Opportunities Funds Commentary

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UPDATE
Trident Investment Management, LLC
Opportunities Funds Commentary
December 31, 2011
Performance Discussion
Equity markets remained volatile during the last two months of 2011, finishing the year flat to down overall
(excluding dividends). The S&P 500 index finished the year flat, the MSCI Europe index was down 10.94%
and the Nikkei down 18.68%. The emerging markets did especially poorly with the MSCI Emerging Markets
Free Index down 21.34% on the year. Bond markets remained choppy over the last two months of the year, but
finished the year with strong overall gains. The U.S. 10-year Treasury yield declined 1.42% in 2011 ending at
1.88%. Commodities suffered in general, with gold and oil the primary exceptions for the year being up 13.3%
and 14.8% respectively. The U.S. dollar, despite the problems in Europe and the huge selloff in emerging
currencies in the latter half of the year, barely budged with the U.S. Dollar Index appreciating just 1.5% for
2011. Finally, credit spreads came under pressure, although the bulk of the widening was in sovereign and
financial credit spreads in Europe. Corporate credit in Europe remained relatively well-behaved, and the U.S.
appeared largely immune from the turmoil shaking the rest of the world (all figures in U.S. dollars).
Our funds were up slightly in November but more than reversed these gains in December to leave us
slightly up for the year. Our long fixed-income positions outside the U.S. were the primary contributors to
performance, with our equity holdings and gold also contributing marginally. Our U.S. curve steepeners,
short positions in the U.S. dollar and short credit bets all subtracted, though not meaningfully, from
our returns. 2011 proved an extremely frustrating year for us. While many of our overall themes proved
fundamentally correct, the high degree of market volatility and poor overall liquidity limited our gains. We
discuss the last year in greater detail below and consider what 2012 will bring.
Market Outlook and Strategy
1. 2011 Review
1.1 The Fundamental Situation
Reality finally began to overwhelm hope in 2011. Most observers went into the year with optimism. They
expected global growth to be strong, accelerating from the relatively anemic levels of 2010. They also believed
that the U.S. economy would gain strength, especially given the extension of the Bush tax cuts through 2011.
While observers worried about the European debt crisis, they expected it to be limited in its scope with
Greece perhaps proving the only badly affected nation. Most investors also expected emerging countries to
power ahead, with growth in the BRIC (Brazil, Russia, India, China) complex serving as the locomotive.
They believed that unemployment would decline significantly, especially in the U.S. Not surprisingly, the
Wall Street consensus projected a significant rise in equity markets. The emerging markets in particular were
to do especially well thanks to a benign combination of strong growth and easy global monetary policy.
The year, however, confounded the optimists with most of their prognostications going awry. This was in
part due to unrealistic expectations, but to some degree also because the world was buffeted by a number
of unexpected and significant events.
On the economic front, global growth slowed significantly instead of accelerating. The U.S., which many
had projected would grow at over 4% in 2011 appears to have eked out a 1.8% growth rate. This looks
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respectable only when juxtaposed with the even worse figures posted by many other developed nations.
Most emerging countries saw increased inflation driven by worrying rises in food and energy costs. Their
central banks tightened policy, in some cases significantly, to bring down inflation. This in turn created an
unpleasant mix of weakening growth with still high inflation in many of these countries. India currently
faces such a situation with growth falling below the magic 7% threshold of the last several years. China’s
growth has also slowed. More worryingly, its real estate market, a major driver of its recent growth, appears
to be close to a hard landing creating considerable uncertainty about the country’s future growth prospects.
On the debt side, the situation in Europe deteriorated markedly in 2011. The Greek sovereign debt
problem, far from being contained, infected many of the larger nations in the European Union (EU).
Portugal, Ireland, Belgium, Spain, and Italy all faced questions about the sustainability of their sovereign
debt with a dramatic increase in their borrowing costs in the capital markets. The rise in these costs makes
the debt of these countries increasingly risky creating a vicious feedback loop. Thus, Italy, the third largest
sovereign debt issuer in the world, has a debt to GDP ratio of about 110%. A significant increase in its
financing rates could well result in an unsustainable increase in debt service leading to default.
European sovereign defaults, especially involving Italy, are a daunting prospect for the world’s banks.
