Download 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
March 31, 2013
Performance Discussion
Markets greeted 2013 with ebullience. Global equity markets were up in the first quarter with the S&P 500
Index up 10.03%, the MSCI Europe Index up 4.79% and the Nikkei up 19.27%. Fixed income fared less
well, with rates on 10-year U.S. Treasuries rising 0.09% over the period to end at 1.85%. Commodities were
mixed with oil being up 5.89% to end at $97.23 a barrel of WTI and gold down 4.57% to end at $1,598.75 an
ounce. Credit rallied with spreads on U.S. Investment Grade Credit Default Swaps declining 0.03%. Finally,
the U.S. dollar rose against most currencies appreciating 4.02% over the quarter (all figures in U.S. dollars).
Our funds got off to a good start in 2013. Our biggest gainers during the year were our substantial positions in
Japan. Our long stock positions in Japan were the largest contributor to performance, and our short position in
the yen helped as well. Our biggest losers were our long positions in gold and our slightly net short positions
in U.S. equities. Our long positions in Korean fixed income also contributed to our performance. Rather
surprisingly, our short in Japanese bonds hurt performance despite the robust equity markets in the country.
We entered 2013 believing that it could be the year of Japan. The country looks to be entering a period of
considerable change which could shape its destiny for generations to come. Markets so far have gone along
with our thinking, but have yet to anticipate the potentially transformational impasse at which the nation
finds itself. The policy shifts being contemplated in Japan will have far-reaching implications for the country,
its markets and ultimately for the world economy. Over the next several months Japan could prove one of the
most important macro drivers for the global markets.
We discuss the situation in Japan in some detail below. First, we look at the challenges faced by the country
putting them in historical context. Next we consider its available policy choices in some detail. Then, we
take up the changes that have recently occurred in the country and why they might represent a true break
with the past. Finally, we consider the investment implications from the potential transformation that could
occur in Japan.
1. Japan – Post War Reconstruction to the Bubble
Japan was the first major Asian success story in the period following the Second World War, managing
successfully to rebuild its shattered economy and emerge as a major economic power. The Japanese success
involved both economic restructuring with a breakup of the pre-War industrial conglomerates or zaibatsu by
the Occupying Powers, and significant new domestic investment. The Japanese government implemented
a stringent set of tariffs and repressive financial measures to encourage its citizens to save. The ample
level of savings meant an abundance of investment capital, much of which was used to develop Japan’s
manufacturing and export sectors. The relatively undervalued yen over the period coupled with strong global
growth post 1950 also made such investments in manufacturing extremely profitable overall for the country.
The 1970s were a period of high U.S. inflation. The Federal Reserve, headed by then chairman Paul Volcker,
starting late in the decade used a combination of high interest rates and a strong dollar to bring down
inflation. These policies helped Japan’s already capable export sector which was just starting to dominate
2013
MAR
UPDATE
in many areas such as automobiles and consumer electronics. As the U.S.’ strong dollar policy continued
into the early 1980s, it took a huge toll on the profitability of U.S. manufacturing companies, which, in turn
lobbied the government for tariff relief. By 1985 the U.S. Congress was actively contemplating enacting
protectionist legislation to safeguard American industry. The Reagan administration forestalled such a move
by negotiating the Plaza Accord in 1985 with the U.S.’ major trading partners. The agreement engineered a
substantial depreciation of the U.S. dollar largely reversing the huge appreciation that had occurred over the
last several years. In particular, the Japanese yen was revalued from ¥250 to ¥160 per dollar, and continued
to strengthen further to ¥120 by 1988.
Faced with the significant appreciation in the yen post 1985, the Bank of Japan (BOJ) eased monetary policy
significantly, from 5% to 2.5%, in a bid to offset the contractionary effects on Japanese exports and thence
the economy. However, the Japanese economy was already awash in investment capital thanks to ample
domestic savings. The policy-induced decline in rates fostered at first more investment and then a massive
speculative boom. Japan’s stock and real estate markets soared to dizzying heights in the late 1980s, even as
the country continued to invest in manufacturing and export capacity.
