Opportunities Funds Commentary
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Trident Investment Management, LLC
Opportunities Funds Commentary
August 31, 2011
Equity markets were down again in August with the S&P 500, MSCI Europe and Nikkei indices down 5.6%,
10.0% and 8.9% respectively. Fixed income rallied with yields on the U.S. 10-year Treasury bond falling
0.58% to end at 2.22%. Credit spreads widened, with financial companies getting hit in particular. Gold
rallied 12.1% to close at $1,825 an ounce, a new high, and most other precious metals followed suit. However,
energy and industrial commodities were relatively weak with oil falling 7.61% to end at $88.81 a barrel. The
U.S. dollar rallied on the month with the U.S. Dollar Index appreciating 0.3% (all figures in U.S. dollars).
We had a strong month in our funds with many of our positions contributing significantly to performance.
Our biggest winners were our long positions in global fixed income, especially in Australia and Norway.
We also benefited from our long gold position. Our short credit position also helped our performance.
The primary losers were our U.S. curve steepeners that suffered from the significant rally in the 10year Treasury, and our short dollar positions. We believe that markets are finally starting to price in the
economic reality that has been apparent to us for several months. We feel this adjustment is in its early
stages with considerable room to run. Our funds have been positioned for such an outcome and we expect
that they will continue to benefit as this trend continues.
Market Outlook and Strategy
The global economy appears to have hit stall speed in August. Most of the economic indicators across
the world deteriorated to the point that a global recession seems imminent. The countries of Southern
Europe have been in trouble on the growth front most of this year, with their economies already in decline.
However, markets were surprised in August by the steep slowdowns observed in Germany, Australia, the
U.K. and the U.S. In the U.S., the declines in some leading indicators suggest that a recession may have
already started. Much of the developing world is still tightening policy to slow economic growth and rein
in inflation – August provided evidence of slowdown also in these countries. The data suggest that we
might have entered the first synchronized global recession that most of us may have seen in our lifetimes.
As we have discussed in prior communications, much of the developed world is operating with record
levels of sovereign debt. History suggests that countries typically run into trouble with debt sustainability
when the debt to GDP ratio exceeds 90% -- something that is already true for most of the developed
nations. The ratio of total net public sector debt to GDP in Japan, Italy and many other smaller developed
countries such as Greece, already exceeds 100%. In the U.S., the U.K. and most other major countries in
Europe, this ratio, if computed correctly, very likely exceeds 100% as well. When nominal growth rates
are lower than the interest paid to service debt, the debt to GDP ratio inevitably increases. If the growth is
made possible only by the assumption of more debt, the ratio rises even faster.
Slow growth and huge debt burdens together raise serious questions about the ultimate repayment of
debt. The simple fact is that the largest economies in the world are virtually all on the path of explosive
debt growth. Policymakers across the world have differed widely in their responses to this problem. Some
have argued that the debt levels do not matter. Yet others have proposed or implemented significant
belt-tightening measures to reduce debt, even though such steps might reduce already paltry economic
growth. Various pundits have added to the cacophony in the discussion of these issues.
Since 2008, governments have become the backstops to financial institutions, consumers and markets, and
much of the recent increase in sovereign indebtedness has arisen from these actions. Absent government
support, financial markets will have to price in the underlying economic reality that is increasingly bleak.
As such, understanding how policies will evolve in the ongoing debt/growth problem that the world faces
will be a critical element of investment success.
Below, we analyze the various policy choices governments have and consider how various countries differ
in their approaches to the problem. Finally, we discuss our outlook in light of this analysis, and consider
how our portfolios should behave given our views.
1. Policy Choices in Dealing with Debt
There are three broad ways to deal with the problem of too much debt, each of which involves different
tradeoffs. They are as follows:
The classical solution that most individuals are urged to adopt when faced with a problem of too much
debt is to live within their means. This approach can take two forms. Assuming the debtor has (or can
generate) income that exceeds his debt service, he can use some or all of the excess income to pay down
his principal. An alternative would be for him to sell assets that he might have and use the proceeds to
reduce his debt. Either way, the debtor will experience a reduction in his standard of living. In the first
case, he will have less disposable income because he has essentially sold a claim to that income stream.
