brait multi strategy fund overview 30 august 2009

Brait Multi Strategy Fund

Fund Overview 30 August 2009

Doug Thomson – Director Client Service Tel: +27 21 673 7806 Cell: +27 82 901 4823 Email: [email protected]

Lourens Pretorius – Portfolio Manager Tel: +27 21 673 7830 Email: [email protected]

Yunus Moolla – Fund Administrator Tel: +27 21 673 7853 Email: [email protected]

Investment Proposition

The Brait Multi Strategy Fund aims to deliver an annualised return, net of fees, that exceeds ZAR cash returns by 15% over rolling three-year cycles. Emphasis is placed on achieving the return objective independent of the performance of the markets or any particular asset class.

The Fund Manager pursues alpha across multiple underlying disciplines that employ diverse investment strategies. Each discipline is managed by a focused investment professional, who collectively make up the Brait Capital Management investment team. As a result the Fund benefits from an expanded opportunity set whilst maintaining the benefits associated with specialisation within a particular niche. A dynamic risk allocation process across underlying disciplines drives efficient capital utilisation, while exposure to multiple strategies of varying time frames ensures sufficient diversification of alpha streams.

The Fund currently focuses exclusively on South African investment opportunities and employs a wide range of instruments across equity, fixed income and currency asset classes.

Commentary Fund Manager The Fund followed up pleasing performance in July (2.7%) with a solid August performance of 2.8%. The Fund is on track to deliver on its (demanding) investment objective (cash +15%) for 2009 albeit that this objective is orientated towards a 3 year annualized target. The biannual strategic risk allocation meeting was concluded in August with the following salient outcomes: Only 90% of the risk budget has been allocated with a view to save room for an anticipated statistical arbitrage discipline likely to be incorporated in the next three months. Three disciplines received 12% of the risk budget each and three disciplines 18% each. A new discipline, Equity Derivative, was incorporated in the mix at 12% of the risk budget. The equity derivative discipline will be managed by Brad Welsh and appropriately backed up by the deep derivative and volatility skill set in the Volatility and Fixed Income disciplines. The discipline will focus on absolute and relative volatility opportunities in both index and single stocks. The discipline will have a long volatility bias and will only pursue dispersion opportunities from the “long single stock volatility” side. This month’s back pages features an excellent research framework assessing the polar cases (and commensurate polar portfolios) of inflation and deflation. The author and investment manager of the tactical equity discipline, Kevin Cousins, uses an alternative competing hypothesis methodology to stack up the two cases and concludes with a Third Way and associated portfolio – enjoy the read!

Brait is a listed investment group established in 1991 specialising in the structuring and management of alternative assets. Brait’s product set includes hedge funds, fund of hedge funds, private equity funds and mezzanine debt funds.

Brait Capital Management, a division of Brait, manages ZAR1.3 billion (USD167.6 million) across a range of hedge fund products including the Brait Multi Strategy Fund. Other funds include the Brait Matrix Fixed Income Fund and the Brait Ruby Fund (short-biased equity).

Key Terms

Fund Inception Date: 01 October 2006 Net Asset Value (ZAR): 811,251,832 Status: Open Fund Currency: ZAR Domicile: South Africa Liquidity: Monthly Notice: 1 calendar month Manager: Brait SA Ltd FSP 820 Auditor: Deloitte Administrator: Self-Administered (In transition to JP Morgan) Prime Broker: RMB Prime and Cadiz Securities

Cumulative Return vs Cash – January 2007 Series

Net Performance Record

Date Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Year

2006 - - - - - - - - - -3.84% 0.95% -2.26% -5.12%

2007 1.78% 2.66% 2.69% -2.08% 4.31% 8.69% 3.21% -3.49% -1.44% -7.40% 1.95% 0.50% 10.95%

2008 1.81% 3.86% 2.21% 2.02% 4.87% 2.32% -1.54% -0.19% 1.95% 2.50% 6.16% 0.12% 29.15%

