Hugh Hendry: Betting on deflation

Jody Clarke talks to hedge-fund manager Hugh Hendry of Eclectica about what he's investing in now.

You've stayed out of the current rally. Are you regretting that?

I don't really give a damn what the market is doing I don't have the constraints of a benchmark and my actions are not determined by the mad booms. You lose money by trying to stay up with the Joneses. You lose money when you hear about some superstar who is making lots of easy money and you think you need to jump in and join him. And we've had a lot of Joneses jumping in since March.

My view is that the market is up 60%, and you've just got to sit aside. The remarkable aspect of this remarkable rally is that if you look at the stockmarket over the last ten years, it's not gone anywhere. That has to be telling us something. I think it's urging some degree of caution.

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Do you think there's anything wrong with the way money is managed today?

I want to look after the money of people who don't want to lose it. I'm having a desperately bad year. Government bonds, my favourite asset class, have been pants this year. Yet I'm flat. You know from talking to other fund managers that when they're badly wrong, they're down 40%-50%, which is why I think a change in mindset is necessary in the industry.

Fund managers can't go on running the risk of losing 30% one year in the hope of regaining it the next, because if I lose 30% one year, I have to make 43% the next just to break even. But if I was only down 5% last year, I only have to make 7% or 8% and I break even again. That just facilitates the ability to make money. If you can steer clear of the crowd, you stand a better chance of avoiding those precipitous drawdowns.

Eclectica is based in Notting Hill. Why don't you work in the City?

I live in Notting Hill. My house is around the corner and my kids go to school down the road. But I can't conceive of any networking effect of being in close proximity to every other manager. I certainly don't understand why hedge funds congregate around Mayfair. I try to be a little bit aloof. I physically try to remove myself from the crowd.

You're betting on deflation, aren't you?

I am, yes. The retail price index reveals falling prices and we are only one year into this drama. The authorities have taken interest rates to zero, they have printed money yet retail prices continue to fall, and bank lending continues to contract. Those are the hallmarks of deflation.

So what are the most compelling investments right now?

The greatest attraction lies in continental European government bonds, especially German bunds over a 30-year duration, because the longer you go out, the more you'll make if you're right. In Europe at the present time, there's been no expansion of bank lending to the private sector. Companies across all regions are eager to swap debt with equities, so everyone is deleveraging and the euro is rising. The central bank has been the most determined to be monetarist and protect the value of money. So getting paid over 4% just to wait and take no risk, I find quite compelling. A 30-year bund won't make you rich, but it could just preserve your wealth.

I'm also playing short-term interest-rate expectations in Britain and Australia. The markets are pricing in interest-rate increases. In Australia, short-term interest rates are forecast to double to 6% over the next two years.

In Britain they are 0.5% and expected to be 2% as we move forward. If those expectations are wrong and the central bankers are true to their word and don't raise rates, I stand to make between seven and ten times my money on those interest rates. So that's kind of what keeps me going.

Are you investing in any equities?

In my hedge funds, I don't have any equities, but I have equity funds that are 80% invested. The novel aspect of today's markets is that you can invest in the safest, most liquid areas of it. You're getting yields of 6%, 7%, 8%. And the dividend is not at risk, it's just the business is deemed to be a little bit flat and a little bit boring. We have a portfolio of equities in our long-only business where the average yield is 4.5%.

So as you can imagine we own pharma, tobacco, telecoms and big oil. Names like BP (LSE: BP), GlaxoSmithKline (LSE: GSK) and Vodafone (LSE: VOD). They are trading at valuation levels that marked a low in the equity markets in the 1970s. If only the wider market was trading at some of the yields you are getting from these larger companies, then perhaps I would be less worried about the need for market timing.

Hugh Hendry

The son of a lorry driver, Hugh Hendry, 40, shoots off bursts of information with the speed of a Gatling gun. Born into a working class family in Glasgow, he turned down a job with KPMG after becoming interested in investing in the late 1980s and taking a job with Baillie Gifford instead.

A KPMG partner told him: "Young man, you will always regret this decision". But he prospered, later going on to join Odey Asset Management in London, where he reportedly kept the heating at 13C to make everyone work harder.

His hedge fund, launched in 2002, made more than 30% in 2008 as the FTSE 100 tanked by 28%. "If you can make money while everyone else loses theirs, that really bolsters the power of your money."