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
October 31, 2015
Performance Review
Entering the third quarter of 2015 we had believed that global economic fundamentals would continue to
deteriorate and that quantitative easing (QE) in both the Eurozone and Japan would continue. We had also
expected the U.S. Federal Reserve to move closer to the elusive goal of finally raising interest rates, given that its
stated objectives in terms of unemployment had been achieved more than a year earlier, although we did not think
they could raise rates much given the fragile nature of the U.S. “recovery.” Finally, we had anticipated that markets
would be much more volatile as participants considered the consequences of less monetary accommodation from
the U.S. central bank, juxtaposed with more monetary emission overseas.
We cut risk entering the third quarter, both by reducing positions as well as by replacing much of our outright
exposure with options both in fixed income and equities. Despite these actions, our portfolio has had a difficult
four-month period from July to October. Our equity holdings hurt performance materially with our long positions
in Japan suffering considerably with only a small offset being provided by our U.S. index shorts which proved
surprisingly resilient. Our equity losses were largely but not completely mitigated by our gains on our long
fixed-income positions, which, while meaningful, were nevertheless mediocre given our significant positioning.
Our credit book actually hurt our performance significantly over the period despite our net short credit positioning.
Remarkably, some of the highest quality overseas credits widened out considerably especially in the emerging
countries, even as junk-rated instruments in the U.S. and Europe remained relatively tight. Other positions we
had in the portfolio such as our currency positions had only a minor impact on our portfolio.
Our core portfolio themes have not changed much and as such we have made only tactical changes to our
portfolio over the last few months. We cut down even further on our risk during the third quarter anticipating
more turmoil but have started to add to our positions over October as markets have become increasingly stretched.
In particular, we are being presented with better opportunities in sovereign fixed income since the broad economic
trends have become clearer. Also, the developed world (ex-Japan) equity and credit markets which had started
to factor in reality in August have gone back to their Utopian visions despite fundamentals that have continued
to deteriorate. As such, we see considerable opportunity on the short side here much as we did in 2006 in real
estate credit and equities and have started to add to our positions. We believe that we have now entered a period
where conditions are much worse than they were in late 2006 with policymakers having even fewer options.
We anticipate a significant market adjustment.
Market outlook and portfolio strategy
We take up first the global economic climate which has become much bleaker in the last few weeks. Then we
discuss why the markets continue to remain so divorced from reality and why a rapid adjustment or crash is
possible. Finally, we take up how we expect to profit from these views.
1. The coming global recession?
The economic data in the last several weeks have turned decidedly bearish for global growth. The deterioration
has been widespread – no country or region has been spared. The last time we observed such a synchronized
slowdown was in 2008 and prior to that in 1998 during the height of the Asian crisis. The data in fact suggest
that the world may already be in a recession much as we were in late 2007, even though the official estimates
recognized the same only much later.
2015
OCT
1.1 China
UPDATE
By the official data, the economy in China has either bottomed out or is slowing to an acceptable 6.5% or
thereabouts. Yet non-governmental, hard data do not support such optimism. Chinese rail freight volume,
a barometer for goods movements across the country, has collapsed 10.1% through the first eight months of
2015 compared to the same period last year, hardly suggesting an economy that is growing strongly. Electricity
consumption is close to flat year on year, again suggestive of growth closer to 3%. GDP growth for the third
quarter as reported was only 6.9%, but thanks to deflation of 0.8%, the nominal growth rate was only 6.1%. Trade
contributed positively to GDP growth but not because of exports which shrunk by 3.7%, but by imports which
collapsed an unhealthy 20.4%.
The anecdotal evidence from key industries also suggests a growth rate that is much slower than the official
numbers. Numerous industries such as steel have been forced to curtail output substantially, even as they dump
inventories into the world markets. The auto industry, which was a huge driver for growth appears to have slowed
dramatically thanks to huge dealer inventories – a fact that the international companies operating in the country
have indicated in their earnings reports. The locals have reacted with concern. For starters, the stock market
has swooned recently forcing the government to resort to desperate measures (punishments for short sellers,
banning sales) to prop it up. Next, a significant amount of amount of capital has been fleeing the country. Over
the last four months about $506 billion has exited and while these numbers pale in relation to China’s very large
reserves, they are nevertheless huge in absolute terms. The government is sufficiently concerned about the latter
phenomenon that they have moved to increase the flexibility in the yuan (with what analysts perceived as a
“mini-devaluation” even though it appears to have been more a signal of future action). They have also cut rates
and reserve requirements to prevent the credit crunch that could arise from the progressive withdrawal of highpowered money through capital flight.