By the late 1980s, the Japanese speculative frenzy was nearing its culmination and the signs of excess were
everywhere to be seen. In 1989, the Nikkei hit its all time high of 38,957, with most observers forecasting
even higher levels in perpetuity. Real estate soared to almost unimaginable levels – the Imperial Palace
in Tokyo was worth more than all the land in California, and prices in the swank Ginza district in Tokyo
averaged about $139,000 per square foot! The largest banks in the world were virtually all Japanese. The
largest company in the world by revenue was Japanese trader Mitsubishi Corporation. Every company in the
world wanted to emulate Japanese production techniques, and every business school tried to become more
Japanese in its outlook.
2. The Post-Bubble Era
The BOJ decided to reverse its policy of easy money in December 1989, when new governor Yasushi Mieno
took office at the institution. Interest rates were raised five times to a peak of 6% from 1989 through 1990.
The lack of cheap leverage led to a collapse in markets and a bursting of the bubble. The scale of the
bubble’s deflation meant horrific consequences for the country’s economy and in particular, its banks. To
put things in perspective, the Japanese real estate market collapsed over 80% from 1990 and even today has
not recovered its glory days. Yet, even at today’s prices Tokyo remains one of the world’s most expensive cities.
The equity market fell over 80% from its 1989 peak and today, after the major rally of the last several weeks,
is still down about 70% from its peak. Not surprisingly, the Japanese banks were devastated by these declines.
The country now has just three large so called “city” banks which are the merged results of scores of formerly
much larger and globally revered institutions, and even these firms are not the fearsome global powerhouses
they once were. While many of these results were perhaps predictable, what was perhaps not as clear in 1990
was the multi-year slump into which the Japanese economy would be plunged. Japan’s economy has lived
with more than two decades of weak growth and deflation – a trend that has proved difficult to reverse so far.
And it is precisely the weak economy that concerns Japanese policymakers the most today.
After 1991 Japanese policymakers used a combination of fiscal and monetary policies to stabilize the economy.
The government used fiscal measures aggressively to boost growth and keep unemployment low. In particular,
it attempted direct expenditure through public works programs, repeated tax cuts and other similar efforts all
of which only served to increase growth in the very short term, while also increasing the country’s sovereign
debt. The BOJ cut rates virtually to zero very quickly following 1991. The BOJ and government cooperated in
2013
MAR
recapitalizing the banking system with significant injections of government funds. They also forced a reduction
in banking capacity by promoting mergers between large institutions. Finally, the BOJ maintained a relatively
steep yield curve to help banks boost their earnings during the transition.
UPDATE
The heroic measures since 1991 did little to create sustainable economic growth, but they have saddled
Japan with prohibitive costs. The government has had to run consistently high fiscal deficits every year post
the bubble to prevent a serious depression in the economy. As a consequence, the nation has moved from
being one with the healthiest sovereign debt position in the developed world, with a net debt to GDP ratio of
only about 12% in 1991, to now being the largest problem borrower with the ratio about 140%. Even worse,
Japan still needs to run large fiscal deficits projected to be around 9% of GDP in 2013 to generate what has
inevitably been anemic growth. The country simply cannot continue on this spending path without courting
economic disaster.
3. Japan’s Current Policy Choices
Japan needs to act to put its government finances in order given the unsustainable growth of its debt under
the current regime of taxes and benefits. The unpleasant fiscal dynamics become much less of an issue if the
country can generate strong domestic growth. The first and best policy without doubt would be to act to boost
domestic growth. Yet, there are alternative measures Japan can adopt to deal with its debt burden even if its
domestic growth remains weak. The country can look to invest overseas more aggressively to generate the
returns needed to pay off its domestic debt. Alternatively, it can adopt measures to accept a lower standard of
living and ensure that the pain of such an adjustment is equitably shared by its citizenry. We consider each of
these alternatives in more detail below.
3.1 The Challenge of Domestic Growth
Growth in an economy can arise from two factors. The first is population growth – the more workers there are
in the labor force, the more the output will be. The next is an increase in worker productivity – the more an
individual worker can produce, the greater the total output. Neither of these factors can power growth easily
in Japan today.
