argonaut capital may 2010

8/9/2019 Argonaut Capital May 2010

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Argonaut Macro Partnership, LPGlobal Macro Fund, LTDMay 2010 Investor Letter

The fund finished the month down 3.0% net, and suffered setbacks across assetclasses. In the weeks leading up to Mays climactic events in the Eurozone, weobserved that economic activity in most major economies (including keyEurozone economies such as Germany) had actually accelerated since the endof the winter. The combination of solid growth around the world combined withwhat appeared to us to be fairly limited transmission channels of financial stressfrom the Eurozone to the rest of the world led us to take a handful pro-risk

positions in the portfolio. Consequently, these positions set back as a result ofmarket skepticism over the Eurozone rescue package, combined with growingfears over policy-induced economic slowdown in China. These losses werenonetheless smaller than the 8.2% decline in the S&P 500 during the month andeven larger declines in most emerging market indices. Furthermore, the fundremains up slightly year-to-date.

Our biggest winner in the month was our position in the euro and relatedEuropean distress trades. Unfortunately these gains were offset by losses inother currency positions, predominantly our long in Asian currencies that weexpected to appreciate alongside what we believed would be imminent

appreciation of the renminbi. We likewise suffered a setback in our short yenposition. The flight to quality, particularly out of the Eurozone, also caused apowerful rally in the long end of the U.S. yield curve that set back our steepener.In equity indices and related products, we lost smaller amounts of money in bothU.S. index futures and sector ETFs.


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An Assessment: What Went Wrong in the Markets in May

Although the month of May began with markets fixated on the fiscal problems insouthern Europe and the possibility of sovereign default, the volatility in thesecond half of the month was due to a confluence of events around the world

that caused market confidence in the global economic outlook to evaporaterapidly. Indeed, what began with concerns over the integrity of the Europeanmonetary union had by the end of the month become a full-blown panic overglobal conditions. In our opinion, this was caused by a combination of threefactors.

1. Evidence of the peak in economic growth. First, evidence is accumulatingthat the global growth cycle is currently at its apex and set to fall in themonths ahead. While we have long held the thesis that the peak in globaleconomic growth would coincide with the period of the maximum stimulusfrom both fiscal and monetary policy (in the first half of 2010), the markets

generic expectation has been that growth would remain at trend levels overthe balance of the year and into 2011.

GDP Growth With Contribution from Fiscal Stimulus

quarter-on-quarter seasonally adjusted annualized rate

-8

-6

-4

-2

0

2

4

6

8

1Q 2009 2Q 2009 3Q 2009 4Q 2009 1Q 2010 2Q 2010 3Q 2010 4Q 2010

GDP Grow th Not Attributable to Fiscal StimulusFiscal ImpulseGDP Grow th

Source: Argonaut Capital, Goldman Sachs, and Congressional Budget Office

2Q 2010 - 4Q 2010 data are estimates

It is interesting that U.S. and European economic data released over thecourse of May by and large exceeded market expectations, consistent withthe cyclical acceleration that we described in last months investor letter. Yet

this positive news was shrugged off in the throes of the market sell-off in themiddle of the month. One of the reasons for this, we believe, was thedeceleration in economic data released out of the major emerging marketsover that same period. As our data surprise index for the emerging marketsillustrates (on the next page), the growth deceleration over the past severalmonths has shaken complacency regarding ever-higher growth rates in theemerging world.


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Argonaut Growth Diffusion Indices

2-Month Change in Index Levelchanges in index level correspond to strength of eco nomic data relative to expectations

-10

-8

-6

-4

-2

0

2

4

6

8

J-08 A-08 O-08 D-08 F-09 A-09 J-09 A-09 O-09 D-09 F-10 A-10

US Grow th Surprise DI

EM Grow th Surprise DI

2. The impact of Europes debt crisis. The second major factor behind the sell-off, particularly in the second half of the month, was the dawning implicationof fiscal austerity on the growth outlook in Europe. The need to redressunsustainable fiscal deficits is clearly an urgent one not just in the troubledeconomies on the European periphery, but also in core Eurozone economiessuch as France and Belgium as well. At the same time rapid fiscalretrenchment is highly problematic for the growth outlook. The multiplier onfiscal spending is sufficiently high such that GDP growth going forward islikely to undershoot current projections. This also means that debt/GDP ratiosare likely to remain more elevated than currently envisaged in the variousEurozone countries austerity plans.