2009 2.10% -1.95% 5.45% 3.19% -0.65% 1.14% 2.72% 2.83%

15.62%

90

100

110

120

130

140

150

160

170

Jan

/07

Mar

/07

May

/07

Jul/

07

Sep

/07

No

v/0

7

Jan

/08

Mar

/08

May

/08

Jul/

08

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/08

No

v/0

8

Jan

/09

Mar

/09

May

/09

Jul/

09

Cu

mu

lati

ve P

erfo

rman

ce

Brait Multi Strategy

Cash



h

This Investor Report is for information purposes only, and does not constitute either an offer or a recommendation to buy or sell any of the stocks mentioned or the fund itself. It is a private publication intended for private circulation, and outlines the fund structure and past performance. The value of all investments can go down as well as up, and the past is not necessarily a guide to future performance. Brait SA Limited is an approved Discretionary Financial Service Provider under the Financial Advisory and Intermediary Services Act (FSP Reg. No. 820) However, the Brait Multi Strategy Fund, along with all other hedge funds in South Africa, is unregulated by the South African Financial Services Board.

page 2 of 13

Monthly Performance Attribution per Discipline Comparative Performance

Risk Budget Utilisation Total VAR and VAR Offset

Return Distribution Since Inception Risk Analysis Table

Since Inception Brait Multi-

Strategy Fund All Bond

Index All Share

Index

Standard Deviation p.a. 10.77% 8.35% 21.23%

Downside Deviation p.a. 5.39% 2.90% 13.08%

Sharpe Ratio 0.65 -0.18 -0.28

Sortino Ratio 1.30 -0.53 -0.46

Correlation 1.00 -0.31 0.04

% Profitable Periods 71.43% 57.14% 62.86%

Largest Draw Down -11.92% -7.34% -42.01%

95% 1 month VAR 5.72% 4.73% 11.95%

-200

-100

0

100

200

300

400

500

600

700

YTD Aug-09

Bp

s R

etu

rn

Equity 1 Equity 2 Fixed Income Volatility Tactical

-30%

-20%

-10%

0%

10%

20%

30%

40%

2007 2008 YTD%

Ret

urn

Brait Multi Strategy Fund ALSI ALBI Cash

0

10

20

30

40

50

60

70

80

90

VaR

Uti

lisat

ion

(%

)

Net VaR

Average

0

20

40

60

80

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120

140

VaR

Uti

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(%

)

Total VaR

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0

2

4

6

8

10

12

14

Monthly Return (%)

Number of Returns



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page 3 of 13

Commentary

Tim Bond v. Hugh Hendry Macro-Economic Research - September 2009

The Inflation v. Deflation debate

The key current market debate to our mind centres around which risk faces the US economy in the medium term – inflation or deflation? Of course this would apply to many other developed economies, but given the importance of the US financial markets we will focus there. The implications of this debate are far reaching – with the two outcomes requiring polar policy responses from the Federal Reserve, and almost totally inverted portfolio positioning by investors.

We call the inflation scenario “Tim Bond” and the deflation scenario “Hugh Hendry” after two well known market commentators. We will examine the characteristics of each scenario in detail, and develop portfolios that we believe would be appropriate to each, globally and locally. We will seek evidence as to which scenario has the higher probability, what the price impact of each would be from today’s levels and set milestones to plot our future positioning between them. Finally we will detail our trading strategy to profit from the Tim Bond and Hugh Hendry dilemma, and distil from this a position plan.

The Tim Bond Characterisation

Global growth recovers sharply in 2010. This is primarily driven by strong growth in Emerging Markets (“EM’s”), but also by a recovery in developed markets, albeit to below trend levels. The massive monetary and fiscal stimuli are gaining traction from rising asset prices, improving household balance sheets and hence driving a recovery in consumer confidence. An inventory rebuild, from currently very depressed levels, will drive the next leg of the recovery. With the dramatic increase in government spending, the afore-mentioned inventory rebuild in the corporate sector and a continued reduction in the trade deficit the US could print positive GDP growth by Q3 2009, even with the consumer sector languishing. Given the substantial over-capacity and high unemployment, no short-term pressure is likely on the CPI, and short rates are only expected to start rising in H1 2010.

Notwithstanding the below trend growth expected in developed economies, the high resource intensity of the growth in EM’s quickly results in sharply higher commodity prices. The medium term threat is inflation. The unprecedented policy action has hugely grown the monetary base. While currently the lion’s share of this increase has been deposited back at the Federal Reserve as bank surplus capital, as the household balance sheet recovers, it will seep back into the economy as new loans with inflationary consequences.