In the second situation, he will have sold his past capitalized income and will lose the benefits that
accrue from this accumulated wealth. Obviously, if a debtor’s earnings are inadequate to maintain even a
subsistence standard of living while servicing debt he will have no alternative but to sell his assets, if any.
An important point to note here is that the burden of debt repayment is borne entirely by the debtor with
the creditor not having to suffer any losses.
When it comes to countries, most modern economists argue that the rules that apply to individuals do
not apply to nations. They often claim, correctly, that a significant level of national debt can be sustained
indefinitely. Unfortunately, the case for national debt itself is rather weak. While it is true that various
financial market participants have different risk preferences that debt might cater to, this factor does
not explain why such debt needs to be taken on and sustained indefinitely at the governmental level.
A government might certainly want to take on debt at certain times where the private sector may be
incapable of achieving desirable outcomes – examples abound in the realm of infrastructure where private
markets cannot finance the scale of investment required, or in social policy where providing support
to the less fortunate members of a society might be deemed desirable. On the infrastructure front, if
such government investment were efficient, the returns would more than outweigh the cost of the debt
ensuring the repayment of the same over time. And on the social front, it is clear that the benefits provided
by the government have to be paid for by current or future taxation – after all, the cost of socially desirable
programs has to be borne by some group in society. But all else being equal, a high level of sovereign
indebtedness is an inevitable sign of bloated government expenditure at some time in the country’s history.
In a democracy, sovereign debt becomes an excellent tool for governments to provide benefits in the short run
to their electorate without paying for them. Many of the developed countries have seen dramatic increases
in their levels of debt over the last few decades, as they undertook huge deficit-financed expenditures
that were supposed to be paid off by future taxation. Most of them today, run huge fiscal deficits, even
as they labor under crushing debt burdens. The austerity approach to dealing with this is rather simple
– the political leadership simply needs to admit to its population that their level of national expenditure
cannot be sustained and that a structural reduction in the country’s standard of living is unavoidable.
Unfortunately, this is easier said than done.
Any attempt by a politician to tell the truth about indebtedness will result in the problem’s being laid at the
feet of the current leadership, however blameless it might be. Also, we have no shortage of opportunistic
charlatans and demagogues who will parrot their own solutions, without austerity of course, to get elected.
Even the academic profession has been co-opted into this shameless exercise where more time is spent
arguing the need for debt reduction at all, rather than the mechanics for achieving the same. The only
arbiters that can force a solution in this context are either impartial bureaucrats or free financial markets.
Yet, most bureaucrats today are anything but impartial and the financial markets are increasingly controlled
by policymakers intervening to achieve desired outcomes.
1.2 Hard Default
The hard default approach requires that the creditor accept a writedown in the debt owed by the borrower.
A hard default could result because a debtor is either unable or unwilling to pay his obligation. A debtor
faced with a substantial deterioration in his financial circumstances might not have the wherewithal to
service his debt in full even over time. In such an event, some or all of the debt has to be written off as
uncollectible by the lender. Typically, such a default is a negotiated arrangement with the lender, or could
involve the courts as in a formal bankruptcy. A borrower can also default because he wishes to, even when
he may have the resources to pay. In an individual context, most people would view such default as being
unethical if not illegal. Most private debt contracts require that the borrower not shirk payment by choice
– the courts in such a situation can be relied on to enforce the debt agreement in favor of the lender with
attachment of the borrower’s wages, property and the like. Of course, in the absence of such covenants and
the ability to enforce the same, the lender has limited recourse if there is no repayment which is why one
of the foundations of capitalism is a justice system that enforces such contracts.
A hard sovereign default has been a rather rare occurrence in the last decade, even though such defaults
have occurred historically with regularity. A country could default when its leadership deems that the
national sacrifices needed to pay down debt are unacceptable for its citizens. Such an assessment can result
from either a true inability to pay, or unwillingness by the citizenry to make the adjustments needed to pay
Separating the ability of a country to pay from its willingness is much harder than for a private borrower.