Separately, the significant fiscal tightening planned by the Germangovernment further clouds the European growth outlook beyond 2010. As wediscussed in last months letter, the big risk going forward is that slowergrowth in Europe causes problems to emerge in over-levered private sectorentities within the Eurozone. Continued pressure on markets such as Spain(where the problem of the cajas, the debt-laden state-sponsored banks,remains at the forefront of market concerns) suggests that the risk of overlyaggressive fiscal tightening continues to trouble the market.


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Cumulative Change in Spanish Sovereign CDS

(40)

(20)

-

20

40

60

80

100

120

4/30 5/5 5/10 5/15 5/20 5/25 5/30 6/4 6/9 6/14

Source: Bloomberg

5/9/10:

Announcement

of EFSF

With so many serious questions hinging on political and economic outcomes

in Europe, senior Argonaut researchers spent a portion of May in Berlin andFrankfurt discussing the Eurozone crisis with policy analysts and local marketparticipants. A couple of clear takeaways emerged:

First, and foremost, there remains no wavering in the political commitmentto the monetary union in Germany, which spans the political spectrum.This is an important anchor to the euro that is often under-appreciated inNorth America.

That said, there is a huge divide between the policy community andmarket participants (generically speaking, Berlin and Frankfurt,

respectively) over the appropriate course of ECB action going forward.Those with closer links to policymakers in general were extremelyuncomfortable with how the ECB had strayed from its statutory mandate ofprice stability, and expected vociferous action by the ECB to re-assert itsindependence and inflation-fighting credibility as soon as markets calmdown sufficiently. Those in Frankfurt, by contrast, anticipate that the ECBwould continue to be pragmatic and would not seek to tighten conditionspre-emptively or shade market expectations through hawkish rhetoric.

While there can be no certainty about which side in this debate will prevail,we found the discourse to be quite revealing about the schisms within the

ECB. What this suggests to us is that the coherence of monetarypolicymaking in the Eurozone is less than optimal, and that headline riskwill remain substantial.

In our view, one of the key mistakes made by the Fed in the early stagesof the financial crisis was an attempt to guide inflation expectations lowerby increasing the hawkish rhetoric in their communications (in the fourthquarter of 2007). This certainly was not helpful at the time, and may in


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fact have exacerbated the crisis at a time when the markets requiredreassurance on the provision of liquidity by the central bank. The oddsthat the ECB repeats this sort of mistake appear high to us, as the currentsituation in Europe has many commonalities with the United States in late2007 and early 2008. Perversely, those voices within the ECB that would

seek to talk up the euro may in fact ultimately undermine marketconfidence in the stability of the monetary union.

S&P 500 Reaction to the Fed's Waffling in 2007

1300

1350

1400

1450

1500

1550

1600

Aug-07 Sep-07 Oct-07 Nov-07 Dec-07 Jan-08

8/7/07:Fed keeps

rates on hold

8/17/07:Fed holds extraordinary meeting;

statement is dovish

9/18/07:Fed cuts rates

50 bp

10/31/07:Fed cuts rates 25 bp;

statement is hawkish 12/11/07:Fed cuts rates 25

bp; statement is

hawkish

1/22/08:Fed capitulates, cuts

rates by 75 bp;

statements is dovish

Source: Bloomberg, Federal Reserve, and Argonaut Capital

One area in which European governments are clearly moving faster thanthe United States is in their recognition of the problems associated withlarge long-term structural deficits. The German governments plan to

bring its fiscal deficit back into line with a constitutionally-mandated 0.35%limit of GDP should be interpreted in this light. While we applaud theresolve of policymakers to bring longer-term deficits back down tosustainable levels, we remain highly concerned about the way in whichthey are going about it.

We have long described the current economic environment as acontained depression, by which we mean that the global economy washeaded for a second Great Depression before the combined impact offiscal and monetary policy easing in 2007 and 2008 pulled the globaleconomy back from the brink. While one can debate the efficacy of the

specific fiscal programs enacted, and the optimal distribution of fiscalexpansion between expenditures and tax cuts, we believe that a largeshare of the recovery in GDP growth since early 2009 is due both directlyand indirectly to fiscal policy.