The composition of the economic data in China also gives us reason for concern. The country has an investment/
GDP ratio over 40% and a trade surplus of about 4% of GDP. As such, it has a savings rate approaching 50%, an
almost unheard-of level for any economy let alone a developing one. Consumption makes up less than 40% of
China’s economy. Few would argue today that China has rampant excess capacity, much of which has been built
with debt. A significant fraction of the country’s manufacturing facilities, especially in the commodity arena, are
already loss-making and continued investment in the same will only mean even more bad debt. If investment
were to slow from its torrid double digit pace to a still-respectable 4% (remember the country has to actually force
a contraction in investment!), its consumption will have to grow at close to 12.5% to generate 7% growth, barring
a substantial pickup in trade (unlikely) or a sudden, gargantuan fiscal boost. Put differently, if China has to rein in
investment, the smaller consumption sector has to grow much faster than it has over the last several years. While
this is possible, it is unlikely without a dramatic change in government policy.
It appears that China’s investment bubble phase of growth may be ending and that it might be forced to start its
transition to a more consumption-led model, assuming this is what its leadership wants. Such a reorientation
with continued high near-term growth rates would be virtually impossible for even a small country let alone
one as large and as diverse as China. The hard data suggest that the growth rates in China have already started
to plummet, even though the country’s policymakers still prefer to fabricate economic statistics to achieve lofty
growth objectives. Rather than call the leadership out on their economic fiction, Wall Street has only been too
happy to tout it as proof that all is well and will only get better!
1.2Europe
Recent data from Europe have shown broad-based stagnation or deterioration in economic conditions putting
the much forecasted economic acceleration for 2015 and beyond in jeopardy. While home prices in much of the
2015
OCT
UPDATE
Eurozone have started to rise thanks to the European Central Bank’s QE, this has not translated into either robust
job gains or growth prospects, though sentiment appears to have improved somewhat. The Eurozone’s locomotive,
Germany, has itself started to deteriorate especially in exports where its auto industry is facing significant headwinds
in China. The French economy never even felt the expected recovery. Spain, one of the poster children for the
supposed efficacy of structural reform has actually continued to deteriorate in nominal terms even though its
nominal debt continues to increase. The country’s authorities deem that its inflation rate is more negative than its
nominal GDP decline, from which we get the fodder for the belief that its economy is growing in real terms. In
fact, the Spanish government is contesting national elections in December and a key element of their campaign
involves taking credit for the supposedly stronger economy notwithstanding considerable evidence to the contrary.
While the Wall Street analysts remain perennially optimistic about the prospects for Spain, if not the rest of Europe,
the political data are suggestive of a region that is mired in depression with political discontent increasing. The
popular revolt against the status quo in Greece culminated with the election of Syriza. Unfortunately Syriza simply
rolled over to European demands regarding austerity and as such there is little hope of significant improvement in
Greece where the level of debt is too high. In Spain, the Catalan election of September 27 handed a mandate to
the pro-independence parties. The political signals sent from Madrid to the Catalans since then have very likely
strengthened the Catalan resolve for demanding more in the form of autonomy if not outright independence. This
crisis is likely to flare up at any time. Again, Portugal voted strongly against austerity in its own national elections but
its president, in an unusual anti-democratic twist, gave the mandate to form the government to the existing ruling
party despite its relative lack of support. This action was perhaps driven by the need to maintain the status-quo
vis-à-vis the Eurozone in terms of making sure the new government did not reject austerity and/or the huge debt
burden foisted on them by the Eurozone. This move has sowed the seeds for a political crisis that could fracture a
nation that is already divided about how to deal with its forthcoming challenges.
The economic situation in Europe remains dire with little hope for a sustainable upswing. Debt levels keep rising
and fiscal deficits, despite austerity remain stubbornly high. Even worse, deflation has taken hold everywhere in
the region making the debt that much harder to repay.
1.3 United States
The economic environment in the U.S. is also rather fragile, especially given the lofty expectations most analysts
and policymakers have for U.S. growth. U.S. unemployment is virtually at record lows while participation rates are
at levels last seen in 1978. The former signals a strong labour market while the latter indicates the exact opposite.
Initial weekly unemployment claims are at all-time lows providing support to the strong labour market thesis. Yet,
these figures could just as easily suggest an increasing cadre of long-term unemployed that cannot file an initial
claim because of their lack of recent employment and are instead swelling the ranks of food stamp recipients to
all-time record levels.