Japan faces an unpleasant demographic profile. Over the last several years the country has experienced a net
population loss. It has a falling birth rate and almost no net immigration. As such, the country is likely to see
a shrinking labor force as increasing numbers of older workers retire relative to the number of new entrants.
The only way to avoid this would be with significant reforms to promote later retirement, more immigration,
increased employment of women and a higher birth rate. Without such changes, the country cannot count
on economic growth coming from labor force increases. Even worse, Japan’s citizens enjoy one of the highest
life expectancies in the world at over 80 years. Given the low birth rate, this means that Japanese society is
aging rapidly. The country has a problem already in that there are not enough young workers to pay the taxes
to support retirees, with the problem only expected to get worse over time.
The lack of organic growth in the population might be partially mitigated if Japan can count on big increases
in worker productivity. Yet, such increases are not easy without radical structural reform. Japan already
invests about 20% of GDP and its productivity growth has actually exceeded the OECD average even after
the bursting of the bubble in 1991. Productivity growth has been strong in most manufacturing industries,
but it lags behind in most services sectors. In particular, Japan has low levels of investment in Information
Technology and computers in many service sectors suggesting that there is some scope for future increases.
2013
MAR
UPDATE
Yet, barriers to entry are very high in Japan’s services sectors preventing more productive start-ups or foreign
competition from challenging the established, albeit less efficient, players. There is some evidence from the
developed economies that suggests that growth rates can be boosted significantly by structural reforms in the
services sector. However, these changes take time to work suggesting that any growth benefits will occur in
the medium to longer-term -- in fact, reforms might actually hurt growth in the short run. So far, the Japanese
government has been less than aggressive in pushing for a major structural overhaul of the country’s economy.
The simple conclusion that one can draw is that there is little Japan can do quickly to generate sustainable
domestic growth. The country does not have an untapped reservoir of productive capacity that can be
readily unleashed. Rather, it needs structural reform that will take considerable time to generate an increase
in growth rates.
3.2 Living off Foreign Investment
Despite its problems, Japan is still an extremely wealthy country. It has considerable domestic private savings
and remains a net saver in external terms running a current account surplus. If Japan were to actively invest
its capital overseas, targeting countries with favourable population dynamics and low capital intensity in
production, these opportunities could potentially provide the high investment returns to sustain Japan’s
standard of living. Put differently, Japan can become the provider of capital for countries that have cheap
labor and low domestic savings rates and live off its investment earnings rather than attempt to generate these
returns domestically in its mature economy. Were the Japanese government to actively pursue such a strategy
of looking outwards for investment returns going forward, it would use its political clout to ensure the safety
of its investments, while setting up a foreign investment operation such as Norway’s Oil Fund or Singapore’s
Temasek to profit from international opportunities. Of course, for such a policy to make sense, it would have to
generate ex-post risk adjusted returns that are much higher than the effective cost of Japanese sourced capital.
Japan has already pursued the strategy of looking outwards for investment returns, although this move has been
led so far largely by the private sector. The threat of tariffs has prompted many Japanese manufacturers to locate
operations in many of their end-markets such as the U.S., even in the 1980s. The high costs of operation in Japan
have pushed many other companies to locate production in South East Asia. And Japanese firms made many
outright financial investments such as purchases of real estate in the U.S. Unfortunately, the record for Japanese
firms has been at best mixed in these ventures. Most of the U.S. non-manufacturing investments proved to be
disasters. Investments in Asia, undertaken for the most part before the Asian crisis, were decimated by the events
of 1997. And the relentless appreciation of the Japanese currency over the last several years has meant that even
the best of these investments ultimately did not pay off to the extent expected in yen terms.
Despite the historical record, there is considerable justification today for Japan to expand its overseas investment.
