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
September 30, 2012
Performance Discussion
Markets were generally euphoric in September following central bank action. The S&P 500 Index was up
2.42%, the MSCI Europe Index was up 0.73% and the Nikkei up 0.34%. Bonds suffered with yields on the
10-year Treasury climbing 0.08% to end at 1.63%. The dollar was weaker with the Trade Weighted Dollar
depreciating 1.18%. Commodities were mixed with gold rising 4.73% to end at $1,772.1 an ounce and oil
down 4.44% to $92.19 a barrel. The general bullishness was also prevalent in credit where spreads tightened
overall (all figures in U.S. dollars).
Our funds were almost unchanged in September. We were hurt by our long fixed-income investments and
our short credit positions. Our longs in gold and defensive equities helped just enough to offset our losses even
accounting for our index hedges. We remain convinced that a global market accident is likely and that the
events of September have only increased the chances of the same. As such, we have used the sell-offs in fixed
income over the month to add to our already sizeable exposure, albeit almost entirely with options. We have
also initiated some significant new positions in the currency markets where we expect a major realignment.
Market Outlook and Strategy2011 Review
The weak economic conditions of the summer continued into September, with data from most of the
world coming in generally below expectations. Europe seems firmly in a recession, the U.S. has decelerated
significantly with no prospect of near-term improvement and Japan has weakened much more dramatically
than had been expected. The emerging world has slowed down too with China, in particular, not showing
any signs of a turnaround. The data overall show a slow-growing world, albeit not one in the throes of a
dramatic recession.
The recent data on the weakening global economy appears to have been enough to force many of the developed
world’s central banks to hit their panic buttons with dramatic expansions in monetary accommodation. We
take up the major measures announced over September on the monetary policy front below and then
discuss the investment implications.
1. The European Central Bank as Eurozone Crisis-Fighter
The European Central Bank (ECB) moved early in September to address the crisis facing the Eurozone. For
several months, the troubled EU nations of Greece, Portugal and Ireland have been virtually shut out from
the bond markets relying almost entirely on official lenders for their funding. More recently, markets have
balked at funding the debt issuance of both Spain and Italy by demanding much higher interest rates. The
higher interest rates raise concerns about the sustainability of their debt, leading in turn to a vicious feedback
loop of even higher rates. The financing needs of Spain and Italy cannot be met just by official lending from
other EU countries or the emergency facilities set up for that purpose. As such, the ECB was spurred into
action to support these nations.
The ECB is prohibited from financing member governments by the Maastricht Treaty under which it was
established. In particular, it cannot purchase bonds at issuance from the governments. However, it can
2012
SEPT
UPDATE
engage in secondary market bond purchases as part of its normal monetary open-market operations. The
ECB’s intervening to support the bond markets of member nations, therefore, is inherently against the
spirit of its governing treaty. The institution however managed to come up with a convoluted argument to
justify such intervention.
The ECB’s logic is as follows:
1) The Euro project is irreversible. As such, the idea that a nation currently in the Eurozone could exit is heresy.
2) T
he high interest rates demanded of the weaker EU nations were largely a consequence of market concerns
about their potential exit from the Eurozone.
3) T
he divergent interest rates across countries preclude the proper transmission of monetary policy, essentially
because interest rates should be largely the same across a single monetary zone.
With points (1) and (2) above, the ECB essentially dismissed market concerns about the solvency of EU
member nations. With point (3) it provided a specious argument for bond purchases to ensure proper
monetary “transmission.” Its argument should be seen for what it is: a thinly disguised excuse to hide its
arrogation of the power to monetize EU debt.
The specific actions the ECB announced were that it might intervene to backstop the bond markets of
an affected EU country by purchasing short-term sovereign bonds of maturities less than three years. The
ECB left the size of these so-called Outright Monetary Transactions (OMT) unspecified and pledged
that such purchases would only be in the secondary markets to ensure that it was not engaging in the
prohibited activity of directly financing governments. In a concession to those in the governing council
who were opposed to these actions, the ECB made its potential purchases contingent on the affected
nations’ formally applying to the EU for assistance through established vehicles like the European
Stability Mechanism (ESM). To the extent such aid came with conditions attached, the recipient had to
abide by these conditions to be eligible for ECB support. The ECB made such conditionality a necessary,
though not sufficient, requirement for support. That is, the ECB council could, at least in theory, reject
intervention even when an affected nation had met all the conditions needed for ECB support. Also,
the ECB terminated its bond purchases under existing programs such as the Securities Market Program
expecting in future to intervene only through OMT.
