Opportunities Funds Commentary

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UPDATE
Trident Investment Management, LLC
Opportunities Funds Commentary
June 30, 2015
Market outlook and portfolio strategy
The last few weeks have been very eventful in the markets. The Greek situation is finally nearing a true resolution
despite the policymakers’ manic efforts to kick this can down the road. The Greek turmoil is distracting from
another crisis that is brewing in China’s equity and credit markets. We consider both these crises in detail below,
and then turn to how we can profit from these events.
The Greek tragedy
The Greek crisis that started in 2010 appears at long last to be coming to a head. The economic situation has
been almost unbearably bleak in the country for the last several years and what is perhaps most surprising is how
long this crisis has been allowed to fester. There has also been considerable misinformation about the origin and
the nature of this crisis to the point where most market participants do not fully appreciate what is truly going on
in Greece. To fully understand the crisis in Greece and its implications for the Eurozone, we need to understand
the logic behind the Maastricht Treaty of 1992 and the move from that to the actual creation of the Eurozone in
1999 with the launch of the euro. We take this up in detail below.
1.1 Eurozone – philosophy and intent
The Maastricht Treaty was intended to integrate its European members into a common economic and monetary
union while not impinging on individual members’ sovereignty. As such, the agreement laid out strict criteria
for economic union regarding budget deficits, debt amounts and exchange rates across member states so that the
nations could “converge” or become very similar in economic terms before true currency union occurred. The
idea behind convergence was that Euro-wide monetary policies post-convergence would have broadly the same
effects across member nations given their economic positioning. To the extent that the Maastricht Treaty dealt
with political or fiscal union, it was in setting up supra-national institutions such as the European Commission,
Parliament and Court of Justice to deal with a variety of issues that members felt would be better handled at a
union-wide level. The Treaty explicitly did not attempt to interfere with members’ domestic policies unless they
resulted in significant breaching of the convergence criteria for accession to and membership in the union.
The Maastricht treaty set the framework for the creation of the euro in 1999. The converged member states at
that point adopted a common currency, the euro. The supervision of this currency was delegated to the European
Central Bank (ECB) which was actually created by the Treaty of Amsterdam in 1998, even though the groundwork
had already been laid in Maastricht.
The ECB’s primary mandate by charter was to ensure price stability within the Eurozone. It was charged to act in
accordance with the principles of an open market economy with free competition and to favour efficient resource
allocation. The ECB’s charter reflected the simple view that the management of the euro currency had to operate
outside of national political agendas and pressure. As such, policy had to be set on a Euro-wide basis for the needs
of the region as a whole and not based on a single member state’s situation. The ECB was also explicitly precluded
from financing member governments directly or from being a lender of last resort to individual countries. It was
supposed to be an independent guardian for the euro currency that could not be swayed by national politics. The
Germans, who had to contend with repeated hyperinflations in the post World War I period, were the primary
architects of the ECB charter. As such, the ECB was largely modeled on the German Bundesbank which, when
created in 1957, was legendary for its independence.
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The Eurozone’s setup had a strong, and in retrospect, idealistic free market bias that pervaded every facet of its
creation. In particular:
UPDATE
- Nations were free to adopt their own policies while being loosely subject to the convergence criteria. As
such, markets had to discipline nations with poor policies both in terms of higher bond yields and reduced
investment flows.
- The monetary system could not be used for political advantage. The monetary rules were set and it was up to
member nations to adapt to them
- The supranational bodies were intended largely to deal with intra-European Union competition and other
pan-European issues. As such, these institutions ensured that the laws and taxes that affected cross-border
commerce could not be arbitrarily manipulated or changed. This simply meant a more level playing field for
all euro investors and corporates.
Thus, the Eurozone set up a simple set of rules for countries to be members and leveled the playing field somewhat
for cross border activities. It was up to the bureaucrats to ensure that the rules were followed and it was up to
markets to allocate capital efficiently and penalize policy offenders.