Most of the world’s financial institutions have considerable exposure directly or indirectly to the EU, and
by extension to Italy. A debt default by Italy would dwarf the 2008 bankruptcy of Lehman Brothers in its
scale. Not surprisingly, European policymakers spent much of the latter half of 2011 trying to find ways to
contain this growing financial crisis. The overall financing needs of the problem nations of Europe are not
large in the context of the region’s GDP. Yet, any resolution to the crisis will mean huge (and potentially
costly) support from the stronger nations of the EU such as Germany to countries such as Italy and Spain.
The political divisions and the lack of a common fiscal framework for the nations in the EU have made it
impossible for member nations to agree on a comprehensive solution to the crisis. Instead, what we have
seen are a number of inadequate measures that have served to undermine investor confidence to the point
where the Eurozone itself faces an existential crisis entering 2012.
Political events did much to dash the optimistic expectations for 2011. Middle Eastern tensions boiled
over early in the year with a so-called “Arab spring.” Popular movements arose in Egypt, Tunisia, Bahrain,
Libya and Syria to unseat these nations’ repressive governments and replace them with more representative
bodies. Tensions also increased between the U.S. and Iran because of the latter’s nuclear ambitions. These
political developments served to keep oil prices over $100 per barrel almost all year, adding to the global
inflationary pressures already stoked by U.S. quantitative easing.
Finally, Mother Nature also felt it necessary to show her power. In March, Japan contended with an
earthquake, the resultant tsunami, and ultimately a significant and crippling nuclear meltdown in a number
of its power plants. The Japanese disaster led to huge global supply chain issues in the automobile industry
as well as in other key technology arenas. Later in the year, Thailand faced huge floods in key manufacturing
regions, forcing the closure of several factories that produced critical components for the technology industry.
The disruptions from these events served to keep inflation high across much of the world.
Policymakers faced a complicated set of choices in 2011. On the one hand, they had to deal with slowing
growth in most regions. Yet they also faced relatively high and sticky goods inflation that appeared to be
flowing through into wages and services prices. Even worse, given the global climate, they had to worry
about whether a rise in domestic borrowing costs engendered by tighter monetary policy could lead to
questions about debt sustainability. Finally, they had to accept that a truly viable resolution of the world’s
problems required global coordination which was simply not forthcoming. Many of the world’s largest
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democracies face elections in 2012. Painful policies, especially in response to a global calling, that would
have created unpleasant domestic conditions were not politically acceptable to global leaders. As such,
global decision-makers have almost certainly missed the opportunity to take any pre-emptive action to
address the problems the world continues to face.
From a policymaking perspective, 2011 was more than a missed opportunity. In fact, countries such as the
U.S., the U.K. and Japan did virtually nothing to deal with their domestic problems, preferring instead to use
the European crisis as justification for their policies of continuing to take on more debt with monetization
of the same as needed. Thus, the problems have simply grown larger with the prospect of a solution with
the current leadership being even less likely. The unfortunate result of this is that we can look forward to a
world with continued economic turmoil in 2012.
1.2 Market Analysis
Markets, not surprisingly, faced a year of extreme volatility. Uncertain growth prospects and constant, shortterm policy responses created a climate where longer-term investors lacked the clarity to deploy capital. As
such, brokerage volumes dropped substantially. Most large financial firms, especially in Europe, prepared
for the consequences of at least a few sovereign debt write-downs and the potentially significant capital
replenishments that these losses might entail. Given the potential capital losses that could be expected,
financial institutions started to harbor their increasingly scarce capital and became unwilling to take on
proprietary risk to facilitate customer transactions. The overall increase in risk aversion across both the
investors and intermediaries meant an increase in volatility.
The volatility was exacerbated by the fact that investors became increasingly polarized on their outlooks.
Many investors believed that Europe would continue to have problems and that a breakup of the Eurozone
itself could not be ruled out. Yet, the majority of participants also believed that the contagion from such a
breakup would not affect other major indebted nations such as the U.S., the U.K. and Japan. In fact, most
observers still call for reasonable economic growth in 2012 with the U.S. expected to be a robust contributor.
However, a significant minority of investors came to the conclusion that more pain was inevitable and that
strong future growth would prove a challenge. Unfortunately, there was little middle ground between these
opinions which meant that markets swung violently between these views depending on the news headline
of the moment. Schizophrenic investor behavior coupled with illiquid markets made for an exceptionally
difficult investing environment.