The ECB’s announcement is decidedly against the founding philosophy of the Eurozone. The Maastricht
prohibition on the ECB’s ability to finance governments stemmed from the expectation that the public
markets would prove a disciplining force for profligate nations. As such, ECB intervention would have
distorted the workings of the markets increasing the risks to the more responsible member nations. A simpler
approach to allow the ECB to monetize the debt of problem states would of course have been to modify the
Treaty itself. However, such a step would have meant that the parliaments of all the EU nations would have
to approve the change – something that the politicians of the region can ill afford given public antipathy
towards bailouts.
The ECB’s announcement is at best a mixed bag. On the one hand there is the definite promise of potentially
unlimited firepower to stabilize bond markets. Yet, the conditionality attached for intervention means that
nations like Spain or Italy that seek such assistance need to cede domestic fiscal sovereignty to EU authorities
and the IMF, an unpalatable outcome for the country’s politicians. Moreover, the euphoric stock and bond
market reaction to the ECB measures has alleviated the crisis mentality across Europe and has convinced
2012
SEPT
UPDATE
the policymakers of problem countries that aid with draconian conditionality may not be necessary at all.
As such, neither Spain nor Italy has applied for ESM support, hoping that a no-strings-attached bailout can
somehow be negotiated in the future. Unfortunately, this only increases the vulnerability of the region as a
whole because it has delayed the urgent structural changes that are necessary in the crisis countries to ensure
a long-term solution to their problems.
2. Quantitative Easing (QE) to Infinity in the U.S.
The US Federal Reserve refused to be outdone by the ECB. In September, the Fed announced a new program
of additional quantitative easing (QE) to shore up the anemic U.S. economy. Specifically, it committed to an
additional $40 billion in monthly mortgage purchases. It indicated that it could expand such intervention, if
needed, to other markets as long as the US economy remained weak and unemployment remained high. The
Fed also expanded the period over which it pledged to keep rates pegged at virtually zero in the short-end to
2015 – a time when the current Fed board and chairman would not even be in office.
The Fed’s announcements were momentous in many respects. The Fed’s so called dual mandate established
by the Federal Reserve Act (as modified in 1977) directs it to set monetary policy to promote the goals of
maximum employment, stable prices and moderate long-term interest rates. A central bank has the tools to set
interest rates and affect the money supply. However, growth, unemployment and other real economic factors
are determined by the actions of the agents in the economy responding to monetary, fiscal, political and other
considerations. The Fed has about as much influence on unemployment as it does on income distribution or
world peace. By linking its monetary actions to objectives that are patently not under its control, the Fed has
put us firmly on the road to disaster. We are no longer in the realm now even of unconventional monetary
policy, but instead are participants in a grand monetary experiment where unelected central banking officials
have taken on the role of central planning with inappropriate tools. Bernanke can be likened to a woodcutter
attempting delicate brain surgery with an axe. The action is breathtaking in its hubris, but it would be sheer
lunacy to expect it to produce happy macro outcomes.
3. Will the Bank of Japan (BOJ) join the party?
Even before the U.S. and EU monetary actions, Japan faced an unpleasant combination of a relatively strong
currency and weak growth among its major trading partners. The country has recently also seen a rise in
political tensions with China, one of its largest trading partners, because of a dispute relating to ownership of a
few uninhabited islands (variously referred to as the Senkaku and Diayou islands by the Japanese and Chinese
respectively) in the South China Sea. The dispute between the two nations turned into outright anti-Japan
sentiment and boycotts in September across China. Several Japanese firms operating in China were forced
to suspend operations during the month due to violent protests across the country. The weak exports and
Chinese tensions have served to depress Japanese consumer sentiment and domestic growth. However, Japan
has little fiscal room to address its flagging growth. The country labors under the highest sovereign debt to
GDP ratio in the developed world and is working to rein in its government deficits. In fact, the politicians in
the country recently legislated an increase in consumption taxes that will take effect next year. The ultimate
repayment of Japan’s staggering sovereign debt is a matter of some concern to most observers who look at its
debt and demographic profile.
The Japanese yen has become a safe haven for investors escaping the monetization efforts of the Fed and
the potential breakup of the Eurozone despite the country’s difficult economic situation. The yen has
strengthened over the last several months hurting the country’s exports and increasing deflationary pressures.