Even if we accept that the U.S. consumer might have decent job prospects, this has not translated into strong
consumption growth unless accompanied by cheap debt. The reasons for this are rather obvious. With U.S. worker
incomes largely static but costs for rents, medical care and education soaring, the consumer has been left with little
in the way of a discretionary consumption surplus. This was a predictable consequence of QE and a critical failing
of the policy for generating sustainable consumption growth. The hard U.S. data on consumption reflect this
reality. Retail sales have been troublingly weak for the last several months except for auto sales which have soared
because of record levels of credit, and especially subprime credit, extension.
Moving away from the consumer, the U.S. situation looks equally bad. The U.S. dollar has appreciated significantly
in trade-weighted terms, resulting in a large decline in exports, but unexpectedly also in imports even adjusting for
import price changes. This has fed through into weaker growth from the trade front. Optimists argue that the dollar
2015
OCT
UPDATE
rally may be over and that the near-term trade weakness does not portend a longer-term problem. Yet, supporting
this view will mean that exports from the U.S.’ primary (non-commodity) import providing nations should have
increased dramatically. The data however, indicate the exact opposite. Exports from Japan, China, South Korea,
Taiwan and others that primarily export manufactured goods to the U.S. have declined dramatically – in fact, the
decline rates mirror levels last seen only during a full-blown crisis period such as 2008 or 1998.
1.4Japan
The economic data from Japan have also turned decidedly mixed. The nation’s aggressive QE initially weakened
the yen and provided some lift to inflation as well as created a pickup in bank credit growth. Yet, commodity price
weakness over the last several months and a relatively stable if not appreciating trade-weighted yen have served to
depress headline inflation lessening the impact of QE. The country’s consumption tax hike last year has also served
to depress growth.
Much of the data over the last few months in Japan have been anemic, and have recently got worse once again
raising the specter of outright recession and deflation. Many observers are calling for more QE from the Bank of
Japan to forestall such an outcome. Unfortunately, in the current global environment, more QE from the Bank
of Japan will mean a weaker yen and a renewed deflationary impulse to a world already awash in excess capacity.
1.5 Emerging countries ex China
The weakness in the developed world and China is not being offset by strong growth in the developing nations.
Countries such as Brazil are large resource exporters to China and have to contend with falling exports feeding through
to weaker growth. Yet others like Taiwan and Malaysia have to deal with weak demand for their non-commodity
exports from the developed world to the point where even their growth is slowing.
While economic conditions in many of the developing countries have weakened, they are still in much better shape
than their developed counterparts. First, the developing country currencies have depreciated substantially against
those of the developed world and particularly the U.S. dollar. As such, their continued problem is the ongoing collapse
in developed world demand rather than their own internal competitiveness. Next, few if any developing countries
have pegged exchange rates and have expended little of the considerable reserves in holding their currencies at overlystrong levels. As such, a crisis induced by capital-flight alone seems unlikely. Finally, most of these countries have little
foreign debt at the sovereign level at least in relation the developed world – Greece, Portugal or Spain would make
Brazil look like a model of economic virtue.
All this said though, there is little in the economic data that suggests that the developing countries as a group can serve
as a locomotive for global growth in the near future.
So, to sum up, growth in the world today has slowed to the point where we are experiencing the weakest global
economy since 2009. And the structural challenges faced by most countries in the developed world do not suggest an
imminent liftoff.
2. Policy prescriptions and market effects
The primary tools to deal with the post 2007-2008 crisis have been and still are monetary.
The tool of choice for many global central banks has been QE with the U.S. and the U.K. being the initial
proponents of this approach. QE is a forced expansion of the central bank’s balance sheet through asset purchases.
2015
OCT
As such, it represents direct intervention in the asset markets to force prices to levels that true free markets will
not support.
UPDATE
Today, the original sponsors of QE have stopped their money printing, but this approach has been embraced by
both Japan and the Eurozone which are engaged in QE that is almost as massive as the U.S.’ especially in terms of
the percentage of GDP involved. The currency weakness engendered by QE has meant that many countries that
might not have engaged in this measure have nevertheless been forced into it for exchange rate reasons – witness
how Sweden is engaging now in limited QE if only to counteract the effects of the Eurozone’s QE on its currency.
The second monetary tool is the Negative Interest Rate Policy (NIRP). Interest rates are below zero now in the
short end (up to two years) in much of the Eurozone, the Nordic countries and in Switzerland. Negative interest
rates in the short-end are best viewed as a tax on bank deposits and especially foreign inflows into banks. There is a
limit to how negative interest rates can become because the public will eventually respond by simply withdrawing
their money from the banks as paper currency and storing it elsewhere. To prevent this, paper currency will also
have to be devalued based on how long it has been in circulation, a process that would be a nightmare to administer
and could well signal the end of our current monetary system.