Since 1991, the country invested about 20% of GDP in its domestic economy, which is a huge percentage
given rampant excess capacity. As such, the returns on investment have been abysmal even adjusting for
the potential employment and social benefits that might have accrued. In fact, most observers would agree
that Japan has been earning negative returns in most of its domestic investment. When such investment was
undertaken by the public sector, these results were obvious – Japan has an ample measure of white elephant
civil projects that can never cover their costs. What is not perhaps equally clear is that such investment even
by the private sector has not paid much in the way of dividends. The domestic manufacturing industry has
typically been the major recipient of Japanese investment largesse. However, many Japanese manufacturing
companies have already reached a scale where they produce more than the domestic market will ever need –
2013
MAR
they have to export to justify even their current production. Yet on the export front they face strong competition
from other lower cost producers and are simply not profitable enough to warrant more expansion.
UPDATE
Of course, adopting this course of action at a much bigger level as Japan needs has numerous risks. The
countries Japan invests in have to provide both economic and political stability, in addition to having a
legal system that respects investors. Next, they need to be open to foreign capital both in terms of allowing
ownership of domestic companies as well as the repatriation of earnings. After all, by investing overseas Japan
will be tying its future well-being to its investment making these critical considerations for adopting such a
policy. Few low cost developing countries fit all the requirements for outsize Japanese investment while the
developed countries that might, will typically provide much lower investment returns.
3.3 Acceptance and Redistribution
Japan’s final policy choice is simply to acknowledge its economic issues and work to adjust its society to this
reality. Lower future growth could well mean that a number of the current benefits enjoyed by the elderly in
Japan might become unaffordable. The government could take steps to ensure both higher taxes and reduced
benefits to make the entire social welfare system in Japan sustainable. In fact, the ethnic homogeneity and the
history of Japan perhaps make it easier to engineer such changes relative to almost anywhere else. A number
of other measures can be tried at the micro level here, most of which ultimately will mean a redistribution of
wealth across society. Such policies could be set up to create strong near-term growth. Thus, a big investment
tax credit or a middle class tax cut, even if financed by tax increases on other sectors of society, could be targeted
to generate growth in the short run. However, such a boost is likely to be transient unless accompanied by
structural changes to permit longer-term sustainability.
Measures to boost inflation by bond or other asset purchases by the Bank of Japan should be rightly viewed
in the above context. Were such policies to work to create inflation, they would engender a redistribution of
wealth from savers to borrowers including the largest borrower of them all, the government. This shift will
likely create short-term growth, especially if the currency were to depreciate and fuel exports. It could also
help in the medium term if it leads to a normal credit cycle with more bank lending. Yet, it is equally clear
that such growth does not address Japan’s longer-term problems. If the demographic and productivity issues
are not addressed, the higher near-term growth rates will simply not be sustainable. The effective result will be
continued economic stasis or outright decline with a shifting of the relative burdens of the same.
To sum up then, there are three policy prescriptions for Japan to deal with its current malaise:
1)Significant structural reform to boost domestic productivity and/or improve the country’s demographic
profile. This should help long-term growth rates but could well affect growth negatively in the short run.
2)Expanded international investment by the sovereign to generate the investment returns to ensure an
improvement in Japan’s standard of living. This approach might have some short-term benefits if the yen
were to decline, but its major effects are in the longer-run.
3)Redistribution of domestic wealth and adjustment of future expectations to reality. If this is achieved
through inflation or direct redistribution through taxation, it could be tailored to have strong short-term
growth effects. Yet, it does not solve the problem longer-term but rather, forces acceptance of a lower
standard of living.
The above policy prescriptions work in different ways and with different time horizons. As such, they are not
2013
MAR
mutually exclusive and it is possible for the government to work with elements of all of them. We believe,
given the scale of its problems, the best outlook for Japan would come from the simultaneous adoption of all
three of the above approaches reinforcing their overall effects.
UPDATE
4. The Abe Restoration?
The challenges that Japan faces are all too clear to most observers. Japanese politicians and bureaucrats
openly acknowledge the need for change to deal with the country’s issues. Yet, there has been little discussion
of a unified “big-bang” approach and a focus instead on micro elements of specific policies.
