THE ECLECTICA FUND

FUND MANAGER COMMENTARY
JUNE 2009

Warning, I am about to repeat myself I have been keeping a low profile and have reduced the length of my reports. There has been little to note: my favourite asset class is long duration bonds; not index linkers. These have performed poorly so far this year. I have not fought this trend aggressively. By March I had rebuilt a modest sized position owing to the severity of the weak economic data. However this was mostly eliminated by the first week of April out of respect for the formidable price correction that was ongoing. As a result the Fund is down modestly on the year to date following last year’s surge. However, with the long bond yield in America now not far off 5pc, it is my contention that the trend may be approaching another extreme. I therefore thought it appropriate to once more outline my thoughts: what if the trend in the charts below continues; what if this year is a re-run of last year?
MSCI World (£) 2008 v. 2009 YTD
110

Crude Oil ($) 2008 v. 2009 YTD
160

MSCI World 2008 MSCI World 2009
140
100

Crude Oil 2008 Crude Oil 2009

120

90

100

80
80

60
70

40

60 Dec Mar Jun Sep Dec
Source: Bloomberg - Data Series Rebased to 100

20 Dec

Mar

Jun

Sep

Dec

Source: Bloomberg - Data Series Rebased to 100

The decision to reduce the book in April reflected an unpleasant seasonality in our preferred trade. The second quarter in four out of the last five years has simply not been kind to risk aversion. Furthermore, markets continue to swing from the binary outcomes of inflation and deflation. At this point last year inflation was in the ascendancy. Backwards, forwards, since July of last year the same investors had to adjust to profound deflationary forces as all risk asset classes fell precipitously. Can we be any more confident that the market has it right now? Let's swallow a frog I do not have the requisite level of confidence to make such a commitment. Better I would contend to always have a vivid image of the worst that might happen in our uncertain future and have this shape our behaviour today. So let's consider the "bad things" which might initiate another dramatic rotation towards deflation. My greatest angst is reserved for the four-fold rise in private sector, non-financial, leverage in America. In just 60 years, the private sector increased its debt from 43pc of GDP to 175pc. To put this into perspective, the UK is on the verge of having its formidable tax raising franchise downgraded because its debt may reach 100pc in two years time. And yet, until last year, there was little hand wringing about the private sector having borrowed more than 4x the public sector’s then debt. Don’t get me wrong, I am sympathetic to the plight of America’s debtors. I understand why they came to believe that they were invincible. In truth, something without precedent occurred earlier this decade. Fearing the fall out from the tech bubble, businesses across all sectors of the economy set about cutting costs and laying staff off to prepare for the impending deep recession. Unemployed workers should have cut back on spending and rebuilt their savings. Instead they leveraged themselves against appreciating home prices to maintain their spending habits. Corporate revenues should have fallen. Instead, with disposable income boosted by home equity extraction, sales rose and profits boomed like no time before. Today, by comparison, the corporate sector is threatened not so much by its own debt but rather by the loss of spending in the economy from the debt laden workers it has fired. Businesses are slashing costs and letting staff go. American unemployment is at a 26 year high of 9.4pc and total nominal wage payments have fallen for the first time in at least 50 years. This time around the economic orthodoxy is reasserting itself. Companies are discovering that in their quest to contain costs (by firing the economy’s consumers), they are suffering from a loss of revenue in future quarters; because of this I am wary of most prospective profit forecasts and not tempted by trailing 10 year earnings multiples.