2012
SEPT
UPDATE
A significant, engineered depreciation of the yen would address both problems. While currency intervention
is in the domain of the Ministry of Finance, the unsterilized monetization that might be needed to achieve a
dramatic decline in the yen would require the cooperation of the BOJ. Pressure on the Japanese central bank
has intensified of late, with lawmakers threatening to curtail the institution’s independence and force it to
conduct policy aimed at achieving specific economic goals.
The Bank of Japan has started to bow to such pressure. In its last meeting in September, it decided to expand its
outright purchases of securities by ¥10 trillion (about $127 billion) from the earlier program size of ¥70 trillion.
The institution did not increase its monthly purchases of securities however – the additional purchases were
to be undertaken through an increase in the duration of such purchases. The BOJ’s board has recently seen
the addition of two relatively dovish, and market friendly economists. Early in 2013, the current governor and
his deputy will be retiring, and it is likely that their replacements will also be considerably more dovish than
the old guard. As such, we can expect more aggressive action on the monetary front from the BOJ. We believe
that this has been happening already, albeit at a glacial pace. The Fed’s newest QE and the ECB’s potential
monetization’s could finally move the BOJ to react at their version of warp speed.
Despite all three of the developed world’s central banks moving potentially to increased monetization, their
philosophies regarding this approach are really quite different. The table below summarizes the basic elements
of QE thinking and implementation among the largest 3 global central banks:
The Fed globally remains the only true cheerleader for QE, even if other central banks are being forced into
this approach. It views this as a panacea for everything that ails the U.S., if not the global, economy despite
virtually all of economic science which suggests that its approach may be fraught with risks. In this context
it is important to note that the Bank of Japan, despite its use of QE to a limited degree since 2001, continues
to insist that the policy is not a solution for the current global situation. Its arguments merit consideration
because the BOJ, alone among the central banks, has a mountain of actual evidence from Japan relating to
the efficacy of this approach.
4. An Analysis of Credit Bubbles and their Aftermath
2012
SEPT
4.1 The Japanese Bubble Experience
UPDATE
During the 1980s, the Japanese economy had an enviable combination of a relatively weak exchange rate and
high trade surpluses, efficient manufacturing and high savings. By the Plaza Accord of 1985, Japan agreed,
with other nations, to a significant appreciation of the yen against the U.S. dollar. To offset the impact of the
strong yen on the domestic manufacturing sector, the Bank of Japan countered with easy monetary policy that
worked to create a domestic boom. The boom was in large part fueled by real estate with banks being the major
facilitators. By the end of the 1980s, Japanese real estate prices were such that land occupied by the Imperial
Palace in Tokyo was worth more than the entire state of California! Not surprisingly, the largest banks in the
world were virtually all Japanese as well. And the Nikkei hit its all-time high close to 40,000 in 1989.
When the Japanese real estate bubble deflated, virtually all the country’s banks were bankrupted by the
crippling losses they sustained. The government engaged in a series of capital injections over the next few
years to shore up the financial system and the BOJ provided banks with ample liquidity by lowering rates
to rock bottom levels and keeping them there. To keep the economy growing, the government also used its
own balance sheet and became a direct lender to construction and other industries through various special
building and infrastructure programs. The government’s incentives may have forestalled a steep, short-term
decline in the Japanese economy, but it did little to arrest the long-term malaise that has since characterized
the country.
Post 1991, the Japanese banks had shrinking balance sheets. Much of the shrinkage can be attributed to a
paucity of capital. Yet, most banks in that constrained era were prepared to lend at attractive rates to high quality
firms like Toyota and Honda. However, these healthy companies did not look to additional bank financing at
all – in fact, they became increasingly cash rich. There was also no shortage of firms that desperately wanted
financing, but they were essentially shut out of the loan market because the banks knew that they were
unlikely to repay. Banks generally parked their funds in government bonds, using the BOJ’s cheap funding to
lever themselves for these purchases. Thus, there was adequate liquidity but no lending activity to speak of.
The Japanese experience teaches us some important lessons. First, the aftermath of a leverage-induced bubble
is not pleasant – the economy needs substantial time to adapt to the changed reality and new investment
opportunities are not easy to find. If the lending opportunities are in fact so plentiful, one can reasonably
expect new well-capitalized banks to be set up to capitalize on the same, even if the older financial firms are
bankrupted. However, this did not occur to any significant degree in Japan. Next, while QE in this context
may reduce borrowing costs, it will have little to no effect in igniting an investment boom and strong growth.
Yet, it will very likely expose the economy to much greater risks such as high (or hyper) inflation, and more
market bubbles, all of which could prove much more costly.