A third monetary tool that was unique to China because of its centrally planned economy is what we would call
Forced Credit Expansion (FCE). The Chinese approach since 2009 was to dramatically boost overall credit in
their economy by simply forcing their banks to grow their loans at a directed rate. This approach is different from
QE in that it does not directly involve asset purchases or expansion in the central bank’s high powered money.
There is no doubt that this method did work to boost growth. Chinese new lending picked up substantially since
2009 with total credit to GDP rising from 160% in 2009 to about 300% today. Much of the Chinese growth since
2009 came from the boost, primarily in investment, delivered by this force-feeding of credit. Unfortunately, this has
also led to mal-investment on an epic scale since 2009. There is no free lunch.
Policymakers have used a variety of justifications for their unconventional monetary policies. Negative interest
rates are justified on the grounds that when there is outright deflation, even a zero interest rate might present too
high a real effective borrowing rate. FCE as practiced by China has the indubitable effect of boosting growth
immediately, and might represent a worthwhile tradeoff even given the mal-investment it might engender.
Both these policies while questionable in terms of effectiveness, at least make sense in the context of
economic theory.
QE on the other hand is not easily justified by economic theory. The developed world’s central banks have
implemented QE mostly by purchasing government bonds across a variety of maturities and have argued that this
policy will serve to boost confidence and through this somehow increase inflation. The tenuous logic for this stems
from two effects.
The first effect of QE is that by boosting high powered money, it could lead to a significant currency depreciation
which in turn could feed through to domestic inflation via imports. This mechanism could work well for
a small country with a freely floating exchange rate, but will not be effective when the country in question is
a dominant global player whose trading partners peg to its exchange rate. It certainly cannot work at all if all
the countries try it at the same time. Thus, QE did little to boost U.S. competitiveness globally because most
developing nations refused to let their currencies appreciate against the U.S. dollar. European QE will likely have
a muted impact because it is being resisted by countries like Sweden, and de facto most of the emerging world,
thus reducing its potential effects. Japan perhaps has the best chance of pulling off a sustainable inflation shift
with QE, but it has nevertheless embarked on its experiment with the worst possible timing where it comes to the
global backdrop.
2015
OCT
UPDATE
The second effect of QE is that it forces risk-free rates across all maturities to levels much below what free markets
would support. This should typically boost investment in the economy. It should also boost asset prices because it
reduces the effective discount rate for risk assets.
Most countries in the developed world were plagued with excess capacity at all levels in 2009. Therefore, new
investment was inherently unprofitable even at the zero bound and so expected huge pickup in investment did not
materialize. This is perhaps the reason that China had to resort to FCE to boost its (mal) investment since 2009.
There is no doubt, however, that QE since 2009 has worked wonders for asset prices. Despite weak demand from
first time homebuyers, housing prices in the U.S. have rebounded, and in some states to levels much above what
prevailed in 2006. This rebound has happened even with incomes and mortgage terms being considerably less
supportive for home purchases. Again, the equity and credit markets have risen to levels approaching all time highs
even though corporate fundamentals appear to be lukewarm at best. While the boost to asset prices has enriched
holders, it has not prompted much in the way of sustainable consumption growth, because the owners make up a
very small sector of the population. That is, enriching the wealthy with higher asset prices does not make the nonendowed better off and prompt them to consume more.
The problem with repeated QE is that it does not permit markets to ever become “normal” again absent a major
crisis. In free markets, asset prices, business investments and incomes are all simultaneously determined by the
workings of the market price mechanism. Thus, if asset prices are too high relative to incomes and/or profits, the
demand for them declines and prices fall, and vice versa. Again, if a company engages in unprofitable investment,
its stock price falls and vice versa. When left to themselves, markets will determine the “right” price for assets
relative to the available real business opportunities.
When QE is perceived to be a policy that is anything other than temporary, the linkage between the asset prices
and the productive investment side of the economy is broken. Real business investment may still be determined
by profit and loss considerations, but asset prices become increasingly reliant on financial and liquidity conditions.
Thus, we can have asset prices that are completely divorced from any fundamentals because of the willingness
of the monetary authorities to support financial asset prices at any cost. Obviously, if QE ends, the manipulated
prices cannot persist either which means that the closer the end of QE, the more the potential downside to the
manipulated asset prices engendered by the authorities.