Russia, a highly resource rich nation nevertheless defaulted on debt in 1998. Argentina, one of the world’s
richest nations at the start of the 20th century, repeatedly defaulted on its debt with its most recent such
action being in 2001.
A country can default with potentially fewer real consequences than a private borrower. Domestic creditors’
only recourse might be to take to the polling booths or alternatively, the streets. Foreign creditors might be
able to attach a country’s overseas assets if it defaults. Yet, neither group can garnish the tax revenues of the
government or effect the enslavement of the country’s people. The prospect of social unrest and ostracism from
the world’s financial markets (and especially trade finance) are the main impediments to a sovereign default.
When a nation defaults, the eventual result is a negotiated settlement between the nation and its lenders where
the country typically agrees to pay back some portion of its debt in order to avoid these consequences.
A hard default by its very nature removes any ambiguity as to the repayment of the debt for the lender. As
such, the lender is forced to recognize the losses and accept a reduced payment for his claim. Much of the
lending in the developed economies is done by intermediaries who work with the funds of the actual savers.
A hard default by a sovereign borrower they have lent aggressively to, will require them to recognize losses,
reducing their earnings and potentially even bankrupting them. So, a hard default when coupled with
leverage creates an immediate crisis that has to be dealt with.
A hard restructuring of debt is not without its benefits. A realistic assessment of a country’s prospects
generally allows for the best plan to be arrived at to get it back on its feet. It also ensures that all debtors are
treated fairly in the process of restructuring given the nation’s resources. For these reasons, supra-national
bodies like the International Monetary Fund typically require a non-payment or “standstill” agreement with
creditors while they work out a plan, so that future aid disbursements to the defaulting countries are not
siphoned off by corrupt public officials to pay favored creditors.
However beneficial a restructuring might ultimately prove, what is very clear is that pain is immediate,
especially to the leveraged lenders. If such a default will bankrupt such lenders their managements have
little to gain from an immediate default, even if that will ensure the maximum recovery on the overall loan.
As such, these intermediaries have little incentive to engender the best long-term solution here since their
interests are at odds with those of the group of claimholders (which includes depositors, the government
and others) they represent.
1.3 Soft Default
When a loan is made, both the borrower and lender have to value it using some unit of account. Modern
loans are typically valued in terms of currencies such as the U.S. dollar rather than a numéraire such as
gold. When a country has debt outstanding in its own currency, and has the ability to create more of its
currency without impediment, it can pay back loans by simply printing more money. If the scale of such
printing is significant, the purchasing power of the currency used to repay the debt could be considerably
less than it was when the debt was incurred. Lenders typically factor such a decline in purchasing power
by considering the inflation (or depreciation of the currency against an international currency basket), and
thus loss in purchasing power of the currency unit, that they could expect over the term of the loan. Thus,
the interest rate charged on the loan is a real rate coupled with an expected rate of inflation/depreciation for
the life of the loan. To the extent that realized inflation or depreciation however is higher than that expected
when the loan was made, the lender suffers a loss in purchasing power. When a sovereign borrower uses
policy to deliberately effect a significant, unanticipated loss in the purchasing power of its currency unit, it
is expropriating from its lenders and engaging in a soft default. Importantly, the borrower benefits only if the
reduction in purchasing power is unanticipated by the lender.
A soft default with currency creation does not have a private sector analog and is in the sovereign domain.
Historically, many countries have relied on soft defaults to manage debt burdens. Several countries in Latin
America including Brazil, Argentina and Mexico, monetized their domestic debt to the point where there was
significant, unanticipated inflation and a huge loss in the currency’s purchasing power. Venezuela, achieved
the same effect by large unanticipated devaluations in its currency that created significant domestic inflation.
The government owned the nation’s oil wealth, and a devaluation immediately increased its oil revenues in
local currency terms since these earnings came in U.S. dollars, while leaving its obligations unchanged.
The appeal of a soft default is that, at first glance, it appears that everyone wins. The concept of purchasing
power is hard to quantify for most lenders since much of the world’s financial system is denominated in
nominal currency units. Even worse, the financial institutions that intermediate the actual lending by
the real savers in the economy get paid on their nominal results and not being forced to recognize their
losses allows them to propagate the myth that they are profitable. Yet, over time, the consequences of these
policies are all too predictable.