4.2 The post-Asian-crisis Credit Bubble and Aftermath
The economic collapse in Asia in 1997 was a severe global demand shock and was inherently deflationary. The
Fed responded to the Asian crisis with considerably easier monetary policy and was successful in engineering
low inflation in the U.S. notwithstanding the collapse in Asian export and commodity prices. The Fed’s
actions were also mirrored to a degree by other central banks and so we had a world that was awash even then
in cheap credit. The plentiful supply of loans meant an investment boom and a consumption boom fuelled
by higher asset prices. The telecoms, media and technology (TMT) bubble of 1999-2000 was almost entirely
a consequence of overly easy policy that unleashed speculative fury, not to mention real excess investment
into these supposedly new growth areas. The collapse in the bubble in 2000 and 2001 led to an overall decline
2012
SEPT
UPDATE
in global growth. The Fed and other central banks responded to this with even easier monetary policy that
ignited an even larger housing bubble. Unfortunately, when the housing bubble was pricked in 2007-2008
with home valuations declining by 30% or more across the U.S. and other bubble markets, the associated
leverage had to be written down. Since the entire financial system was involved heavily in lending to housing,
its virtual bankruptcy was a foregone conclusion.
The unfortunate fact is that post 1997, much of the growth in the developed world came from the assumption
of leverage. To keep the growth going, central banks encouraged even more credit creation every time the
developed economies slowed, no matter what the consequences.
When we have an extended period of easy credit, there are two major unpleasant consequences. First, lenders
will fund virtually every investment whose risk-adjusted returns are superior to their funding costs. This is
the standard transmission mechanism for monetary policy in classical economic theory. Next, the pricing
of risk itself will get distorted with most investments soon being viewed as being much safer than they really
are. The latter effect arises because a cash flow deficient business can simply borrow to cover its debt service
and will likely continue to do so until the credit spigot runs dry. The fact that it is current in its Ponzi scheme
payments will in itself reduce the perceived risk in lending to it. Even worse, when the central bank is the
lender in question and the financial system is the business, there is little chance that the latter will show any
discipline in its lending. Put differently, if the government provides free money to the banks, and bears the
entire cost of bad loans while the banks get all the benefits from good loans, there is likely to be an orgy of
lending with over-investment economy-wide. After a decade of such lending, good investment opportunities
are likely to be scarce. Thus, even if credit provision becomes normal, it is unlikely that there will be enough
demand for credit from high-quality borrowers.
Post 2008, the U.S. and other bubble-pricked countries faced two constraints on the monetary front. On
the supply side, their financial intermediaries were essentially bankrupt making new credit prohibitively
expensive to fresh borrowers. The U.S. Government’s Troubled Asset Relief Program, the Fed’s taking rates to
zero and its huge $12 trillion+ open-ended guarantees to the financial system largely worked to deal with the
supply issues. Yet, the demand side is arguably more important than the supply side, as shown by the Japanese
experience. Even though the Japanese credit bubble lasted a scant five years, the country is still suffering its
aftermath two decades later!
The Fed, however, remains undeterred by history or experience. Chairman Bernanke believes that with
enough QE, growth, reduction in unemployment and other happy outcomes can be achieved. If the other
global central banks match the Fed’s QE policies, it will not be possible for the Fed to achieve much growth
through exports or inflation through a sharply weaker US dollar. However, the institution can drive up asset
prices further forcing markets to be even more divorced from reality. The logic of the Fed’s new QE Infinity
then is to engender public “confidence” with rising asset prices which might in turn create an investment
or consumption boom. Banks know full well that strong loan growth in this environment is madness – there
is a shortage of high quality investment opportunity which is why the cash reserves of the banks remain
exceptionally high. Yet, a consumption boom among borrowers with no income growth and too much debt
to handle seems equally insane. Therefore, what we have is central banking policy predicated on a rise in
asset prices that cannot ultimately be justified by fundamentals – a true centrally planned bubble! If the ECB
joins this party propping up quasi-bankrupt sovereigns with QE, we will have the two largest economies in the
world actively working to impose their fantasy valuations on markets.
