What you can learn from Hugh Hendry’s latest bets on the eurozone

 

Marine Le Pen © Getty Images
A victory for Marine Le Pen would be terrifying for the markets

Hedge fund manager Hugh Hendry made his name during the 2008 financial crisis, earning double-digit returns in a year when most people lost huge amounts of money.

In the early years of the post-crash recovery, his overly bearish stance didn’t do him or his investors any favours.

He learned from painful experience, and went with the flow of quantitative easing and central bank intervention from late 2013 onwards.

But now he’s getting edgy again. He’s taking out insurance against the eurozone crisis flaring up again.

And it’s not just about French politics…

Useful lessons in investment psychology

My colleague Merryn Somerset Webb interviewed Hugh Hendry a couple of years ago. It’s a fascinating series of interviews for lots of reasons. Hendry is very frank about how his own cognitive biases and views on the morality of bailing the banks out (he didn’t like it) skewed his own investment process following his wildly successful 2008.

He also talks about why and how he shifted his approach and – effectively – learned to embrace the bull market. If you have any interest in investment psychology at all, I’d recommend you watch it. It’s both a cautionary tale and also an object lesson in the importance of dealing with the world as it is, rather than as you think it should be.

Anyway, after a few years of being comfortable with “avoiding betting on really bad things happening”, Hendry is now not so sanguine about the outlook. Specifically, he’s decided that it’s worth hedging against a potential victory in May’s French presidential election by Marine Le Pen.

We’ve already discussed on several occasions why a Le Pen victory would be terrifying for markets. As Hendry puts it, “markets would need to grapple with the real threat of a euro break up”. In short, if you thought Grexit, Brexit or Donald Trump’s election were disruptive, wait until you see “Frexit”.

Obviously, we don’t know what the outcome of the French election will be. The pieces on the board keep changing. François Fillon was the great hope just a few short months ago and now he’s under formal investigation – “one step short of being charged”, the FT tells me – for putting his family members on the state payroll.

And most people still think that there’s not much chance of Le Pen actually winning (though it’s interesting to see that we’re also now seeing articles questioning whether she could in fact implement her promises if she is elected).

It should go without saying that Hendry has no special insight as to whether Le Pen will win or not. So why does he reckon it’s now worth hedging against the outcome?

Why Europe could struggle regardless of the French vote

Firstly, he says, the weak economic backdrop in Europe “is a fertile environment for populism”, while a relatively painless exit from the European Union by Britain will encourage other nations to follow suit. So a French “leave” vote is certainly possible, if not necessarily likely. The huge impact of that makes it worth hedging against (it might be low probability, but in risk/reward terms, you get a huge potential payoff in return for paying a relatively low stake).

Secondly – and perhaps more importantly – the European Central Bank (ECB) will struggle to maintain its own money-printing regime as German central bankers start to fret about inflation. That will make it harder for troubled eurozone countries to raise funds and roll over existing debts. As Hendry points out: “I do wonder what price the private sector will demand to finance the Italian government’s persistent and substantial debt re-financing”.

So on the one hand, Hendry is betting that the “spread” (the gap) between Germany’s cost of borrowing and Italy’s cost of borrowing (as measured by government bond yields) will widen. If Le Pen wins, that seems almost certain to happen in the short term, although in the longer run, a Le Pen victory might enable the ECB to maintain looser monetary policy for longer.

On the other hand, if the political picture doesn’t end up being as scary as everyone fears, then the ECB – under pressure from Germany – might stop printing money to buy the sovereign debt of troubled countries. That will widen the spread too.

This isn’t his only bet on eurozone turmoil. Hendry is also betting on the price of eurozone bank shares going down, relative to the price of their safest debt. In effect, he’s betting that investors have over-egged the recovery in the eurozone banking sector – if that belief turns, then equity would be hit hard, whereas senior debt is about as safe as it gets.

His rationale here is that – again – a French panic would hammer eurozone banking stocks. However, even if there is no French panic, then a tighter ECB monetary policy would hurt any economic recovery in the region, which would dent banks’ profitability, and thus put a stop to the rally in eurozone banks.

What this means for you

These trades are fairly easy to understand, but they’re not easy for your average investor to put into place. So what can you take from this?

Hendry is not daft. He’s learned the hard way that in markets, idealists pay a hefty premium for the sensation of ideological purity – and it’s the pragmatists who reap that premium.

The scenarios he’s hedging against might not come to fruition. Maybe Le Pen will lose, populism in Europe will fade, the eurozone recovery will continue, and Mario Draghi at the ECB will be able to keep fudging things successfully. (My own view is that there’s a good chance of the first two happening, and the odds of the last two are at least 50/50.)

But it’s not about being right. It’s about the balance between reward and risk. If he’s wrong, it doesn’t matter much. Markets aren’t pricing in a particularly downbeat scenario right now, so even if the news is better than expected for the rest of the year, a sudden, devastating loss arising from these hedges is virtually impossible.

But if Le Pen does win, or the ECB does have to taper early, or some combination of the two happens – well, the pay-offs could be huge.

And that’s the point. You don’t know the future. So if you plan to make a bet on a future outcome, you have to make sure that it qualifies as a big enough surprise to be worth doing; and that your downside is minimal if you get it wrong.

Two simple questions: what’s my upside if I’m right? What’s my downside if I’m wrong? Add those two questions to the columns in your investment journal, and make sure you answer them before you make a decision to buy into a stock or fund.