This extreme monetary expansion dictates a weak USD going forward. The huge fiscal deficit (13% of GDP projected for 2010!), together with the weaker currency, will result in much higher long rates. That said, the already steep yield curves in nearly all global markets are an excellent leading indicator of the recovery to come.

The massive amount of liquidity injected into the economy is far more likely to be directed towards rapidly inflating assets than to attempt to revive household lending. Importantly even if the recovery is muted, the huge US monetary expansion will force investors to hunt out dollar hedge assets. Commodity prices, EM equities, gold and forex carries against the USD will all have dramatic bull runs – potentially even massive bubbles. These assets substantially overlap with those benefitting from the resource intensity of EM growth outlined above.

The Tim Bond Portfolio

BUY SELL

Emerging Market Equities USD

Cyclical and dollar hedge US equities US long bonds, Bunds

Commodities Volatility

Precious metals

Resource sector equities

Carry trade currencies



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page 4 of 13

Globally EM equities, commodities, resource equities and carry trade currencies form the key components of the Tim Bond portfolio. In South Africa the Tim Bond would favour resource sector exposures (overlap of EM growth exposure and benefiting from a run in traded commodity prices) and would be an environment of continued foreign purchases of SA equities, which has historically benefited key members of the MSCI SA index and our so called “foreign favourites”. Deserving of special mention is the Platinum sector, the metal price ripe for a squeeze in an environment of substantial cash flow into commodities, and the shares near the top of the list of “foreign favourites”. It would be a strong ZAR environment, however, although firm gold and oil prices should keep SOL and the gold sector supported. The ALSI would be strong. Defensive shares, notably BTI, SAB, PIK, TBS and VOD, would under-perform. The SA exposures would be fine-tuned given domestic institutional active bets.

Key drivers of Tim Bond

The China growth engine must hum – no room for hiccups. US returns to growth from Q4 2009 or early 2010 and does not slump back into recession. Inflation fears remain prominent.

The Hugh Hendry Characterisation

US households have built a debt burden only matched once before in 1930. The servicing and collateralisation of this burden has become increasingly onerous, culminating in the financial crisis. There has been a massive decline in US household wealth (some $14tr to date) that dwarfs attempts at fiscal and monetary stimulus (about $2tr). A deflationary outcome is inevitable, with declining asset prices and incomes further pressurising households to reduce debt, in turn triggering further asset sales and declining spending. This is a powerful feedback loop.

Corporate America’s response to declining sales, to slash costs (the most significant of which is payroll), makes sense for individual firms, but collectively is a disaster for the economy as unemployment continues to rise.

Huge additional fiscal and monetary stimulus is needed to prevent deflation. This is politically problematic – the common wisdom is that the stimulus to date has guaranteed a massive inflation problem in the future. Politicians, legendary investors, Chinese politburo members have all voiced their alarm at the inflation threat. The Fed for once, however, understands the problem. But while the massive increases in private sector debt over the past decade happened almost by stealth (largely in the shadow banking system), every increase in the government debt issuance cap has to be approved by Congress. Until the deflation problem is universally acknowledged, little further action of significance will be possible.



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page 5 of 13

The future massive issuance of government debt will be easily absorbed by the market, historically under-weight bonds and with a looming deflationary crisis. Banks will buy vast quantities of bonds to earn carry rather than lend to households. Since 1990 Japan’s government debt to GDP has grown from 40% to 200%, but yields have dropped. Bullish on bonds is currently considered a contrarian investment view, but actually it is the myriad of bond bears that are contrarians. Bond yields have only been lower than the current level on 2 occasions over the past 50 years, one of which was through the current crisis. Bonds are still firmly in a 28 year bull market of epic proportions, and epic bull markets end with a bang not a whimper. Yields will reach outrageously low levels, everyone will be sucked in.

As an aside, in the short term any significant move up in bond yields now will have a disastrous impact on the economy. With short term rates at zero, the treasury market is effectively now setting monetary policy. Mortgage rates are higher now than they were in January meaning interest rates are tightening for households!

Gold will not be a safe haven this time, true safe havens are not popular and gold is a very crowded trade. In 2002/3 gold was considered a “barbarous relic” and almost universally hated – then it was a safe haven. There is no inflation, nominal prices are falling in the US, UK and Euroland for the first time in living memory, yet people are fearing inflation and buying gold.

