Portfolio Commentary Q211
Absolute Investment Advisers
By Jay Compson
August 4, 2011
The Fund's overall positioning and exposures have changed very little over the past few months as our managers continue to see almost all asset classes priced to deliver unsatisfactory long term returns. There is no real change in overall thoughts from our previous commentary except to add that many of the issues and risks we have discussed are starting to become more significant and weakening fundamentals are finally becoming more apparent to investors. Ironically, the things that have created short term rallies of late are largely noise and are less positive than they were 3-6 months ago. This includes the potential for Eurozone "bailouts" and the US debt ceiling debate, which are largely media distractions away from the underlying fundamental problems that got us to this point. The financial crisis and ensuing bailouts are not one-off events. They are steps in a long process of inevitable deleveraging and we are clearly still in the early stages, (you might call the past two years "denial"). It's now clear the experiment of adding more debt and stimulus cannot generate a growth rate necessary (>4%?) to reduce the massive debt burdens. Starting discussions around fiscal responsibility (both spending and taxation) is likely to create short term negatives, but long term positives for the economy as a whole.
Since little has changed in the Fund's positioning, we will not rehash old commentaries or discuss QE failures and will instead summarize what we and our managers view as most concerning. Macro, momentum and "machine trades" continue to drive global markets at a time when global fundamentals are deteriorating and asset prices are inflated. These positions and leveraged carry trades are driving the correlation of everything. The following financial markets are more linked today than at the time of the 2008 financial crisis: S&P 500, gold, oil, commodities, MSCI World and Emerging, EUR/USD, (Source: Knight Capital). Most large capital allocators are also strongly correlated to these positions. There may be little liquidity should there be a reversal in one or more of these markets.
Much like 2007, investors are excited about interrelated themes that cause some of our managers the most concern. This time around the larger concern is China and Europe, not the U.S. While Europe's issues are becoming more obvious, China is a bit less understood and is most interconnected to the above correlations and asset inflations. As discussed in prior commentaries, many developed countries are over-indebted and are highly challenged economically and politically. However, China may be much more meaningful when considering investor expectations for global growth and earnings.
China and much of Asia may be near an inflection point where an inflationary spiral and associated credit bubble may start breaking down over the next 12-18 months. Beyond China being a communist country and having fraud issues, the country has executed massive lending that is roughly equivalent to the lending surge that fueled the US housing bubble (despite the fact the China's economy is roughly only 70% of the size of the US economy). This excessive stimulus and lending has been necessary to achieve a stated 8% annual GDP growth goal that China believes is necessary to prevent civil unrest. Unfortunately, it has sparked massive inflation that some estimate may be in the double digits. China has begun attempting to tame inflation and reduce bank lending at the same time that rumors of bad loans suggest China's banking system is in a highly precarious position. Taming inflation and slowing bank lending may prove difficult for an economy where fixed investment represents 60% of annual GDP. This level of investment-fueled growth has never been sustainable. Therefore, reducing lending and investment may be necessary to cool inflation; however, this will make 8% growth difficult to achieve.
This does not mean that China is headed for a collapse or that their long term growth will not be attained. But the likelihood of a slowdown in growth is a higher probability than many are willing to accept. As mentioned above, given that many investors have very high expectations on themes related to Chinese growth, any slowdown could dramatically impact commodity markets, global and emerging market equities, and currencies. Additionally, if the slowdown turns to a hard landing, severe global volatility across all markets could result. Ultimately, if this were to happen, the U.S. would be in a relatively decent position and prudent investors would eventually refocus on "free markets" for preserving and compounding real wealth.
Given the above, the focus of our managers is to continue to invest in pockets of idiosyncratic opportunities that are less dependent on the current economic cycle and associated status quo. This includes a mix of strong businesses with sustainable high free cash flow yields that in many cases are significantly undervalued. The Fund's short positions continue to focus on companies and associated hedges that couple high valuations with financially vulnerable businesses or potential margin pressures. Some of our short positions also incorporate the global themes above that may serve as additional insurance should there be a dramatic unwind in the troubling high correlations that exist across interrelated financial markets.
We continue to believe the margin of safety gap between our longs and shorts provides an attractive mean-reversion valuation opportunity as well as protection against systemic risks and liquidity events. Our more neutral positioning allows the Fund to be flexible and dynamic should volatility and the pricing of risk change and opportunities to put more capital at risk improve. Given the potential for market dislocations, our managers are excited about opportunities for mispricings. As a reminder, the Fund is designed for patient, disciplined investors who are looking for ways to help preserve capital and provide a diversifying element to a mix of directional asset classes. Given the high sensitivities and correlations across most global asset classes, diversification can be incredibly difficult; we cannot think of a better time to be using our Fund.
(c) Absolute Investment Advisers