What is perhaps most surprising is that many major markets, for all their volatility, did not move much in 2011.
Thus, despite the prospect of a potential breakup in the Eurozone, the Euro currency itself depreciated just
3.16% on the year against the U.S. dollar. This is amazing considering that the currency moves almost that
much each week! The S&P 500 was down 0.31 bps on the year, which is one of the smallest annual moves
the index has made in its history. So, even if fundamentals have reasserted themselves in the markets, they
have done so by creating divergent views among investors and increasing headline volatility. The strong,
sustained market trends that the facts would suggest have not materialized yet in many of the world’s major
markets. Even worse, some of the markets have been so driven by momentum and illiquidity that they have
diverged almost totally from what the fundamentals would have suggested.
2. Portfolio Analysis
Entering 2011, our portfolio was positioned with the view that growth would be weak and that policymakers
would take extraordinary action to forestall a worsening of conditions. We expected significant market
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moves reflecting the divergence between expectations at the start of 2011 and the reality that would ensue.
We were correct in our economic assessments but wrong in that markets did not fully price in the scale of
the problems that the world faced. Policymakers, even today, are resorting to mechanisms to postpone the
ultimate resolution of the truly gargantuan problems we face. While markets began to price in the relatively
somber global reality, they did not to the extent we expected at the start of 2011. Even worse, the risk of
positioning increased substantially as volatility picked up over the year. As such, we eked out some gains for
the year, but considerably less than what we had expected given world conditions. Disappointing though
this is, we are encouraged by the fact that the markets still do not entirely reflect fundamentals and as such
provide ample opportunity for profit in 2012.
2.1 Main Drivers of Our Performance
We look at each of our major bets in 2011 in some detail below.
Fixed Income Positions
Our fixed-income book was by far the biggest contributor to our performance. We correctly forecast a dramatic
slowdown in global growth, and were aggressively long fixed-income instruments in Australia, Norway, Sweden
and South Korea. We also were short U.S. fixed income (through curve steepeners) expecting a Federal Reserve
that was committed to creating inflation. Our long positions in Australia were the biggest contributors to our
performance. Our holdings in Norway also helped, but by much less than we had expected because rates there
did not come down as much as they did in the U.S. Our short positions in the U.S. (which were thankfully
taken largely with options) subtracted, though not much, from our performance.
We added to our fixed-income book of late, looking to exploit the differences in interest rates across the
U.S./U.K. and other more solvent nations. To put things in perspective, U.S. inflation today is over 3%, the
country’s fiscal deficit would make most EU nations blush and its debt levels, measured correctly, suggest
that it may have already passed the point of no-return where it comes to repayment. Thanks to political
gridlock, the U.S. nearly defaulted on its debt in August. In contrast, Norway’s inflation is close to 1% and
falling, the country has no net debt and the economy there is slowing. Yet Norwegian 10-year (swap) rates at
3.565% are much higher than U.S. rates which are at 2.03%. The Norwegian kronor could also be viewed
as a viable safe haven for fleeing Euro holders much like the Swiss franc, but unlike Switzerland which
now has negative short-term rates, Norway continues to have among the highest rates in the developed
world. Put differently, real Norwegian 10-year swap rates are at 2.565%* with the U.S. being at -0.17%* and
Switzerland at 1.725%*. The divergence in these real rates is simply not supported by fundamentals and
represents a compelling opportunity.
The same is true, though to a lesser degree, in Australia which has indeed the highest nominal rates in the
developed world.
(*) Computed as nominal swap yields – CPI (yoy)
Gold
Our next big bet was our long gold position which also contributed positively to performance. We anticipated
that gold would be viewed as the alternative currency of choice and that it would be revalued against the paper
monies of the world which were increasingly being debased by their respective central banks. Yet, despite more
than a trillion dollars in money printing last year, gold managed only a 13% move over the year, with constant
corrections along the way, some amounting to over 20%. The gold miners performed abysmally, falling over
16% on the year in the face of a flat U.S. equity market. Our gold positioning was in a combination of physical
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gold and gold stocks. Our physical gold did show healthy gains, which were partially erased by our stock
positions making our overall gains less than just the move in gold would have suggested.