1.2 The failure of euro idealism in Greece
The Greek situation shows that even the best intentioned systems can be gamed with enough venal participants.
Greece adopted the euro in 2001 on the basis of its 1997-1999 fiscal accounts – the country had not met the
convergence criteria in periods prior to that. Unfortunately, ever since it entered the euro, the country has had
difficulties meeting the deficit and debt targets imposed by euro membership. In particular, Greece has had
repeated run-ins with Eurostat, the data gathering department for the Eurozone, because of the poor quality of
the data it provided on its national accounts. The country’s leaders used numerous questionable tactics to hide
the true state of its financial affairs to the point where the reported data significantly understated the actual deficits
and debt levels. In fact, the government of Prime Minister George Papandreou in 2009 revealed that Greek
deficits were much larger than what his predecessors had reported.
The euro’s designers would have logically expected that a nation which constantly attempted to circumvent
European Union (EU) economic rules would have been disciplined by the markets. Unfortunately, global banks
and large investors, particularly in the Eurozone, poured money into Greece blithely assuming that the country
had quasi-German economic fundamentals. They did so, even though these very same institutions had actually
helped Greece structure the complex transactions needed to hide their level of debt from EU regulators. The
influx of capital meant a boom in the Greek economy after euro entry. Instead of using the boom to reduce debt,
the Greek government actually increased its indebtedness with the sovereign debt/GDP ratio rising from about
94% in 1999 to about 114% in 2009.
After the 2007-2008 financial crisis, the era of easy money for Greece was finished. The country therefore had
to get its fiscal house in order to service its already high level of debt. Yet, its economy, whose growth was fuelled
mainly by cheap credit, began a long contraction from which it has yet to emerge. Since 2009 Greece has seen
a cumulative 25% GDP contraction, very high unemployment which has boosted social spending and anemic
export growth in part due to the straitjacket of a fixed exchange rate. As such, the country was (and still is) in a
bind where it could neither grow its GDP and tax revenues nor service its debt. As such, Greece’s sovereign debt/
GDP ratio has spiraled out of control going from about 114% in 2009 to about 175% today, and this too after a
significant writedown of debt by creditors in 2012.
The standard approach in dealing with an untenable situation as the one Greece faced in 2009 is to simply default
on all the debt, change the country’s leadership to a cadre that better understood the issues faced and restructure
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UPDATE
the domestic economy to improve debt servicing ability. This is in fact the standard operating procedure for the
International Monetary Fund (IMF) which has repeatedly inflicted its pain on the poor citizens of most developing
nations that have faced a crisis. The IMF’s guidelines for disbursement of money in fact require that the nation
requesting assistance develop a debt restructuring plan that can be deemed sustainable by its own staff.
The debt write-down approach if applied in a timely fashion would have meant huge losses for the clueless investors
who had poured money into Greece, among the biggest of whom were the European, and to a lesser but still
significant degree, U.S. banks. These institutions in 2009 were already insolvent thanks to their investing prowess in
the U.S. real estate market where they had levered up to purchase their own fraudulently originated, non-repayable
toxic derivatives.
Facing another potential banking crisis, the panicked EU officials scurried to structure a series of bailouts for
Greece which were nothing other than an elaborate fiction. In particular, the bailouts largely replaced private
sector loans to Greece with official lending thus transferring most of the private sector losses onto the backs of the
European taxpayer. There was no plan moreover to restructure Greece and get it on a sustainable growth path.
Instead the official EU lenders imposed fiscal austerity on Greece forcing it to generate a primary budget surplus
which had the unfortunate effect of simply hastening the country’s economic collapse. The fact that these bailouts
were nothing but smoke and mirrors was apparent even in 2010 when the IMF’s own staff refused to sign off on the
Greek plan’s sustainability. Yet, the IMF made one of the biggest loans in its history to Greece anyway. The logic
for this disbursement was that this loan had to be made for “global stability,” a newly invented investment rationale.