Commodity prices have risen near term driven by the poorest types of demand – restocking demand, speculative demand and stimulus demand. There is no improvement likely in underlying demand, the only one that is sustainable and hence important for valuing resource sector companies.

Market participants and more importantly policymakers appear oblivious to the existence and implications of the debt cycle. Conventional analysis will repeatedly predict the beginning of a new growth period and be repeatedly disappointed that recoveries weaken and falter until the context of the debt contraction cycle is understood. Indicators of the economic cycle that worked reliably for decades during the debt expansion cycle, will prove ineffective during the new debt contraction cycle. Does a steep yield curve (viewed as the most reliable leading indicator for GDP growth acceleration), mean the same when the short rate is at zero? The Japanese experience (short rates have been close to zero there since 1995) would say not.

The Hugh Hendry Portfolio

BUY SELL

US Bonds, Bunds Carry trade currencies

USD US Equities, especially highly leveraged

Emerging Market Equities

Commodities

Precious metals

Note volatility spike means put options will be appropriate way to reflect the sells

The Hugh Hendry portfolio is essentially an “inverse” position to the Tim Bond. Key positioning is long US bonds and the dollar, and bearish on equities, commodities and emerging markets. The SA version would be short the Alsi, short high beta resource counters, long volatility and relatively long defensive counters, especially those that benefit from a weaker ZAR. Put options in key shares and the index would be ideal holdings.

Evaluating the Tim Bond and the Hugh Hendry scenarios

We created an index of the majority of the components of the Tim Bond portfolio, a graph of which over the past 2 years is below. Given that the Hugh Hendry portfolio is by and large an “inverse” positioning, it is fair to reflect the consensus view between the scenarios as well represented by the directional trend in the index.



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page 6 of 13

YTD the Tim Bond index is up some 52%, although still substantially off the peak reached in June/July 2008. We can view this is strong evidence that the market currently is a believer in the Tim Bond scenario. We must ask the question though, could the Tim Bond index be rising for a reason other than the market assigning an increasing probability to the Tim Bond scenario eventuating? Said another way, is the Tim Bond index moving due to the market anticipating an EM-led recovery in global growth, or could the move YTD have resulted from a resumption in risk taking fuelled by cheap cash?

An economic recovery or a reduction in risk aversion?

Many of the so-called green shoots have resulted from the stimulus package’s impact on prices. A steep yield curve is inevitable with a policy rate of zero. Narrower corporate and mortgage spreads have resulted from substantial and direct purchases of securities by the Federal Reserve, or indirectly with subsidised lending to purchase this securities in term of TALF. By providing enormous amounts of cheap liquidity to the financial sector the Fed has indirectly driven up the prices of many other risk assets, notably equities, commodities and carry trade exchange rates. As we know stock prices, money supply growth and the interest rate spread are important components of the leading indicator (year on year change for the US shown below), meaning it’s no surprise that it has turned up from low levels. Rising prices also have dramatically improved consumer sentiment as market participants anticipate the moves up presage a normal recovery cycle. It’s worth noting that in our experience there’s nothing like a pop in prices to get market participants more bullish on prospects, irrespective of valuation impacts.



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page 7 of 13

Can it be so simple that the Fed and Treasury spend vast amounts of cash to engineer rising asset prices, and that moves the economy back onto a growth path? While not publically acknowledged, it is clear that their policy goal is to increase nominal asset prices. “Reflating nominal GDP by inflating asset prices is the fundamental, yet infrequently acknowledged, goal of policymakers. If they can do that, then employment and economic stability may ultimately follow.” Bill Gross July 2009. But what’s the causality here? Is it the change in asset prices that spur the recovery, or are the change in prices a symptom of an underlying improvement in the economy? This is not semantics; it is the key to the sustainability of the rally, the key to the Tim Bond v. Hugh Hendry.

It is clear the Tim Bond portfolio has enormous momentum, driven by a recovery in sentiment from very bearish levels, China’s success in flooding stock and property markets with liquidity, US data contracting at a slower rate and importantly the fear of investors who feel they cannot afford to miss the rally. But, to be very bullish on the Tim Bond in the medium term, you need to believe there will be a V-shaped recovery “with legs”, commodity prices can sustain the rally despite substantial over-capacity or investors will continue to trade momentum and not worry about valuations.