2012
SEPT
5. Investment Implications
UPDATE
The monetary steps taken by the Fed and ECB in September have made the investment environment
scarier, but in some ways simpler for the long-term. Most of the QE countries today have bond markets that
are in major bubble territory. The bonds of the U.S., UK, Japan and even Germany (and by extension the
EU) are now roundly overvalued. As a case in point, real rates in the U.S. as suggested by the inflation linked
bonds are negative at -0.80%, despite the country’s soaring debt and deficits. German 2-year bonds have had
negative nominal yields through much of this year despite the fact that Germany is now effectively looking
to bail out the entire EU, a task that is far beyond even its fiscal capabilities. We have become much more
bearish on the bonds of the QE-drugged nations and have increased our short positions considerably. A
sudden collapse in bond valuations in these countries triggered by either higher inflation or currency turmoil
cannot be ruled out.
The bonds of the more solvent nations such as Norway, Sweden, Korea, Singapore, Australia and Canada
yield, on average, more than their bubble counterparts, despite generally lower inflation across many of
these nations. Yet, given the capital flows induced by QE, these bonds trade lock-step with those in problem
nations. We expect a decoupling to occur once problems start to surface in the QE countries, and accordingly
have been increasing our positions in bond spreads where we purchase the bonds of our solvent nations and
short those in the QE countries.
The attraction of gold has also increased with the central bankers’ recent actions. The paper currencies of
much of the developed world are no longer a good store of value in contrast to gold whose supply is still
limited. As such, most major global currencies could re-price substantially against gold. A move in gold, even
conservatively, to $2,500/oz or above is likely over the medium term. A true super-spike in the commodity to
$5,000/oz+ is also possible. Accordingly, we have been increasing our exposure to gold and to a lesser degree
gold stocks as well. Much of our new exposure is through options – we want the gearing for the moon shot.
We believe that the equity markets in Japan as well as in much of the developing world offer an extremely
good opportunity today. The Japanese equity market is currently pricing in a continuation of the country’s
problems. It trades at a significant discount to the US market, even as many of its asset rich companies
are valued substantially below book. Many of Japan’s oil and commodity giants are at huge discounts to
the global counterparts. Moreover we believe that a dramatic change in Japanese monetary policy may be
imminent forcing a re-pricing of Japanese assets. The emerging stock markets trade at valuations that are
comparable to those in the US, with some at small discounts. As such, they are not as attractively valued as
the markets in Japan. However, they offer much better longer-term prospects with an enviable combination
of good demographics, strong growth, low costs and reasonable fiscal fundamentals. We believe also that the
developing world could soon decouple from the developed world thanks to the strains induced by QE. In that
situation, we expect a major shift in relative valuations with the developing world going back the premium
equity valuations that persisted prior to the Asian crisis of 1997. We have recently started to increase our
exposure to the equity markets of both Japan and the developing world.
Finally, we believe the U.S. dollar’s reserve currency status may be entering its final phase. The recent
meetings of the International Monetary Fund in Tokyo reflected the deep divisions that Bernanke has created
in the world with his policies. By trying to ensure currency stability against the U.S. dollar, the developing
world is asking for higher inflation and commodity prices – something that they can ill afford. By revaluing,
they run the risk of a serious near-term decline in growth. Many of the developing world’s central bankers have
2012
SEPT
UPDATE
berated QE, with some describing it as a “selfish” U.S. policy which it most certainly is. Bernanke responded
to these challenges by arguing that QE was right for the U.S. and that the emerging countries which felt the
strains should do the obvious and revalue. As such, the Fed is literally begging for a devaluation of the U.S.
dollar. The Euro could also use a big devaluation against its trading partners to help the beleaguered nations
in its group. Japan could use a weaker yen to help fight deflation. The emerging countries in this context
offer the best currency upside. We have recently established significant long positions in a group of emerging
country currencies against the U.S. dollar.
6. Conclusion
The world today is far from being out of crisis even though a casual observer looking at the markets could well
be made to believe otherwise. The Fed, and sadly, the ECB appear to have taken on the mantle of central
planning on a colossal scale, engineering wealth transfers that by any metric are stupendous. The BOJ and
other central banks are being slowly but steadily dragged into this world of monetary planning, even though
their instincts and experience warn them of its dangers. Henry Ford once said: “It is well that the people
of the nation do not understand our banking and monetary system, for if they did, I believe there would
be a revolution before tomorrow morning.” We believe that tomorrow morning is fast approaching and are
positioning our funds to profit from at least the market revolution that is virtually certain.
Performance Summary at September 30, 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)
2.6%
3.9%
-3.9%
0.2%
-1.0%
11.6%
11.0%
0.6%
9.9%
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)
2.5%
3.7%
-3.9%
-1.0%
11.1%
11.8%
13.2%
0.6%
16.8%
0.0%
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
SEPT