The decisions in 2010-2012 to bail out Greece were not unanimous. Many of the Euro member states objected
on the basis that a full default might be preferable. Given that the German and French banks were the largest
beneficiaries, the bailouts were nevertheless pushed through with the compromise that the lenders would insist
on Greek austerity. This allowed the beneficiaries to argue that the debt would somehow be repaid. On the Greek
front, the corrupt leadership that had got the country into its mess was not replaced en masse. Instead, we had an
election that replaced one set of entrenched politicians with another equally culpable group that had the same
interest in perpetuating the status quo. The Greek leaders were happy to take the disbursed funds, or at least what
little of it represented new inflows to Greece, if only because they lacked the courage and the internal political
support necessary to even contemplate a full debt default.
The lender requirements for austerity coupled with little net official inflows meant that Greece entered a serious
depression from which it has shown no signs of exiting. The new loan funds disbursed were largely recycled to
repay prior loans made to the country with little left for domestic investment. Faced with such an environment,
the country’s banking system has had to contend with a vast number of bad loans (some estimates put the number
as high as 40% of all loans) and has been rendered insolvent. Recapitalizing these institutions means even more
capital which till now has meant even more debt. So Greece’s already unsustainable debt load simply keeps getting
larger – a clearly unstable outcome. Not surprisingly, there has been considerable capital flight from Greece which
again has required even more emergency lending from the ECB adding again to the country’s debt.
The most unfortunate part in all this is that the average Greek citizen despite his country’s increasing indebtedness,
has only endured more and more misery. His Eurozone counterpart has seen his indebtedness increase dramatically
too, but to no benefit either to him or to Greek citizens. The only beneficiaries in this whole process have been
a group of well-connected private sector lenders and corrupt policymakers that have simply hijacked the political
process to their benefit.
Scenario 1 – Cooperative debt relief
First, the country could arrive at an agreement with the troika that gives them substantial debt relief and a
true program for growth. This is undoubtedly the best of all choices, but we view it as being unlikely now both
because the scale of debt writedown needed by Greece and because of the moral hazard implications of the same.
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UPDATE
Significant debt relief for Greece is likely to be unpopular with most Euro populations which are already struggling
with crushing taxes and slow growth. Also, this might prompt other crisis nations such as Portugal and Spain to also
ask for debt relief especially if their governments change in elections expected later this year.
Scenario 2 – Unilateral debt default
Greece has the power to unilaterally default on all its debt and then attempt to restructure its economy for longerterm growth using the breathing room provided by not having to make debt payments. Such an approach is the one
that has long been advocated by the IMF for most developing countries that were typically better positioned than
Greece is today. A full default has the advantage that it removes any foreign creditor interference from domestic
Greek issues and leaves the country no alternatives other than to achieve trade and fiscal balance almost overnight
because no funding will be forthcoming either from foreigners or even from the domestic savers. All that Greece
can count on here is short-term, debtor-in-possession style financing from its trading partners to ensure that it is not
cut off from all international trading.
We believe that the Greek government should have declared a full moratorium on debt payments almost at the start
of this crisis. Greece is already close to primary fiscal balance – in fact, its creditors demand a considerable primary
fiscal surplus today. On the trade front, the country can likely achieve trade balance too, as long as the government
can manage the near-term shortages that are certain to occur due to that. But most importantly, a full default gives
the Greek government the necessary political consensus needed for structural change because the public realizes
then that all alternatives have been truly exhausted. The current government moreover, has strong public support,
is relatively free of legacy corruption issues and has a radical left-wing philosophy that makes it especially well suited
to force sacrifices on a weary public. The reason that the Greeks have not embraced this approach yet is because
this will likely test their membership in the Euro currency bloc.