Prospects of a sustainable US recovery

The Tim Bond calls for a recovery to below-trend growth in the US. We believe that it is a valid insight that GDP could start expanding in Q3 or Q4 2009 on a quarter on quarter basis (driven by government spending, corporate inventory build and a decline in the trade deficit). However we see significant risk that the US slips back into recession in 2010 or 2011. The key household sector (PCE being >70% of GDP) is, ironically, being left behind by the stimulus package. We expect the flood of liquidity to chase with increasing momentum after inflating assets (i.e. the Tim Bond portfolio) rather than unfreeze lending to households. The core issue for GDP is that consumers are still heavily indebted with onerous debt service and collateralisation obligations. Improved “confidence” has done nothing to pay down debt or rally house prices. On the contrary, consumers appear to have had a rude awakening as to the fragility of their financial position and are saving rather than spending for the first time in decades. Combine this with a stagnation in employment (shocking figures reflected below) and it’s hard to project GDP growth in the medium term.



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page 8 of 13

US LABOR MARKET DYNAMICS

Decade Total Payroll

Employment Growth (000)

% Increase Total Government


% Increase Total Private Sector


% Increase

2000's 956 0.7% 2,024 9.9% (1,068) (1.0)%

1990's 21,723 20.0 2,465 11.2 19,258 21.8

1980's 18,140 20.0 1,895 11.7 16,245 21.3

1970's 19,429 27.3 3,703 29.7 15,726 26.8

Source: Contrary Investor

It is our view that the medium term prospects for the US are blighted by spending impact of the household deleveraging process. In addition, we expect this to be exacerbated by the mediocre employment growth prospects experienced over the past decade extending into the future. It is clear to us that in the medium term prospects for the US economy emphatically support the Hugh Hendry scenario.

China – stimulus, speculation and inventory build

Key to the Tim Bond scenario is rapid continued Chinese growth, and by implication, strong commodity demand. It is our take that the Chinese government were shocked by the depth of the slowdown in Q4 2008, and took decisive action in H1 2009 to ensure that cheap money flooded through the economy. The engine of Chinese growth has been switched from exports to credit growth remarkably quickly. In H1 the value of loans issued trebled YoY, as the banks were directed to lend vast sums, primarily to SoE’s for use (supposedly) in fixed capital projects but also for household mortgages.

The easy credit enabled supply of new residential accommodation to quickly fall from 14 months in January to its long term average, 9 months. The property sector has stabilised, and once again developers appear to be buying land and initiating new projects.

Of course China is no exception to the rule that any government action causes unintended consequences. Cheap money has benefited speculative activities of all kinds – share prices have risen dramatically (the SHASHR is up 61% YTD as at August 18), with record volumes and huge numbers of retail brokerage accounts once again being opened. However, to us the epicentre of the current speculation in China is the commodity sector. The collapse in prices in Q4 2008 has provided an attractive buying opportunity, and prospects are potentially further

China: new loans issued

0

1,000

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8,000

Jan-June 2008 Jan-June 2009

RM

B b

illi

on

+202% yoy

Chinese money supply (M2)

growth takes off

12%

14%

16%

18%

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22%

24%

26%

20

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: M

2

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: C

PI



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page 9 of 13

enhanced by the surge in money supply and resultant potential for future inflation (refer chart above). Demand has naturally spiked given the surge in infrastructure spending, but the level of inventory build has been enormous, leading to record imports across key base metals (chart overleaf). This is well illustrated by Aluminium. China is the world’s biggest smelter of Aluminium, and has been a large net exporter for several years. Yet over the past few months vast amounts have been imported, partially to benefit from price arbitrage and subsidies, but primarily due to speculative inventory build.

Global speculative flows into commodities have followed, with the volume of funds in ETF’s and index funds approaching or even exceeding the pre-crash levels. Resource/basic materials shares have also dramatically out-performed, the super-cycle is back?