THE ECLECTICA FUND
FUND MANAGER COMMENTARY
JUNE 2009

My second concern relates to the willingness of governments to use their own leverage as a remedy for asset deflation. Policy makers seem to believe that the only way to reverse the tide in asset prices is to issue vast sums of ‘money-like pieces of paper’, aka government bonds. In doing so they are mimicking the previous decade when investment banks were able to boost the housing market by issuing trillions of dollars of mortgage backed paper, or the 1990s when it was new internet share issuance which drove the TMT bubble and so on back to John Law and his endless printing of Banque Générale certificates which financed the Mississippi stock bubble. However there is a glaring flaw. Government debt is very visible; certainly more so than the paper previously issued by investment banks. Increase the issuance of mortgage backed securities, from $0.5trn in 1996 to $3.2trn in 2003, and no one bats an eyelid; house prices boom. Suggest issuing a corresponding amount of Treasuries and the bond market quickly fears inflation and frets over who will possibly buy all these bonds. Today bond prices are falling and there is the possibility that economic activity may be subdued by the rising cost of money. US mortgages are now dearer than at the end of last year. Stimulus, what stimulus? So prices are falling on the high street, total nominal wages are in retreat and yet the sovereign debt markets are in open revolt on the premise that “inflation is always and everywhere a monetary phenomenon”. Panic has taken over. Marc Faber is asserting that the US will definitely have hyper-inflation, one investment manager recommends an 89pc balanced fund allocation to inflation-proof Treasuries and CLSA’s Christopher Wood is recommending that US pension funds hold 40pc of their portfolio in gold. In other words people are convinced that inflation is the future. What is less certain is when rising government bond yields begin to remove credit from the mortgage market and so close the door on the exit route of cheaper refinancing; today this is still seen as a distant prospect. The other pertinent question is whether “deficit nations” like the US and UK will be forced to moderate their ambitious spending targets. No one likes criticism and the reprobation of the German Chancellor and the Governor of the Bank of China must produce some soul searching; after all, central bankers are not renowned for their non consensual habits. I keep thinking that it would be ironic if history were to show that US policy makers were right to fear the prospects of a $54 trillion debt deflation and that they should have been more ambitious in their monetary expansion. The bond vigilantes believe that the double dip deflation of the 1930s will ensure that the Fed will be slow to raise interest rates this time around. But what if the economy stalls because the credit markets are premature in tightening monetary policy for them? I am beginning to sense another paradoxical twist. What if the Fed is right and Angela Merkel, Zhou Xiaochuan, Warren Buffet and James Grant are wrong? And that contrary to their inclinations the American authorities are forced to moderate their monetary expansion in order not to undermine the confidence of the international community. Whilst at the same time the bond market pushes long rates higher. Under such a scenario the debt reduction efforts of the private sector would usurp the government’s attempts at stimulus; the economy would falter once more. Back in 1931 the same thing happened. Bond prices dropped and yields rose to the level that had prevailed for the previous ten years; a feeble economy lapsed back into a deflationary spiral. Perhaps if this were to happen again, and we were once more confronted by a truly dire economic outcome, then it is conceivable that the authorities could gain the vital legitimacy necessary to engage in an unquestionably large monetary response which finally purges the system of deflation. That is when I would choose to let rip on buying commodities and cheap equities. The key is the economy’s sensitivity to bond yields. Russell Napier argues that it would require ten-year yields of 6pc (vs. 4pc today) to knock the economy and stock market from their perch and reassert the deflationary trend. But he bases his assertion on observations taken since the early 1960s. My quibble is that today’s leverage is unprecedented and prices are falling. May’s American CPI is forecast to contract by 0.9pc YoY; they fell in April. We never had falling prices in the 1960s, 70s, 80s or 90s. I therefore maintain that it is feasible that some unquantifiable but certainly lower nominal rate could choke the economy. Regardless, it is my contention that many are investing in risk once more almost oblivious to the notion that a heavily indebted economy is confronted by a very real tightening of monetary policy. It is not inconceivable that the macro compass could swing violently towards deflation and wrong foot them again. Will it happen? As I suggested at the beginning, it really comes down to whether we are trading in a groundhog version of last year. By last summer, oil had been bid up to $147 per barrel and markets were anticipating that central bankers like the Bank of England would be forced to raise (not cut!) rates by 200 basis points. The pressure was intense. I recall philosophical conversations regarding short sterling; what did it really represent? And with oil spiking I was taking my gross long position down but replacing it with $200 call option premium; not $50 put strikes. As Robert Prechter reminds his readers, “the news at turning points is just too strong for most people to act contrarily to it…fundamentals so intensely support the continuation of a trend just when it is ready to reverse”; mea culpa.

THE ECLECTICA FUND
FUND MANAGER COMMENTARY
JUNE 2009

I have had cause to think long and hard about what caused the turnaround last July in the commodity spectrum. I believe the persistent and government approved appreciation of the Yuan played a prominent role. Forget quantitative easing, I believe this was the printing press that propelled risk asset prices higher. Chinese speculators could borrow in dollars knowing that their loans could be repaid for less in their local currency. And when the US entered the global recession first, and began cutting rates, the Chinese were emboldened to ramp up their overseas borrowing further; they had to buy something and as we know oil went parabolic. But then the Yuan stopped appreciating. Perhaps the central planners didn't like spending so much on commodities? I suspect it was more that they became fearful of their competitive position vis-à-vis the Koreans and other mercantilist trading countries. Whatever the reason, it is clear that since last July their currency stopped appreciating vs. the dollar. This provoked an immediate response: speculators rushed to reverse their trade and we immediately went from inflation to deflation.