The quickest way to trade balance is through a currency devaluation. Unfortunately, were Greece to stay in the
Eurozone, it cannot resort to this mechanism to boost trade. Therefore, it has to achieve the same effect by rationing
imports which can only be done by also restricting Euro availability which means capital controls. Unfortunately,
since Greece also uses Euros for domestic transactions, the restriction in Euro availability will make domestic
transactions much more difficult and likely exacerbate economic weakness. With greater weakness comes a loss
of confidence and continued capital flight, even with controls, which will mean further credit contraction and
weakness. Thus, were Greece to default, it has to deliver very quickly on its domestic reforms because if it does not,
it will have no choice but to leave the Eurozone.
Scenario 2.1 - Default and stay in the Eurozone
Greece can achieve a hybrid devaluation by creating a parallel currency which we shall call Euro-IOUs or EIs. The
EIs would be issued by the government and usable as payment for any domestic Greek transactions, in addition
to the Euro itself. Wages within Greece would be denominated at say an official 1:1 exchange rate between Euros
and EIs. However, the government, with its capital controls, would not allow for EIs to be convertible freely into
Euros at the official rate. With such a mechanism, the EIs will likely trade at a significant discount to the Euro
despite the 1:1 official parity – those who need their EIs converted to Euros immediately will therefore be hit with
a significant loss. The benefit of this parallel currency is that it now allows Greece to achieve a significant real
reduction of its Euro wages boosting competitiveness, while boosting net exports moving the country closer to
balance. If the government were effective in restructuring Greece, there is every likelihood that the EIs and Euros
will trade at parity even in the open (non-official) market eventually, which would represent the ultimate success
of this program.
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Scenario 2.1 - Default and exit the Eurozone
UPDATE
Greece could simply exit the Eurozone altogether after a full default and introduce a new currency that would replace
the Euro. This approach would be the same as that involving EIs, except that the EIs, which will we now rebrand as
the new Greek drachma, would be the official and only currency. The exchange rate of the drachma would be set
by the free markets after a short period of capital controls during the transition. There is no doubt that the converted
current Euro holdings of Greek citizens would be worth much less in drachmas. That is, a forced conversion to
drachmas would be a wealth tax on all Greeks and an effective income tax going forward on salary earners.
Scenario 3 - Extend and pretend – the bureaucracy favourite!
The last scenario would be of course the continuation of the status quo with some minor changes as the creditors
have repeatedly proposed. Greece would receive even more advantageous terms for its debt in terms of interest
rates and payback periods, at the expense of more real austerity, which in the best case might be a bit less in the
near-term than either of the above scenarios would require. This might represent at least superficially, a win-win
for all parties – Greece would remain in the Eurozone, it would restructure with foreign help, and it would likely
receive loan funds from its creditors to tide it over the adjustment.
The reason that this scenario is unworkable is that the Greek debt as it currently stands is simply too big to remain
serviceable. Giving more loans to Greece when its debt burden is already too high to manage might improve
matters in the near term but gets Greece no closer to fixing its problems. In fact, the unsustainability of Greek’s
debts is so obvious to everyone that any attempt to resume business as usual will simply mean more capital flight
which in turn will force the ECB and others into even more emergency funding. When viewed in this light, it
is remarkable that the Euro zone has seen it fit to advance so many loans to a country whose debt was already
unrepayable in 2010. Even more bizarrely, the IMF has somehow made over $39 billion in loans to Greece
making it the largest loan the institution has ever disbursed in its history and this despite its staff having concluded
in 2010 that the country’s debts could not be repaid.
1.3 Greek crisis conclusions
To sum things up for the Greek crisis, we believe strongly that:
1) A significant debt write-down is necessary for Greece. Whether it be unilateral or cooperative, it is nevertheless
essential. The country simply cannot pay its debts back.
2) Greece can stay in the Eurozone even with a debt default. But this will be hard to achieve especially since the
other Eurozone countries may not help much given the risks of other troubled members demanding equivalent
treatment.