Savers ultimately respond to soft defaults by demanding higher real rates and/or lending less to the country
in question. When they are domestic and capital controls limit their alternatives to saving in the domestic
currency, the savings rate drops. Decades of poor policy in Latin America led to a chronically low savings rate
in the region that is still much lower than in Asia. Most Latin American savers are prepared, even today, to
flee with their capital to more predictable havens if needed. Brazil, after a decade of sensible policy and with
its undeniable mineral and human wealth, does not fully have the confidence of its domestic savers who
still demand higher real rates of its borrowers than most other nations that are in much poorer fiscal health.
2. Policy in the Real World
Debt levels of many of the largest countries in the developed world are already above the thresholds of
sustainability. In particular, the U.S. debt burden, even with the all the machinations in its calculation, is
very likely already at crisis levels. The situation in Japan is arguably even worse on the sovereign front. And
while the position of the European Union taken as a whole, is not as alarming, the debt burdens of Greece,
Portugal, Italy and Belgium are at levels that make them unsustainable. The UK is in the same boat as the
U.S., with some metrics suggesting that its situation might be even worse.
2.1 The Extend and Pretend “Solution”
The political class in all of the developed democracies has abetted the assumption of debt by spending in
the present while postponing the payments. Any recognition by the public of the scale of the debt problem
will force the long-delayed expenditure adjustment and will render the politicians rather unpopular. The
public will very likely demand significant changes in the political system itself to prevent a bloated system
of government from re-emerging. As such, politicians share a vested interest in wanting a deferral of the
The central bankers have an interest in delaying the acknowledgement of the debt problems for the simple
reason that they were responsible for regulating the financial institutions who were the primary enablers of
the debt binge. The financial firms are among the largest lenders to many of the problem sovereigns and have
done so with little to no capital to back their holdings. Even worse, many of them helped problem sovereign
borrowers disguise the true amount of their leverage so as to enable them to take on even more debt – actions
that were unethical if not fraudulent. A hard sovereign default will mean a wholesale bankruptcy of leveraged
financial firms laying bare the incompetence, if not the culpability of the regulators.
Finally, a hard default means that the public has to acknowledge the illusory nature of its debt-induced, prior
prosperity. The idea of a sharply reduced standard of living is frightening to most and commentators of all
persuasions are only too happy to opine that such an adjustment will not be necessary. Numerous opinions
have been advanced as to why the status quo is indefinitely sustainable with Nobel Prize winning economists
taking the view that debt levels of any magnitude should not be a cause for alarm. Most of the public in the
affected countries still believe that the glory days of the past can be restored with the right leadership.
Thus, most domestic interest groups in the various regions in the world want an “extend and pretend”
approach to dealing with the current sovereign debt crisis. The only agents who want a change in the
current situation are the developing countries, such as China, which are among the largest lenders to the
developed world. In the interests of their longer-term stability, they would like at least a recognition of the
problem in the developed world, if not an actual adjustment of policies. However, the only mechanism
for them to enforce their wishes is to limit their new purchases and/or to sell their existing holdings of
the problem countries’ debt. To the extent that the developing nations have been unwilling to take this
“extreme” step they have forfeited their ability to influence events.
But now we have the question of what exactly the extend-and-pretend solution entails. A hard default
even by the most indebted countries can definitely be ruled out in this context, which leaves us either
with an austerity program or a soft default. Austerity that impoverishes a nation overnight is likely to be
unsustainable. Soft default requires a compliant central bank. Thus, even trying to kick the can down the
road as most participants want to, may prove a complex exercise. In fact, markets have recently started to
worry whether such an extension might even be possible any more.
2.2 Central Banks and Soft default
A soft default requires an accommodating central bank that is prepared to print money to monetize debt,
ultimately ensuring that it is inflated away. Yet, not all central banks globally seem to agree on the policy of
monetization even though they all understand the seriousness of their respective nations’ debt problems. The
differences across central banks can be largely traced to the institutional arrangements under which they operate.