The immediate challenge would be a slowing of demand in H2 2009 as the pace of inventory accumulation slows. However, the amazing surge in Chinese imports has certainly saved global demand from a far worse collapse, as illustrated in the charts below. Could an argument be made that any future slowing in exports would provoke similar reactions from the Chinese authorities, meaning the cyclicality of many base metals and bulks has been dramatically reduced, and hence RIO, BIL, AGL and XTA deserve higher ratings?

To conclude on China that we believe the government is capable of ensuring an extended period of easy money, given firstly the moderate levels of consumer indebtedness and inflation currently prevailing, and more importantly as the alternatives for them, at least until exports show a strong recovery, are politically unpalatable.

0

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2005 2006 2007 2008 2009

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ex (

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Coal

Iron ore

Steel

Chinese steel/bulk imports

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2005 2006 2007 2008 2009

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ex (

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2005 =

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Copper

Nickel

Aluminium

Zinc

Chinese base metal imports

Monthly changes in base metals

demand

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Total worldWorld Ex-ChinaChina

Monthly changes in steel demand

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page 10 of 13

Evaluating the probability of inflation

The Tim Bond highlights the medium term risk as inflation. If inflation is really the medium term fear, why is oil behaving like and correlating with any other risk asset? It appears to me that the oil price, like the S&P500, EM equity indices, other traded commodities and carry trade currencies (in other words the whole smorgasbord of the Tim Bond portfolio), has become a crude proxy for risk aversion rather than providing any fundamental insight as to future demand and supply and hence economic growth and inflation.

Perhaps the best evidence of this is looking at the most energy price “sensitive” economy – India. India imports the majority of its fossil fuel needs, and also subsidises the retail fuel price. A sharp rise in oil price expands both their current account and budget deficit, both already pretty substantial. At the height of inflation fear in mid 2008, any move up in oil resulted in a fall in Indian equities – this negative correlation reflected in red below. Currently the oil price and Sensex index show a positive correlation of over 90%. Hardly illustrative of any fear of inflation.

Our conclusion is that despite the rhetoric of market commentators, politicians etc., the run in the Tim Bond portfolio components is due to declining risk aversion rather than any genuine fear of inflation.



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page 11 of 13

ACH Process

Key Evidence Tim Bond Hugh Hendry

Tim Bond index up 50% ytd and in positive trend – important given potential of feedback loops and self-reinforcing cycles

√ X

Chinese ability to sustain recovery good – muted inflation, moderate consumer debt levels √ X

US consumer needs to deleverage and cut spending to below income X √

Policy-driven easy money is chasing the Tim Bond portfolio rather than lending to US households and hence driving a property price recovery

X √

US long bond yield is near the record low and in 28 year bull trend X √

Fed and Treasury intent on reflating asset prices – unintended consequence is the flow of cash to the Tim Bond portfolio

√ X

US employment growth secular flat for 10 years, any cyclical improvement likely to be muted X √

The ACH process is designed to focus on contradictory evidence rather than confirmatory. In this case it has really not assisted in the research given that neither scenario stands out. However it is fair to say that much of the evidence that contradicts the Hugh Hendry appears to relate to the near term, while the key aspects contradicting the Tim Bond are perhaps longer-dated, secular factors. We caution that “near term” could be anything from a few months to several years.

Research Conclusion

We believe the Tim Bond portfolio is currently benefitting from an on-going decline in risk aversion. Market participants are sensibly directing the cheap liquidity provided by Fed policy at already inflating assets – the Tim Bond portfolio. This is a much quicker route to profits than attempting to lend to moribund US households in the hope of an eventual reversal in the decline in house prices. This process of following inflating assets has considerable momentum, and given its obvious feedback loop, has potential to continue or even accelerate. It also has, ironically, negative implications for the longer-term sustainability of an economic rebound that in essence leaves the largest sector, the consumer, behind.

Key events in the near term include the likely reporting of the end of the recession in the US as QoQ GDP data shows growth as quickly as Q3 2009. Chinese liquidity provision is also likely to remain very supportive, even if at a more moderate rate. Accelerating investor flows into commodities may also buffer any slowing of Chinese demand in H2, at least for base metals if not the bulks. Key evidence that this may happen was the announcement in mid August by BIL’s Marius Kloppers that the Chinese commodity demand outlook was poor for the rest of the year and that Billiton (the world’s largest commodity company) expected no fundamental demand growth until mid 2010. This had no impact on the market – in fact traded base metal prices were strongly up by close of day.