3) Extend and pretend is not really workable any more. If it is tried again, massive capital flight is virtually certain
to ensue unless the Greek government manages to pull off a miracle restructuring.
Our central thesis is that we will have a massive debt writedown for Greece and hopefully soon. Once that happens,
Greece will most likely introduce a parallel currency which might result fairly quickly in the country’s exit from the
Eurozone. From the perspective of the European creditors, there are no pleasant Greek outcomes. Any scenario
will involve debt writedowns ultimately, and the longer the extend-and-pretend continues, the bigger will be the
losses. Also, if the Greek situation is mirrored in other countries like Portugal, the losses for Europe could become
unmanageably high. As such, the Eurozone has a vested interest in making a Greek default as painful as possible for the
Greeks if only to provide a disincentive for such behavior among its other weaker members. However, the Eurozone
has to walk a very fine line – were Greece to completely collapse, even the current losses could be staggering.
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2. The China Syndrome
UPDATE
Were Greece the only problem area in the world today, one could almost be optimistic – after all, Greece represents
a tiny fraction of global output with a population of about 10 million which is less than that of most major cities in
Asia. However, the world’s second largest economy, China, has started what appears to be a hard economic landing.
This has seismic implications for the global economy and markets.
The strong growth enjoyed by China over the last several years has been unusual in that it has been almost entirely
investment led. Investment and net exports have together accounted for almost 50% of Chinese GDP over the last
decade, and have remained at these high levels even after the collapse of 2007-2008. The Chinese have built up
truly extraordinary capacity in many key industries even though there is not enough global demand to soak up their
production. The government forced this investment boom by long maintaining interest rates well below the rate of
inflation, and as such, relatively impoverishing its labour force and consumers.
The interest rate climate also ensured a significant period of real-estate speculation among the public. Rising
real esate prices over the last several years induced more and more entrants into this arena. Thus, most industrial
companies borrowed from their banks merely to speculate in housing in preference to investing in their own
businesses. The real estate price increases coupled with a huge degree of new development meant that China
created significant excess capacity in real estate as well. From late 2013, Chinese real estate volumes and prices
started to fall. Desperate to find another avenue for growth, the Chinese government appears to have decided late
last year that a stock market boom would result in significant gains that could be parlayed into a better economy.
From November last year, the Chinese stock market has enjoyed a parabolic ascent with what appears to have been
implicit government support if not encouragement. The Shanghai Stock Exchange rose a staggering 110% from
November 2014 to its highs in mid-June 2015, even though the economy was posting its weakest growth numbers in
several years over the same period. This rise was accompanied with a large increase in margin lending and leverage
in the financial system with retail investors beginning to participate in larger numbers in this new profit vehicle.
Unfortunately, Chinese company fundamentals have continued to deteriorate given the economic environment
and as such, the equity market has taken on the same overvalued, Ponzi-like character of most of the developed
world’s stock casinos.
Unfortunately for the Chinese stock market bubble-growth policy, the sentiment towards equities has soured
considerably over the last few weeks. The equity market has been in virtual free fall over the last days, with increasing
reports of building stresses in the financial system. This comes on the back of a credit system that had already started
to freeze up for speculative investing as early as the end of 2013. A collapse in the equity market could well be the
final blow to China’s speculative policies and force a painful adjustment to the unpleasant global demand reality
the country faces.
The government has reacted to the recent huge sell-off in Chinese stocks with draconian measures. It has banned
short-selling and has threatened to jail speculators. It has prevented companies from issuing new stock, and has directed
many of the state owned firms to buy back their own stock with government assistance. It has provided huge liquidity
injections to brokers. And it has explicitly cut both interest rates and the reserve requirement for banks. In short, China
has intervened massively in the “free” markets because they are now delivering the wrong message.