As such, plans for aggressive fiscal retrenchment threaten to underminethe recovery, just as the momentum behind the global recovery appears tobe waning. Clearly unsustainable fiscal policies indeed need to be


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altered, but we would argue that the danger to long-term economicstability comes from ballooning liabilities associated with entitlements,which the current fiscal plans around the world attempt to redress onlyminimally if at all. Thus we are concerned that governments around theworld may inadvertently engineer the next economic slowdown, which, if it

occurred, would perversely cause debt to GDP ratios to rise (in the face ofpersistent deficits but flat to lower GDP).

The combined impression from these observations is that the risks toEurope still lie firmly to the downside. Though cyclical performance in theless-impacted members of the Eurozone has actually been fairly strong,and the impact of a weaker euro should have a salutary effect on theireconomic outlook, the risk of major policy error looms over the entireeconomic bloc. Incoherent and possibly pre-emptively hawkish monetarypolicy combined with premature fiscal tightening will not solve Europesproblems, nor will it foster a rapid improvement in Europes debt/GDP

ratio. Our trend view on the euro remains a bearish one.

3. A policy-engineered slowdown in China. The final factor in Mays globalmarket sell-off was rising apprehension about growth conditions in China.First, fears that the policy-engineered slowdown in the property sector werespreading rapidly to other areas of the economy led to somewhat hystericalfears that the major engine of global recovery was slowing sharply. On top ofthis, semi-official pronouncements that renminbi appreciation against thedollar was off the table for the time being as a result of the rapid rise in thevalue of the renminbi against the euro hit numerous currency markets in Asiathat had priced in imminent appreciation by China.

Argonaut has long been involved in the renminbi trade, and our currency booksuffered in May as a result. Clearly the events of May and Chinas reaction tothem has led us to re-evaluate our thesis. At this juncture, while we do notthink China will maintain its dollar peg indefinitely, the time-table for such amove has probably been pushed off to the later months of the year at theearliest. We still believe it to be in Chinas overwhelming interest to allow forrenminbi appreciation in order to spur domestic demand growth in its owneconomy, particularly in light of slowing economic growth in its major exportmarkets. As such we believe the question of renminbi appreciation remainsone of when and not if.

We also visited China during the month of May, and though the snapshot onesees from visiting only a few places does not necessarily translate into anaccurate view of conditions in the country as a whole, it would appear to usthat economic conditions in China remain solid to robust. Consumptiongrowth still appears strong, and there is little tangible sign that the propertyslowdown has caused a dramatic downshift in activity outside of theresidential real estate sector. Economic databoth the widely analyzed


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official data as well as more high frequency survey and proprietary data wefollowwould appear to confirm this impression as well. The slowdown inconstruction, the main driver of Chinese economic activity since the economicconditions bottomed in 1Q 2009, means that aggregate demand growth inChina has also peaked like that of most other countries around the world.

Strong but slowing:

Chinese Automobile Output YoY%

(50)

(25)

-

2550

75

100

125

150

J-

08

A-

08

O-

08

D-

08

F-

09

A-

09

J-

09

A-

09

O-

09

D-

09

F-

10

A-

10

Source: National Bureau of Statistics Chinese Steel Output YoY%

(20)

(10)-

1020

30

4050

60

J-

08

A-

08

O-

08

D-

08

F-

09

A-

09

J-

09

A-

09

O-

09

D-

09

F-

10

A-

10

Rolled Steel Crude Steel

Source: National Bureau of Statistics

At this juncture it appears likely that the process of policy tightening in Chinais nearing its end. Clearly the authorities wanted to drive housing pricesdown in the frothiest eastern seaboard markets, and have succeeded in doingso. It is equally clear to us, however, that there remains a huge amount ofpent-up demand for housing as the rural-to-urban migration process

continues, particularly in the second- and third-tier cities in Chinas vastinterior. Thus a full-blown housing recession would not appear to advancethe leaderships goals of social stability. As such, we believe that apart froma few further token measures (an official interest rate hike or two, forexample) that Chinese policymakers are likely to err on the side of caution inthe face of global uncertainty and hold off on further policy firming.