Western observers have typically berated Japan for not being aggressive enough in restructuring its banks and
engaging in Quantitative Easing (QE). As our discussion above should suggest, while such measures could
prove helpful especially in the short-term, they will not be enough to solve the country’s problems. The BOJ’s
view post-1991 was that the country’s malaise was entirely structural and that the institution could do little to
address it. There is some merit to this view but what the BOJ has failed to acknowledge is that it might have
a role in a potential solution. Structural change is typically recessionary in the short-term and there is a lot a
central bank can do to mitigate such a slowdown. The fact is that the BOJ can and should be an integral part
of any true resolution for Japan – something that politicians have long urged without specifying clearly the
role the institution was to play, even as they have shirked their duty to promote structural change. Again, other
policymakers have argued for fiscal rectitude with tax hikes and spending cuts to put the country on a better fiscal
footing expecting a supply-side growth response. As such, there has been considerable difference of opinion on
policies that Japan should follow with much finger-pointing as well. Not surprisingly, the investor community,
has reacted to all this with pessimism projecting a crisis of major proportions if not the outright collapse of Japan.
A number of events that have occurred over the last several months in Japan suggest that the cacophony of
opinions might finally be getting modulated into a tuneful policy. In particular, the Liberal Democratic Party
(LDP) won a resounding majority in the December 2012 elections to the Diet in Japan, with Shinzo Abe, its
leader, subsequently being installed as the Prime Minister. Abe is generally viewed as a Japanese nationalist with
an agenda to remake Japan. He has expressed interest in revising three of Japan’s basic modern charters: its peace
constitution imposed by the U.S. in 1946, its education laws and its security arrangements with the U.S. where
Japan has a decidedly subsidiary role. Yet, given the Japanese population’s apathy towards his radical agenda, the
primary focus of his administration, at least initially, will be the economy. Moreover, to cement his power, Abe
needs to win a majority in the Upper House, elections for which are in July 2013, and decisive action on the
economy is sure to improve his chances of success.
Abe’s strong focus on the economy was apparent even before the election. The LDP indicated in no uncertain
terms that it intended to eliminate the Bank of Japan’s independence absent more action from the institution
to support the economy. After taking office, Abe appointed Taro Aso, a former Prime Minister and seasoned
politician, as the Finance Minister. Aso has been charged with delivering more fiscal stimulus, despite Japan’s
huge debt levels. He is likely to use his considerable political clout to force these additional expenditures
through a reluctant Finance Ministry bureaucracy.
The biggest changes under Abe however, were reserved for the Bank of Japan whose Governor and two
deputies retired in mid-March. The last governor, Masaaki Shirakawa, represented the long-held view at the
BOJ that the institution could not do much to address what were essentially structural problems in the Japanese
economy that were to be dealt with by the government. Even though the BOJ under Shirakawa’s tenure did
2013
MAR
UPDATE
engage in QE, it did so without really believing in its efficacy. Further, it was unwilling to experiment further
by expanding such programs given their lack of success. Abe appointed Haruhiko Kuroda, a long-time critic
of the BOJ, to head the institution. One of the appointed deputies is Kikuo Iwata, another fierce BOJ critic
who believes in even more radical action. These two appointees share a common view that the BOJ has a
significant role to play in the reemergence of Japan. In particular, they both espouse the need to generate
inflation (which relates to the goal of redistribution we talked of above) with aggressive asset purchases. They
have also implicitly acknowledged the potential for investing overseas to generate the investment returns to
sustain Japan. They have nevertheless tried to be circumspect when asked if they supported large scale foreign
bond purchases for fear that this might be perceived as an explicit attempt to weaken the yen. The simple
fact is that we have a radically different BOJ now – one that has a much broader view of its role and with a
leadership that is ideologically prepared to act aggressively.
Thus, Japan has changed significantly over the last several months. We have a new sheriff in town in Abe and
there is a willingness among key policymakers, and especially the BOJ, to adopt a true multi-pronged, radical
approach to solve the country’s problems. To top it all, there is true consensus among the leadership, which
in Japan is typically a long time in coming.