We consider the European Central Bank (ECB), the Federal Reserve and the Bank of Japan (BOJ) below.
The Maastricht Treaty which created the ECB, states explicitly that the primary objective of the
institution is to maintain price stability. The ECB may, once this objective is achieved, support the EU
in the achievement of other objectives, but the hierarchy of priorities is clearly established. The Treaty
also explicitly prohibits the ECB from providing credit to the public sector removing any possibility of
direct debt monetization. The ECB was modeled after the German Bundesbank. Germany had faced
devastating hyperinflation, first with the Weimar republic from 1921-1923 and then following the Second
World War with the loss in value of the reichsmark. The Bundesbank was set up in 1957 as the world’s first
independent central bank to ensure that such monetary instability could never recur.
The Bank of Japan is much like the ECB in its setup, except that it is faced with a dual objective of ensuring
price stability and the stability of the Japanese financial system. It is also independent in its setup, and
highly respected in Japan, although its independence is not entirely assured to the extent that the ECB’s is.
Unlike the central banks above the U.S. Federal Reserve has to deal with multiple monetary policy
objectives. In particular, the Fed does not have an explicit requirement to control inflation but instead
is tasked with promoting maximum employment, stable prices and moderate long-term rates. The U.S.
suffered from the Great Depression in the 1930s, an experience that most Fed members feel charged to
avoid at any cost. The prevailing wisdom with the Bernanke Fed (which by the way, we disagree with
entirely) is that the U.S. central bank did not do enough monetization during the early days of the Great
Depression and served to intensify the downturn.
Given the different institutional objectives and philosophical biases of the central banks, we can make the
-A soft default of Eurozone debt engendered by money creation by the ECB would be a clear violation
of its mandate and would not be defensible, especially if it backfired. The ECB cannot purchase the
debt of any country in primary auctions. Such purchases, even in the secondary markets, would be
against the spirit of the ECB’s charter.
-The Bank of Japan might be persuaded to purchase debt or attempt other forms of quantitative easing
on the grounds of ensuring financial stability. But it cannot be expected to move aggressively to
achieve a desired positive level of inflation. It is unclear that a positive level of inflation means more
financial stability. In fact, it is possible that if the BOJ moves to print money, it might engender more
instability, violating its founding law.
-The Fed can be relied on to engage in virtually any possible scheme that might achieve any objective that
Fed Chairman Bernanke desires. Asking a central bank to promote employment which is a tertiary result of
monetary policy, is about as useful as asking it to promote world peace. Even worse, Bernanke, who is a socalled “expert” on the Great Depression seems clueless about the fact that it was monetary accommodation
and rampant speculation that led to the bubble whose bursting triggered the Great Depression.
2.3 Who pays for the solution
An extend-and-pretend solution is not costless. When the solution is arrived at with austerity, the debtor pays
to the benefit of the creditor. Yet, if the creditor is asked to pony up more funds to support the debtor during a
period of “austerity,” he runs the risk of suffering even bigger losses than his original loan if this program proves
unsuccessful. In a soft default, the creditor of course loses. We get more insight into the debt discussions that are
roiling the various regions of the world today when we consider the creditors of the various problem sovereigns.
In Japan, fully 95% of Japanese debt is held by the Japanese public. Much of the debt in fact was incurred
to maintain employment and benefit households. As such, a soft or hard default, or austerity in the country
all have the same general incidence – the most affected are the domestic holders of Japanese debt of which
households make up a significant fraction. In the U.S., almost half of the government’s debt is held by
foreigners. This suggests that a soft default by monetization is highly desirable politically as long as foreign
investors do not stampede out of the U.S. dollar and/or U.S. debt. In the EU’s case, things get more complex.