In a market where prices are being continually manipulated upwards by QE, the primary determinant of price action
will be the market participants’ assessment of whether and for how long such intervention can continue. To the
extent that QE continues, the real effects in terms of actual investment are likely to be negative as discussed above
and as such, the fundamentals will deteriorate as will the asset prices derived from the same. However, markets
will most certainly ignore these fundamentals with participants simply trying to profit from the manipulated prices
engineered by policymakers. In this context, markets cease to have value in the economic sense of being able to
allocate capital efficiently – rather they become a mechanism for wealth transfer.
If QE/price manipulation ends, market prices will quickly fall to the much lower levels suggested by fundamentals.
To the extent that there is uncertainty about when and how definitively (as in no future QE for sure) the manipulation
will end, there will be significant volatility, induced almost entirely by participants’ constant reassessments regarding
the end of the manipulation regime. The larger the gap between the fundamental and manipulated prices, the
larger will be the swings in market prices. It is in this sense that a categorical end to QE is akin to the end of a Ponzi
scheme – there are numerous patsies holding overvalued assets who will be left nursing huge losses.
2015
OCT
To summarize then, the markets in a QE environment will share all of the following characteristics:
UPDATE
1) When manipulation is continued, volatility will decline and fundamentals will not matter.
2) The longer this regime is continued the greater the divergence between fundamentals and prices.
3)
The ONLY thing that matters is the probability of the manipulation continuing, especially as the
divergences increase. As markets change their probability assessments, volatility will increase dramatically.
Again, fundamentals will have nothing to do with these price moves.
4)The only way to ultimately resolve this is via a crash to fundamentals or total market closure. No intermediary
will be willing to provide liquidity to ensure an orderly adjustment on the way down.
The U.S. and European equity and credit markets completely reflect the above characteristics. Witness for example
that October 2015 was one of the best months in U.S. and European equities and credit in recent memory.
Yet, the economic data in October were terrible as were the reported earnings from corporations. The U.S. Federal
Reserve did not raise rates but certainly did not cut them. The European Central Bank did not engage in more
QE nor did the Bank of Japan. The blow-off rally in equities and credit and the accompanying sell-off in fixed
income were entirely driven by the hopes of participants that the Fed would not raise rates for longer, and that the
ECB might engage in more QE in its next meeting. Poor data thus led to even more buoyant markets suggesting
that the actual fundamentals simply do not matter.
3. What can we expect?
We have a world today where growth is slowing both in the developed countries and in China, markets are
extended and policymakers are out of pain-free choices to improve matters. Even worse, the leaders in most of
these countries with the exception of perhaps Japan are in collective denial and prefer to fabricate data to support
their fairy tales of a bright future with the help of a complicit media. The developed world’s unelected monetary
policymakers are conducting some of the biggest market manipulations in history all while propagating the fiction
of free markets. The end results are of course obvious and predictable.
We believe that the cracks are starting to show in the omnipotence of monetary policymakers. After years of
unconventional monetary policy, few if any global economies are truly healthy. Yet, no measures appear to be
forthcoming to alter the status quo. As such, we believe that:
1)The world economy is entering a period of slower growth if not an outright recession. Much of the data
signal conditions that have never been observed outside recessions.
2)Liquidity will continue to get worse in markets even though it is already terrible. Many traditionally lowvolatility markets are experiencing swings that have never been seen outside of crises.
3)The barrier for additional aggressive monetary policy, especially in the U.S., is high. While the Fed might not
raise rates, it is a long way from engaging in more QE. As such, the U.S. is unlikely to add to global liquidity.
4)A corporate earnings recession is already occurring and financial engineering is being increasingly employed
to goose earnings. This is becoming unsustainable and the risks of a financial accident are increasing.
5)The view that the world is recovering and that the U.S. dollar is the currency of choice is almost universally
held. This thesis could change suddenly and violently leading to dramatic market shifts globally given the
illiquidity everywhere.
2015
OCT
Performance summary at October 31, 2015
Trident Global Opportunities Class A
1 Mth.
3 Mth.
6 Mth.
1 Yr.
2 Yr.
3 Yr.
5 Yr.
10 Yr.
YTD
Since Inception
(Feb. ‘01)
-1.5% -2.8% -3.5% 6.3%3.4%1.1% 0.5%10.3% 2.4%
8.0%
CI Global Opportunities Fund Class A
1 Mth.
3 Mth.
6 Mth.
1 Yr.
3 Yr.
5 Yr.
10 Yr.
15 Yr. YTD
Since Inception
(Mar. ‘95)
-2.7%
-3.5%
5.7%
0.8%
0.3%
11.0%
5.3%
2.0%
14.3%
UPDATE
-1.5%
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
risks and uncertainties. A number of factors could cause actual results to differ materially from the results discussed in the forward-looking
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.
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 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.
2015
OCT