In 1868, Japan entered a period of intense change and modernization with the so-called Meiji Restoration
which transferred power from the shogun to the Emperor Meiji. By 1912, the country had transformed itself
from a largely backward, feudal economy into a global power with a strong industrial base. The challenges
that Japan faces today require aggressive policy measures and significant change. The consensus that is
building up for decisive policy action suggests that we might have entered the period of the Abe Restoration.
5. Investment Implications and Conclusion
Equity markets have reacted to the changes in Japan with euphoria so far. The yen has weakened 6.70%
against the U.S. dollar in anticipation of more BOJ easing. The Nikkei is up over 19.27% on the year already,
although in U.S. dollar terms it is up only 8.96%. The Japanese bond markets are among the best performing
in the world this year, with yields on the 10-year Japanese Government Bond plumbing lows of 0.51%, thanks
to more potential QE from the BOJ. This has happened despite the country’s record debt/GDP ratio.
The current economic policy mix, with BOJ support, should spark growth, some inflation and a normal credit
cycle in Japan in the near term. This would give the government a strong economic base from which it could
launch significant structural reforms to create a new paradigm for sustainable growth. A critical component
of the government’s economic plan is to engender asset price appreciation which in turn might trigger more
inflation. On this front, they are likely to get considerable support from the BOJ -- the “old” BOJ actually
adopted a formal inflation target of 2% once Abe came to power and the new team seems determined to
purchase financial and other assets to achieve this target.
Japanese companies today are both asset rich and undervalued making them the ideal target for asset
revaluation. The primary reason for the undervaluation of Japanese firms was the fact that they were generally
perceived as destroyers of wealth. Post bubble, they continued to invest heavily despite domestic deflation,
and their returns on capital invested were generally poor in relation to the costs of the same. A normal credit
cycle in Japan could easily turn many industry sectors in the country into profit generators again, making
them worthy of a substantial premium to the book values of their assets. Even with the re-rating of Japanese
stocks over the last several months, such an outcome is far from being priced in.
2013
MAR
UPDATE
Examples of Japanese stock market undervaluation are legion. The Tokyo Stock Exchange TOPIX index
trades at a Price/Book ratio of just 1.1X and a Price/Earnings ratio of 20.6X. Were Japanese earnings to rise
to the still-deflationary 2005 levels, the TOPIX P/E multiple would decline to 16X. And if the new team at
the BOJ manages to generate inflation, the earnings expansion might be much more substantial. As such,
one can reasonably expect the market to trade at a Price/Book Ratio of 2.3X (which is comparable to the U.S.
S&P Index). Were it to do so, it would be an upside of 100% from current levels!
So, in Japan now we have an exciting combination of undervalued assets and major policy changes that
might lead to huge investment upside. But there are still significant risks. In particular:
1)The policy consensus could disintegrate and the government could prove as ineffective as prior Japanese
governments have been. Abe himself was prime minister from 2006-2007. He entered with great promise
and left with little to show for his first term.
2)The measures contemplated are radical and may not work as intended. Japan’s problems are indeed
significant. A few miscalculations and we might have a true economic disaster on our hands.
3)The conditions in the rest of the world are not benign. The European Union is again in crisis with Italy
not having a government and Cyprus in chaos. The Chinese economy is unlikely to improve much and
the U.S. is facing significant headwinds. Japan could do everything correctly and still fail because of the
global environment and its reliance on exports.
While these risks are real, we believe strongly that Japan itself will not be the primary risk factor at least in
the medium term. The country has had a distinguished history of reinventing itself. Its leaders today appear
to have reached a consensus on the need for change and have started to move quickly and aggressively on
the policy front.
Our funds are betting on a new era in Japan. We believe that we are entering a period of transformation in
the country, and hopefully, significant profits for our funds.
Performance Summary at March 31, 2013
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)
4.6%
3.5%
7.5%
4.5%
1.3%
4.6%
11.7%
4.6%
9.8%
2.7%
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)
4.5%
3.4%
7.2%
1.2%
5.5%
11.6%
12.4%
4.5%
16.5%
2.6%
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.
2013
MAR