However, it appears reasonable to conclude that the Hugh Hendry scenario has a significant probability of occurring in the medium term. This implies a dramatic reversal at some point in the future as the market once again prices in deflation fears. Our best guess is that these fears will re-emerge at the earliest in 2010, but that said the Tim Bond momentum could equally already be over or last much longer than anticipated.

The Third Way

It has been an especially difficult research exercise evaluating two essentially polar scenarios. We believe it is worth posing the question whether the evidence we have evaluated could support another scenario, call it the Third Way. This could be in brief characterised as an environment of poor global growth, with some significant economies even in recession, but combined with rapid inflation in a narrow basket of assets. The poor growth would force policy makers to further reflationary efforts, but the bulk of the created liquidity merely flows to the inflating assets rather than to the real economy. Powerful trends require powerful reinforcing feedback loops. The problem with the Hugh Hendry scenario, as we see it, is that it is considered in isolation of the inevitable policy response from the no doubt panicked authorities. When one considers that policy overtly, the Third Way becomes far more compelling. In fact, given the sustained cheap cost of money implied by the Third Way, it could result in an asset bubble of memorable proportions.



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page 12 of 13

If we re-do the ACH process, we get an interesting result.

Key Evidence Tim Bond

Hugh Hendry

3rd

Way

Tim Bond index up 50% ytd and in positive trend – important given potential of feedback loops and self-reinforcing cycles

√ X √

Chinese ability to sustain recovery good – muted inflation, moderate consumer debt levels √ X √

US consumer needs to deleverage and cut spending to below income X √ √

Policy-driven easy money is chasing the Tim Bond portfolio rather than lending to US households and hence driving a property price recovery

X √ √

US long bond yield is near the record low and in 28 year bull trend X √ ?

Fed and Treasury intent on reflating asset prices – unintended consequence is the flow of cash to the Tim Bond portfolio

√ X √

US employment growth secular flat for 10 years, any cyclical improvement likely to be muted

X √ √

The Third Way is not contradicted by any of the summarised evidence (although we are not sure re the prevailing US long bond yield), in fact the weak economy hypothesized by the Hugh Hendry ensures that the policy-driven liquidity “fuel” for the Third Way extends for an even longer period.

Trade Strategy Alternatives

Positioning Tim Bond Hugh Hendry 3rd

Way

(1)Long Tim Bond, scale in size, watch out for key Hugh Hendry like risks, use wide trailing stops

Very successful provided we give it room to ensure don’t misread corrections as trend changes

Unsuccessful unless TB lasts for a reasonable period prior to HH eventuating

Very successful

(2)Long Tim Bond, scale in size, look to reverse to Hugh Hendry on stopping out

Successful as long as TB lasts a fair period first, and stops are wide enough to cater for normal volatility

Could be very successful provided TB lasts for a reasonable period prior to HH eventuating

Should be successful provided stops appropriately wide

(3)No position, wait for Hugh Hendry positive trend

Unsuccessful but don’t lose cash

Successful and more successful than (2) if HH occurs relatively soon

Unsuccessful

(4)Long Hugh Hendry, scale in Unsuccessful, stop out several times at significant cost

Very successful if HH timing is quick, but risk is get stopped out given TB momentum currently and miss run

Unsuccessful



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page 13 of 13

Of the alternatives reviewed above it is clear that long Tim Bond portfolio appears to have the highest probability of success, making profits in a recovering economy and also in a weak environment as per the Third Way. The key issue for the Third Way is how big the fluctuations in asset prices potentially could be as the market weathers poor economic data and goes through bouts of risk aversion. Also important is how self sustaining the resulting trend could be.

References

Macquarie Research, “Commodities outlook, China stands alone”, August 2009

Citigroup Global Markets, “Australian Steel”, August 2009

CLSA Asia Pacific Markets, “Greed & Fear”, Christopher Wood, August 2009

Ft.com interview with Hugh Hendry, July 2009

Macquarie Research “Beyond the Bund, Beijing Bubblenomics”, August 2007

Barclays Capital, “Global Speculations – Bullish Concerns”, Tim Bond, May 2009

brait multi strategy fund overview 30 august 2009

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