In this report we describe the background to and the extent of the capital spending bubble in China and identify factors that will precipitate its deflation. We focus on Chinese capital spending firstly because it is the single most important driver of current Chinese and global growth expectations and, secondly and more importantly, investment-driven growth cycles tend to overshoot and end in a destructive way.

The Fund produced a net return of 8.8% for the six months ending June 30th 2008, giving a total net return of 37.3% for the trailing 12 months and 300.3% since inception in 2002.

The Fund produced a net return of 26.9% for the six months ending December 31st 2008, for a net return of 51.9% for the calendar year. We were delighted to post these numbers in what was one of the most difficult years for hedge funds and the whole investment industry. During the year hedge funds suffered an average 18.3% loss and total funds under management declined from $1.9tn to $1.1tn1. The Industry was tarnished with a number of high profile failures and was particularly damaged by the Madoff fraud, which has had, and continues to have, a huge impact on many hedge fund investors.

The Pivot Global Value Fund returned 48.4%, net of all fees, for the calendar year 2007. It was by far the best performance the Fund has achieved, with 92% of the return attributable to short positions across all asset classes (equities, options, bonds and CDSs). Geographically our positive returns were attributable almost entirely to 3 regions – Western Europe 45%, United States 38% and Emerging Europe 17%.

Our expectations for 2008 is for a continuation of the broad-based bear market, which became evident in the final months of 2007, as well as, the deleveraging process which, in our view, is only just starting to play out. We believe that the current cycle will end with an emerging market currency and debt crises; global asset and commodity price deflation and global recession.

• European convergence process facing multiple tension points. The Southern and Eastern Europe convergence economies, among the fastest growing in the European Union, are now simultaneously facing a multitude of challenges including widening current account deficits, unsustainable credit growth and vulnerable banking systems.
• Eastern European convergence countries on Asian currency crisis path. New Eastern European EU members, particularly the Baltic States, are reaching readings comparable to Asia in the mid 1990’s in terms of credit expansion, depletion of currency reserves and external liabilities. Similarly to Asia, capital inflows have been predicated on a supposedly inviolable currency peg, meaning there is little tolerance among investors and local banking systems to adverse currency moves.
• Southern European convergence countries in Argentinean trap. The region’s economies, especially Spain and Portugal, with their addiction to housing, construction and credit expansion to drive growth, are highly vulnerable to deflation, which may become necessary to halt structural losses in competitiveness, similarly to the situation that led to Argentina’s collapse in 2001.
• CDS preferred vehicle for European divergence. Although equity, credit and currency markets show an equal lack of concern over potential convergence disappointments, our preferred way to exploit future European divergence is CDS (Credit Default Swaps), where leveraged long term positions can be established at close to minimal costs. The Fund has built significant CDS positions in the Baltics, Portugal and Spain.
• Latvia risk reassessment first step in divergence process. Latvia is the first convergence country to undergo a sharp reappraisal of its convergence outlook, as illustrated by a recent jump in RIGIBOR inter-bank rates and CDS spreads. With growing evidence of stress in the Latvian banking system, we believe this process has further to go and could act as a trigger for a broader reappraisal of the European convergence.

In this report we have set out to describe the background and extent of the credit expansion in recent years, and identify any credible signs of a reversal. We have concentrated on the US housing finance area, where most of the growth has been seen, but this analysis has economic and investment implications well beyond the US. Our first conclusions are that the US Fed tightening has had a limited impact on credit growth, which has continued expanding from what were already historically extreme levels, and that credit is still widely available at a relatively low cost. More significantly, we have identified several factors which indicate a deteriorating credit environment is imminent or already under way. These factors include continued erosion in loan quality since 2004, a sharp slowdown in house price growth and worsening earnings quality at major lenders. These, and other factors, will be discussed in more detail below.