UPDATE
We believe that gold as a commodity remains attractive entering 2012. Also, the considerable divergence
between the prices of the gold companies and the commodity make the gold mining equities equally
enticing. We have yet to see a market realization of the fact that physical gold stocks are finite and that
global money printing is in the trillions of dollars each year. When these facts are fully understood by the
markets, a parabolic move up in gold prices should result, followed very likely by the closure of the entire
market. As such, gold still offers compelling opportunity and we expect to add to our holdings on any price
weakness over the year. We remain concerned about the huge amount of speculation in financial contracts
linked to gold, especially given the very limited stock of physical gold backing these derivatives. As such, we
expect our additions to be either in the physical metal itself or the equities of the largest producers.
Credit
Another significant position in our portfolio was in the credit markets. We were short mostly borderline
investment-grade credit both in the U.S. and Europe (mostly BBB+ and below), and were long what we
believed to be the highest grade sovereign credit (including Germany and France). We retained a net short
bias all year in credit. In particular, our sovereign longs in Europe were more than offset by our shorts in
the same region. Our credit book slightly hurt our performance, notwithstanding the general widening
of credit spreads. The main reason for this was the dramatic widening of sovereign credit spreads relative
to even low-grade corporate spreads. This price action was almost entirely confined to the Credit Default
Swap (CDS) market where we had most of our positions.
The corporate/sovereign CDS spread divergence was surprising in that the cash bond market credit spreads,
which the CDS spreads are a proxy for, did the exact opposite in many instances! For example, we have a position
in the CDS of a poorly rated corporate in France whose 5-year cash bonds trade with a yield 2.11% above that
offered by 5-year French government bonds. Yet, its CDS, which logic would dictate would be anchored at close
to the same spread actually traded at a spread of -0.43% meaning that the CDS market somehow viewed this
company as being safer than the French government, even though the cash market did not.
When one looks at credit spreads across countries the divergences are even more stark. China, the U.S.’
largest single creditor, has its 5-year sovereign CDS contracts trade at a credit spread of 1.50% a year. That
is, an investor needs to pay 1.5% a year to protect against default of a small group of foreign bonds (totaling
just about $5 billion in aggregate principal) by China. Yet, protecting against equivalent default by the
U.S., which has much more than $10 trillion in government debt, costs just 0.40% a year. Thus, the world’s
largest debtor is viewed as being much more creditworthy than its largest creditor, even though it is the
latter that continues to provide the former with much of its credit.
The price divergences above make little fundamental sense. They exist due to market segmentation and
illiquidity. As such, we view them as major opportunities that we intend to exploit further in 2012.
Equities
Our net equity positioning was relatively small over 2011. We believed that growth would disappoint and
as such, remained long defensive equity market sectors such as consumer staples, healthcare and utilities
primarily in the U.S. We also held long positions in less cyclical energy companies, such as the integrated
oil complex. Against our long positions, we were short the major U.S. indices, with some positioning as well
in consumer discretionary sectors.
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Our equity book contributed positively to our performance, albeit with significant volatility. Ultimately, utilities,
healthcare and staples all outperformed the market over the year, although many consumer discretionary sectors
did as well. We believe that the defensive outperformance can last for several years, especially given that the
current de-leveraging “recovery” seems anything but that. Accordingly, we remain ready to add to this theme.
We also believe that the crisis mentality of the latter half of 2011 has led to an exodus from the developing
countries which arguably still have among the best economic fundamentals in the world. The dramatic
decline in the emerging equity markets over 2011 represents a huge buying opportunity in the medium
term. We expect to move sometime in 2012 to capitalize on this undervaluation.
Currencies
We believed entering the year that the dollar would weaken significantly and that the currencies of
emerging Asia would outperform significantly. We proved correct in our thesis until the European crisis
started to get into full stride. The risk revulsion towards emerging markets that ensued depressed both
their stock markets and their currencies. Thus, many of the Asian nations that saw strong growth and were
tightening policy actually had their currencies depreciate. The Indian rupee particularly, was one of the
worst performing on the year, weakening a staggering 15.75% to a new all time low against the U.S. dollar.
Our currency bets were small and were based on the expectation of an emerging market decoupling which
did not materialize. Our biggest position, fortunately, was in the Chinese renminbi (through options)
which bucked the Asian trend and proved to be one of the strongest performing currencies against the
dollar over the year, appreciating 5.11%. Unfortunately, the glacial pace of appreciation only allowed us
to partially recoup the premium we paid on our options – the maxi-revaluation that would have generated
dramatic profits for the portfolio simply did not occur.