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Transitioning Our Portfolio

In light of both our mark-to-market losses and developments that caused materialchanges to the outlook we have adjusted the themes in our portfolio. The mostobvious change was the reduction in the renminbi appreciation theme that we

discussed above. Specifically, we cut out all the Asian currency exposure thatwe believed would benefit if and when China allowed the resumption of therenminbi crawl. We retain a small risk position in outright renminbi forwards,which now price in just over 1% appreciation per annum out over the next fiveyears.

CNY Annualized % Pace of Appreciation Implied by Forwards

1.2

3.2

0.0

1.0

2.0

3.0

4.05.0

6.0

7.0

8.0

1-Month 2-Month 3-Month 6-Month 9-Month 1-Year 2-Year 3-Year 4-Year 5-Year

6/16/10

4/29/10

Source: Bloomberg

Second, we have reduced our long-standing U.S. yield curve steepener. Webelieve that while the potential supply/demand imbalance at the long end of thecurve remains daunting, the crisis in Europe has improved the demand outlook

for longer-dated U.S. Treasuries. Simply put, the euro has been the bigbeneficiary of attempts by big institutional investors (such as central bank reservemanagers) to diversify their holdings away from dollars over the past decade.Only a small portion of reserves are held in outright currency, however, but ratherin fixed income instruments denominated in specific currencies. With questionsover the long-term viability of the euro unresolved, we expect to see thesediversification flows reverse, which is not only bearish for the euro, but shouldalso be positive for Treasuries.

Additionally, evidence continues to accumulate that the risk of deflation remainshigh in the United States. Anyone familiar with our views going back to the

period when quantitative easing began in the United States in early 2009 willrecall that we have long been of the view that deflation, not inflation posed thebigger threat. Our analysis of dozens of pricing series has strengthened ourconviction on this point in recent months, and we fear that core inflation readingsin the United States could dip into outright deflationary territory in comingmonths. This should be positive for longer-dated fixed income.


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On the Road to Deflation?CPI YoY % Change

-

0.5

1.0

1.5

2.0

2.5

3.0

M-09 J-09 J-09 A-09 S-09 O-09 N-09 D-09 J-10 F-10 M-10 A-10

Core

Core Ex-Tobacco and VehiclesCleveland Fed Median CPI

Source: Bureau of Labor Statistics, Cleveland Fed, and Argonaut Capital

We have retained a residual position in the yield curve, albeit in much reducedsize. Our particular expression of this view in the forward interest rate swapmarket, while highly profitable over time, unduly suffered as a result of creditmarket issues in May. In particular, the swap market underperformed cashTreasuries as counterparty credit concerns permeated all areas of the capitalmarkets. Approximately half of the flattening in our position during the month ofMay was due to the spike in short-dated swap spreads. As such, at a minimumwe should gain back this portion of the flattening as counterpart credit concerns

slowly fade.

May Losses in Argonaut's Forward-Starting U.S. Swap Curve Steepener

(60)

(50)

(40)

(30)

(20)

(10)

-

10

30-Apr 7-May 14-May 21-May 28-May

Flattening Due to Rally in 10-Year Treasuries

Flattening Due to Wider Swap Spreads

Source: Bloomberg and Argonaut Capital


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The two themes in which our conviction was strengthened as a result of theevents of May remain, as we discussed last month, our short in the euro and ourlong in gold. The euro position has been reduced from its peak earlier in thespring as a result of both the speed of its decline combined with sentiment that is

heavily biased toward the bearish view. As always, in these circumstances weconsider our use of options to be a competitive advantage, as we are able tomaintain exposure while limiting our downside risk simply to the premiuminvested.

Peak Growth and Market Expectations

One area of intensive research for us over the past several months has been aneffort to identify areas in which embedded growth expectations appearunrealistically high given our expectation of lackluster growth in the developedeconomies. At first glance, it would appear that the data is not on our side on

this issue, as corporate profits have bounced strongly since the end of therecession last summer.

Scratching beneath the surface, however, reveals a different story. The bulk ofthe growth in profits since mid-2008 has in fact come from the financial sector,which has been heavily subsidized both directly and indirectly (via easy monetarypolicy) by the federal government. By contrast, non-financial corporate earningsappear to be trailing the post-recession pace of recovery in every instance datingback to the 1950s. Note that this is inconsistent with the purported strength inprofits being described by the popular financial media.