Crude Oil CNY/USD

Renminbi Strength

Source: Bloomberg

Since early March the price of risk assets has again risen considerably; the Yuan has gone sideways. Perhaps the Chinese don't want to re-price their scarce exports amidst the economic weakness? I see this as a non-confirmation of the move in equities and commodities and it reinforces my bearish slant on the year. However, I happily contend that should the Yuan begin to appreciate once more and establish a new high vs. the dollar then I am just plain wrong with risk aversion and I will change the Fund’s posture; but so far it has been almost a year and nothing. Rapidly Decreasing Pessimism? I have been very fearful of fighting this stock market rally, taking the view that we could see something vigorous enough to convince the majority that we were in a new bull market. I did not expect anything like new absolute highs; more like 1930 when the Dow Jones rallied 52pc from its 1929 bottom. I was therefore heartened to hear, “History says fill your boots, sell your wife, dive in…” from David Schwartz, the self styled stock market historian, in an article from The London Times on the 9th of May, one day after the European stock futures had completed a 50pc rally from their intra day lows back in March. Furthermore, it was taken from a piece entitled, “Investors bet that worst of recession is over and predict new bull market”. These are early days but clearly the process of social herding and higher prices is succeeding in tempting many investors to risk their capital again. I have written previously of life imitating art and continue to take inspiration from Will Self’s collection of short stories, “The Quantity Theory of Insanity”. In one tale a plucky undergraduate succeeds in locating his missing college professor by determining a pattern from a collection of integers copied from homosexual graffiti lifted from the cubicles of London lavatories. But it’s just a lucky coincidence. This got me thinking about Soros and Paul Tudor Jones plotting where the Dow might trade in 1987 from the entrails of the Dow in 1929. They thought the “great crash” of 2008 was due in 1987. They were wrong. But their pattern of integers, by coincidence, matched perfectly and Tudor Jones made 50pc in October 1987. In this business it doesn’t matter if you get lucky; just stay lucky.

THE ECLECTICA FUND
FUND MANAGER COMMENTARY
JUNE 2009

Dow 1929 vs 1987
120

1929
110

1987

100

90

80

70

60

50

Source: Bloomberg. Both series rebased to 100.

Investment Strategy So here I am in June 2009. My favourite asset class is down over 20pc on the year and is popularly derided. But I am feeling lucky. My gut feeling is that this year could follow last year. If I am right then it is time to re-engage tentatively with deflationary trades. Remember, I am fearful that the next few months could still contain further euphoric moments. My preference is therefore to start modestly and go for low delta but big pay-off option trades. Such opportunities are rare today. However, over the last couple of weeks we began purchasing out of the money call options on the current 30 year US Treasury bond. Do not be too concerned, we have only used about 20 basis points of the Fund’s NAV on such option premium so far. However it is our intention to add to this amount should the elevated levels of fixed income volatility subside. Given the capacity of this market to thrash around from extremes, it is not unrealistic to imagine that yields could match their lows of just six months ago. Should this happen before the year end, our options would payout 14 times our investment. Similar asymmetric payouts are achievable in the short sterling interest rate market where investors are pricing in a 2pc hike in Bank of England base rate by the end of 2010. This is eerily like this time last year when they were expecting a 2pc hike for the second half of the year. If this time around the market again reverses its opinion by December, and takes the view that this is unlikely to happen, then our option package could payout over 10 times our money. All we need is for the Bank of England to remain true to their word. I also like German sovereign CDS at this level: an annual fee, paid quarterly, of just $30k (a total outlay of $150k if held for 5 years) to insure $10m of notional debt should something truly calamitous happen to the finances of the German Republic. Could it happen? No. However, those who underwrite credit default swaps today can only see Germany’s formidable strengths and laud it for its high savings, fiscal prudence and large trade surplus. But as I wrote to you previously, I fear the “surplus” nations of China, Japan and Germany have been duped by the West’s borrowing binge. I fear they have over-estimated the global economy’s demand and are confronted with huge pools of surplus marginal capacity. A prolonged and feeble recovery in America’s nominal GDP would have especially dire consequences for such economies; Germany is already on course to contract by 5pc this year. It could be that with a moribund export market (traditionally two-thirds of economic growth) and the likelihood that politicians change the constitution to ban state and local deficit spending, investors might prove willing to pay more for their German bond insurance. Remember it only has to trade at the highs of earlier this year and I would double our money. Sovereign defaults are today priced as black swan events despite the fact that more than half of all governments defaulted on their external debt back in the 1930s. Already in this decade we have seen both Argentina and Ecuador default. In both cases the recovery rate was 25pc. This is low; historically 40pc is more typical. Perhaps 25 is the new 40? Today it seems likely that Latvia will join them. Their sovereign CDSs trade at €750k per €10m of notional protection. What this means is that should Latvia default tomorrow, or within the next 12 months, you would receive €10m minus the assumption of recovery (25pc) and minus any CDS payments incurred; or 10x your money. I own Hungarian protection which is priced at €340k per €10m of equivalent sovereign protection. Again, assuming a 25pc recovery, a default this year would return us 22x our money, 11x if it is next year, 7x in 3 years and so on. Lastly, in an effort to help fund the cost of carrying these risk-averse trades, I have been selectively buying corporate bonds in the tobacco, agriculture, and utility pipeline industries. This portfolio has an average yield of 8pc and I would be happy to take you through its finer details on request. Here is hoping that I get lucky.

THE ECLECTICA FUND
FUND MANAGER COMMENTARY
JUNE 2009

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