The jury is still out on whether China’s measure to prop up equities will work. Yet what is clear is that China’s
economy continues to slow and significantly at that given its considerable excess capacity. Also, there appears to be
significant capital flight from the country despite its huge reserves perhaps because a subset of the Chinese investor
base has begun to look for alternatives outside the country.
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UPDATE
Looking forward, the worrisome prospect is that if China is facing a weak domestic economy it could resort to more
aggressive pricing in the global markets especially if it can engineer some currency weakness. That should serve
as an additional deflationary burst to a world that is already levered more than it has ever been in history, except
perhaps during the darkest days of war. The huge debts that have been built up are already virtually unserviceable
except at the zero or negative rates that already prevail in the developed world which means we have few if any
monetary alternatives. Deficits in most countries are at record levels too, suggesting that huge fiscal stimulus might
not be forthcoming. As such, we appear to be entering a world where conditions are as bleak as they have ever been,
except that we are out of policy options.
3. Opportunities
We believe that global conditions have deteriorated considerably since our last communication. Unfortunately, our
prognosis is not much better. In particular we expect that:
1)Global growth will slow significantly and disappoint the current lofty expectations of analysts. The U.S. is
tracking for slightly more than 2% growth in the second quarter. Europe is weakening and the Greek crisis will
do little to improve conditions. China is slowing more rapidly than most observers expected. Most developing
countries also are missing on growth expectations.
2) Liquidity will deteriorate further. Some of the most liquid markets such as that for U.S. treasuries have started
showing moves that are much higher than what has been usual for the last several years. Many global equity
markets are showing signs of topping and a rush for the exits (such as in China) could render them totally
illiquid.
3) Several major market-moving events are likely in the next few weeks to months. A Greek disaster and financial
problems in China are upon us already. More Eurozone tension is highly likely as is a potential credit crisis
triggered either by China or Europe.
4)More mundane market events, such as a failed merger or takeover, could trigger substantial moves simply
because of the degree of frothiness everywhere. If the swings we are seeing in fixed income markets today are
mirrored in equities, we might be looking at big market swings that could be devastating to confidence.
4. Conclusions
It is hard to imagine that six years after a mega financial crisis induced by too much debt, we are staring at an even
bigger crisis, now with even more debt, larger financial firms and fewer policy options. For any sensible investor,
the last few years have been disheartening to say the least – policymakers have manipulated markets so that they are
totally divorced from any reality that one might choose to focus on. The financial analysts and media, rather than
consider reality, are generating advertising copy for the fantasy world the markets inhabit. Greed today is good, and
truth is revolutionary.
The Greek situation is finally nearing its moment of truth. The Chinese are starting to live in interesting times. And
markets everywhere are whistling past the graveyard.
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Performance summary at June 30, 2015
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)
-3.1% -4.2% 5.1% 14.4%2.4% 2.8% 0.8%11.1% 5.1%
8.4%
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)
14.7%
UPDATE
-3.0% -4.2% 4.7% 13.6%2.5% 0.6% 11.6%5.0% 4.7%
Some of the statements contained herein including, without limitation, financial and business prospects and financial outlook may be forwardlooking statements which reflect management’s expectations regarding future plans and intentions, growth, results of operations, performance
and business prospects and opportunities. Words such as “may,” “will,” “should,” “could,” “anticipate,” “believe,” “expect,” “intend,”
“plan,” “potential,” “continue” and similar expressions have been used to identify these forward-looking statements. These statements reflect
management’s current beliefs and are based on information currently available to management. Forward-looking statements involve significant
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statements including, but not limited to, changes in general economic and market conditions and other risk factors. Although the forward-looking
statements contained herein are based on what management believes to be reasonable assumptions, we cannot assure that actual results will
be consistent with these forward-looking statements. Investors should not place undue reliance on forward-looking statements. These forwardlooking statements are made as of the date hereof and we assume no obligation to update or revise them to reflect new events or circumstances.
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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
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registered trademarks of CI Investments Inc.
2015
JUN