The currency markets today are still beguiled by the U.S. dollar which has amazingly become something of a
safe haven for investors fleeing the Euro. Yet, even though the debt fundamentals in the U.S. are considerably
worse overall than the EU, the country has made no serious attempt to rein in its debt. Almost 50% of U.S.
debt is held by foreigners – a ratio that makes overseas sentiment critical for continued borrowing. Even
worse, we have a central bank that is fully expected to embark on monetization again in 2012 – a move that
could easily precipitate a disorderly retreat from the U.S. dollar and lead to hyperinflation.
We continue to be biased against the U.S. dollar. Yet our task of shorting the dollar is complicated by the
fact that its chief rivals – the Euro and the yen are themselves plagued with issues. In fact, the debt levels
in Japan and its likely return to a deflationary recession over the last months of 2011 suggest that the yen
might perhaps be even more overvalued than the U.S. dollar.
Our core view for 2012 is that a massive devaluation of the developed world’s currencies against the emerging
group is virtually essential for global economic stability. Such a move would reduce inflation in the developing
world and force a transition to consumption-led rather than export-led growth – a shift that is vital to offset the
developed world’s likely slow growth coming from fiscal austerity. We expect to be positioning for this over
2012, although as things appear, most global policymakers appear to be resisting such a shift.
3. Conclusion
On balance, 2011 was a frustrating year. The global imbalances were all too apparent even to the layperson.
Yet policymakers, driven by a combination of ideology, cronyism and at worst, self-serving dishonesty have
managed successfully to prevent a real adjustment that would have put us firmly on a stable, albeit near-term
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painful, economic path. We enter 2012 thus with the world even more vulnerable. Growth is much weaker
than at the start of 2011. Fiscal deficits and debt levels have grown even higher to the point where markets
are increasingly refusing to finance them. Monetary policy is so much on overdrive that inflation is apparent
on virtually every hard asset outside real estate. We are simply out of conventional policy options.
A dearth of conventional policy options will likely engender direct intervention in markets. Quantitative
easing, by any definition, was already such an intervention. We might soon see similar market meddling
policies by the authorities in Europe, and very likely even in Japan. While these actions could trigger more
near-term volatility, the ultimate outcome is much less in doubt. No matter what policymakers do, we
face a world where growth will be scarce. Risk, in terms of the purchasing power of the world’s currencies,
is and will remain extremely high. The likelihood of direct or indirect expropriation of private assets by
populist governments is increasing. Navigating these treacherous trends should prove quite a challenge,
but one that we have been training arduously for over the last three years. We look forward to an exciting
and profitable 2012.
Here’s wishing all of you a Happy and Prosperous New Year.
Performance Summary at December 31, 2011
Trident Global Opportunities Fund
1 Mth.
3 Mth.
6 Mth.
1 Yr.
2 Yr.
3 Yr.
5 Yr.
10 Yr.
YTD
Since Inception
(Feb. ‘01)
-2.1%
-4.4%
5.0%
1.8%
-1.6%
-2.3%
20.4%
10.9%
1.8%
10.5%
CI Global Opportunities Fund
1 Mth.
3 Mth.
6 Mth.
1 Yr.
3 Yr.
5 Yr.
10 Yr.
15 Yr. YTD
Since Inception
(Mar. ‘95)
-2.1%
-4.4%
4.6%
1.6%
-2.4%
22.7%
9.6%
16.2%
1.6%
17.6%
Nothing herein should be read to constitute an offer or solicitation by Trident Investment Management, LLC or its principal to provide investment
advisory services to any person or entity. This is not to be construed as a public offering of securities in any jurisdiction of Canada. The offering of
units of the Trident Global Opportunities Fund are made pursuant to the Offering Memorandum only to those investors in jurisdictions of Canada
who meet certain eligibility or minimum purchase requirements. Important information about the Funds, including a statement of the Fund’s
fundamental investment objective, is contained in the Offering Memorandum. Obtain a copy of the Offering Memorandum and read it carefully
before making an investment decision. These Funds are for sophisticated investors only. ®CI Investments and the CI Investments design are
registered trademarks of CI Investments Inc.
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