as the
dominant financial nation in the world with the dollar being the currency of choice for risky times. And the
Japanese QE is expected by many to yield no result with the country potentially slipping back into deflation
(if bond yields there are any indication) despite the resolution of the authorities there to engineer inflation.
History gives us little to rely on when we look at the world today. We have never seen such high fiscal deficits
globally in the last fifty years, nor have we experienced unconventional if not experimental policies such as
QE. We have not in our lifetimes experienced policymakers relying on and actually creating asset bubbles for
generating economic growth. And we have rarely seen such euphoria among investors who rely only on the
omnipotence of policymakers rather than the fundamentals of the securities they invest in.
Markets today have a normalcy bias in a world which is anything but normal. We believe that the facts are very
much on our side in going against the market consensus.
Our funds are positioned to profit from the seismic changes above that we expect. We are particularly excited
by the fact that the risk in betting on the above highly likely outcomes is currently minimal. The payoffs
however are enormous. The only time we have seen opportunities with a more skewed reward to risk payoff
was in 2006 when the credit bubble was in full swing. We are readying ourselves for an encore to 2007-2008.
We fully expect the fundamental nature of investing itself will change when the above adjustments occur.
5. Conclusion
We have always been firm believers in the free markets. The invisible hand of Adam Smith has delivered
decades, if not centuries, of prosperity to those who have embraced it. The accumulated wisdom over the
years has taught us that the governments should work to keep the free markets actually free by regulating them
adequately so as to prevent thieves and profiteers from breaking the rules under which they operate for their
personal benefit.
Yet, the markets in our enlightened world of today are anything but free. Policymakers have responded to
the crisis of 2007-2008 (which was itself caused by years of economic mismanagement) by rigging virtually
every market be it for fixed-income, credit or equities. Such fixing has been either direct with central bank
intervention, or indirect because of the prospects of a bailout. Rigged markets rarely deliver good outcomes
2014
MAR
UPDATE
and there is no reason to believe that this time things will be any different. Investors believe unquestioningly
in the hype that policymakers and Wall Street are only too happy to provide and, in doing so, are essentially
picking up pennies in front of the proverbial steam-roller. They may soon find out that being run over is not
exactly pleasant.
Performance Summary at March 31, 2014
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)
-1.2%
-4.4%
-5.1%
-10.5%
-1.9%
-0.8%
-3.2%
9.0%
-4.4%
8.1%
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%
-4.3%
-5.2%
-10.6%
-1.0%
-3.2%
9.0%
8.4%
-4.3%
14.9%
Nothing herein should be read to constitute an offer or solicitation by Trident Investment Management, LLC or its principal to provide investment
advisory services to any person or entity. This is not to be construed as a public offering of securities in any jurisdiction of Canada. The offering of
units of the Trident Global Opportunities Fund are made pursuant to the Offering Memorandum only to those investors in jurisdictions of Canada
who meet certain eligibility or minimum purchase requirements. Important information about the Funds, including a statement of the Fund’s
fundamental investment objective, is contained in the Offering Memorandum. Obtain a copy of the Offering Memorandum and read it carefully
before making an investment decision. These Funds are for sophisticated investors only. ®CI Investments and the CI Investments design are
registered trademarks of CI Investments Inc.
2014
MAR