Most of the debt of the problem EU countries is held by households and financial institutions in other EU
member countries. The ECB itself owns a considerable amount of the debt of the problem nations. While
austerity in the Eurozone problem countries could mean repayment of much of their debt, it would also
depress their imports from the more prosperous EU countries, directly affecting the latter’s economies. A
soft default will require a change in the ECB’s Treaty and it is unlikely that the EU members can agree
to it. Outright monetization is likely to boost inflation overall in the Eurozone which is something that
Germany in particular will oppose given its history, no matter what the purported benefits. As such, the
prosperous countries in Europe want austerity for their problem members which might have a small
cost to them but a huge impact on the problem economies. The problem countries, and particularly
Greece, recognize that austerity is likely to prove fruitless which means an immediate default is the most
acceptable solution. The simple fact in Europe is that the European nations are going to pay for their
problem countries one way or another whether or not the crisis is postponed.
Thus, in the EU, the extend-and-pretend solution may not be workable any more. If postponement is
not going to be possible, or even desirable, the best we can hope for is a combination of hard default and
austerity. The quicker this happens, the better off the entire EU will be.
2.4 Policy Conclusions
Given the above, it is clear that the U.S. is predisposed to a soft default. The ECB is unable to achieve that by
policy barring a change in the Maastricht Treaty itself, which is unlikely to happen. The BOJ does not have any
incentive at the current time to engineer any monetary solution. The matrix below summarizes our conclusions.
Monetization and soft default
Some domestic savers
3. Economy and Market Implications
Our analysis leads to a rather unpleasant assessment for global markets. Specifically:
-We cannot expect strong growth in the Eurozone under most reasonable scenarios. Austerity, debt
defaults and an unhappy population do not make for robust economies.
-The U.S. will do everything in its power to postpone the resolution of its debt problems. The recent U.S. debt
downgrade by rating agency S&P must be viewed as the first in what will surely be several such moves. The
insouciance of U.S. policymakers in the face of such huge debt problems and the willingness of the Fed to
keep monetizing debt sets the U.S. firmly on a path to a dollar collapse with the chaos that will surely ensue.
- Japan is mired in its multi-year slow-motion recession. We cannot count on Japan for growth.
-China, and the developing countries, which have served as the production engines for the developed
world had better look for other growth models. The ability of the developed world to sustain Chinese
exports is very much in question.
While the market action in August was perhaps a belated recognition by markets of the extent and severity
of the global problems, we believe strongly that the malaise has just started. The global economy is in
a particularly vulnerable situation and we have neither the monetary policy flexibility nor the fiscal
wherewithal globally to alter the course of events. Any decisive action to arrest the economic slide that has
started carries risks that are much higher than those the world faced in 2008.
Investment Implications and Positioning
We can draw two clear conclusions from the above. Given that global growth is likely to prove very weak,
the interest rates paid by a sovereign should reflect its underlying fiscal solvency. For example, U.S. 10-year
rates at 2.00% and Norwegian 10 year rates at 4.00% make no sense given the superb fiscal fundamentals that
Norway has. Moreover, Norwegian inflation is lower than that of the U.S. A huge interest rate opportunity
is presented by a convergence of Norwegian rates to U.S. levels.
Stores of value are to be highly prized when monetary discipline in the U.S. dollar bloc simply does not
exist. Currency alternatives to the dollar will likely gain in value. Gold and most precious metals provide
such alternatives. A wide range of assets in the developing world might soon become similar stores of value.
We expect significant turmoil to continue in the near term in the markets as participants look to quick fixes from
policymakers which simply do not exist anymore. Most asset valuations in areas such as credit are sustained only
by the prospect of future central bank or fiscal bailouts. It is impossible for such help to persist indefinitely and
market participants are well aware that an ultimate return to reality is inevitable. However, investing in high-risk
assets at inflated prices in this environment is tantamount to participating in a Ponzi scheme secure in the fact
that one can exit before the bottom falls out. Until the scheme ends though, the volatility and fear will persist.
Our funds are positioned to profit from all of the above trends. Much of our positioning is also through options,
which is something we are happy for given the recent huge spike in volatility. To many we may have appeared
like Chicken Little warning of the sky falling. In the increasingly likely event that the sky really does fall in, we
can at least represent that we have heeded our own warnings.
Performance Summary at August 31, 2011
Trident Global Opportunities Fund
CI Global Opportunities Fund
15 Yr. YTD
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