Nonfinancial Corporate Profits in Recessions and Recoveries

Indexed so that last quarter of recession=100

90

110

130

150

170

190

-24 -21 -18 -15 -12 -9 -6 -3 0 3 6 9 12 15 18 21 24

1957-58

1960-61

1969-70

1981-82

20012007-2009

Source: Bureau of Economic Analysis


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Largely because the fall in earnings in 2008 was so acute, analyst earningsgrowth estimates for 2010 and 2011 would be among the fastest on record ifrealized. Here is where we believe the disappointment is likely to lie. Indeed,our bottom-up works suggests that earnings are likely to end 2010 towards the

bottom end of the range of major analysts estimates.

Growth in S&P 500 Earnings in First Year Following Recessions

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

1950 1956 1966 1975 1980 1982 1989 2001 2007

Argonaut

Consensus

Range of

Wall Street

Estimates

Source: CapitalIQ and Argonaut Capital

On a sectoral basis, there are several standouts that we think have an outsized

probability of disappointing analyst estimates. While strong earnings growthexpectations for the materials and energy industries are driven by the anticipationof continued high commodity prices, we believe that it is more difficult to justifythe expectations for strong growth in the consumer discretionary sector. Asrecent disappointments in consumer sector results illustrate, we still believe anover-levered and under-employed consumer sector will be a significant drag onthe economy over the balance of the year. Likewise, we believe thatexpectations for strong growth in technology sector earnings may be overlyaggressive, although the international exposure of the sector may help it meetexpectations. We certainly do not expect the strength of domestic corporatecapital expenditure and consumer spending on technology to be sufficient to

meet consensus estimates, however.

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There are two further reasons why we believe that earnings will be unable tomeet lofty expectations. The first is that top-line revenue estimates are going tobe difficult to meet. The combination of little to no price inflation and relativelyrestrained GDP growth will continue to make it difficult for the nonfinancialcorporate sector to meet these expectations. In fact, the big growth in S&P 500net earnings in 2009 was not a product of top-line expansion, but rather a result

of squeezing costs out of the system. While it might be possible for the corporatesector to eke out further profitability through additional cost cuts, we believe thatit is already operating about as leanly as it can (the record decline in inventoriesin 2009 combined with a nearly ten percentage point increase in the broadunemployment rate would certainly attest to this). Thus we believe that the S&P500 index members will need to generate very strong revenue growth in 2010 tomeet consensus profit expectations, and we see this as a very difficult challenge.


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The second reason we think that aggressive profit expectations for 2010 arelikely to be disappointed comes from the very cost-cutting dynamic we discussedabove. Gross private investment as a percentage of GDP has averagedapproximately 15% going back to the end of World War II. The 2007-2009recession saw investment fall sharply, approaching the rate of depreciation. Putdifferently, the rate of net private investment basically fell to 0%. In the initialstage of the recession it was easy enough to bring capacity back on line withoutbearing significant expenses. Going forward, however, corporations are likely toneed to boost capex substantially to raise output, which would eat into bottom

line growth.


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Gross and Net Private Investment% of GDP

0%

5%

10%

15%

20%

1950

1955

1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

2010

Private Gross Investment Depreciation Net Private Investment

Source: Bureau of Economic Analysis Conclusion

The first several months of 2010 have highlighted an inherent tension in theglobal capital markets, between a skittish market awash in liquidity and a fragilerecovery largely driven by expansionary economic policy. One overwhelmingconclusion from our read of the economic data is that the take-off phase of theglobal recovery is now behind us, with economic growth at best leveling out, butmore likely decelerating going forward. Whether one completely agrees with ouranalysis on the volatility of May or not, the examination of the root causes of themonths market action overwhelmingly point to policy action and the potential for

policy mistake as a main driver of market volatility. With the greatest growthimpulse from policy easing now in the past, there is no reason to expect volatilityand the potential for sudden reversals in markets to fade in the months ahead.

Though months such as May are unpleasant experiences, our risk managementas always was disciplined and unwavering. As we commit to our investors, wecut risk once our monthly losses exceeded 2.5%, and took risk downaggressively as losses continued. Though the events of May have caused us tore-evaluate some of our long-held economic views, we believe that theindiscriminate selling of risk assets and the likelihood of a continued rise in thevolatility of both markets and economic activity will offer an incredibly fruitful

environment for macro investing in the months ahead.

June 17, 2010

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argonaut capital may 2010

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