Hugh Hendry, co-founder of Eclectica Asset Management and hedge-fund manager of the Eclectica Fund, talks to Merryn Somerset Webb about why the consensus view on China is wrong and what this means for investors.
Going to see most fund managers is a straightforward affair. You arrive at a glass building and announce yourself to a receptionist who signs you in and sits you down.
You flick through the FT until the fund manager appears and ushers you into his smart meeting room (oval table, ten chairs, mid-grade art on the walls). You admire the view. You get a coffee. You chuck out a question or two and the fund manager tells you all about how the West has had its day; how emerging markets are where the action is; and how he uses a mixture of special valuation methods to pick his stocks. Making sure, of course, that wherever they are listed they have good exposure to China. You nod a lot. Then you get shown out. You go back to your own office (no meeting room, no coffee, no view) and that is that.
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Not so with Hugh Hendry. For starters, he doesn't have the right kind of office. It's just off Queensway in Bayswater (kind of behind Ann Summers) and while there is a receptionist, she just waves you vaguely towards a grubby series of staircases that lead you to Hugh's very white, very open-plan office. When I arrived there last week, Hugh wasn't in. So I had a coke and read the Evening Standard. It wasn't quite the same.
China and nutcrackers
But with Hugh the differences really show when he starts talking. He arrived in a rush, sat down and said that the big debates in the markets are really just like the "nutcrackers". The nutcrackers? It turns out he is talking about an incident 40 years ago when just before a performance at Amsterdam's Concertgebouw, a group of radical young musicians interrupted proceedings by making noises with nutcrackers and bicycle horns. The idea being to denounce the orchestra as a status symbol of the ruling elite. When he talks about China, Hugh feels like he is banging nutcrackers at the financial elite (of which he absolutely denies being a member he sees himself as more of a "pirate") and their cosy consensus of 10% growth extrapolated forever.
He doesn't see China as the saviour of global growth. Far from it. Think of China as you would have fashion chain Next back in the 1980s, he says. Next was seeing "parabolic growth". By the end of the decade there were "two or three Next stores on every high street, you were falling over them". Revenue growth was growing. But the marginal return on investment "was collapsing".
Now look at China it's got the parabolic growth and rising GDP, but no one seems concerned about the marginal return on investment. They should be. Look at the high-speed rail links. They sound good who wouldn't want to link the prosperous coastal areas of China to the miserably poor? But can it really be a good use of capital? No, says Hugh. You may be "shuffling people backwards and forwards at over 200km an hour", but the people in question are peasants on $1,000 a year. "So the productivity expansion from that investment I suspect is zero."
How to profit from the impossible
On a recent trip to Japan, every investor Hugh met told him that a major fall in Chinese growth was very unlikely; falling GDP was "impossible". He liked that a lot. Before the subprime crisis, Hugh spent lots of time telling people (including other members of the MoneyWeek roundtable, and hence our readers) that the US housing market was going to crash big time. Everyone said it was "impossible". Hugh went on to make "a great sum of money" from its impossibility. He thinks he'll do the same from the impossibility of collapse in China. Where others see endless growth, he sees "dramatic hubris" and over-expansion. Where others see a government firmly in control, he sees a disastrous mixture of operational leverage and financial leverage. China should be pulling back from everything, as consumers in its major markets do the same. But it is gearing up instead.
They could get away with it, I say, if we are in a classic V-shaped recovery from recession, and demand from the US returns to pre-2007 levels reasonably fast. You have to be careful suggesting that you might disagree with Hugh this is the man who told Liam Halligan on CNBC that he clearly had his head "lodged somewhere" and who told a presenter on the same programme that he was a "silly man" who should "wash his mouth out with soap" for suggesting that anything in modern markets is a "screaming buy".
Luckily, Hugh is pretty confident that I'm as pessimistic on markets as he is. So he just points out that if it were a V-shaped recovery, they would. But it isn't something that has "profoundly serious implications for China", already one of the world's worst-performing markets this year. No governments are currently able to boost spending, so the "only means for GDP to be sustained" at even current levels of growth is for the private sector to come back and take on more leverage.
But "there is just no evidence of that".
Instead unemployment is high, pay is static, at best, and there's every sign that the 'recovery' in GDP is nothing more than a rebuilding of run-down inventories. Sure, fund managers are talking to lots of firms claiming that everything is "going gangbusters". But that tells you nothing. Imagine, says Hugh, that you'd gone to the same firms in early 2009. Then they would have told you their businesses were "falling off a cliff". Instead, they had a great year. The upshot? "I don't really see that as a source of wisdom for directing my portfolio."
Meaningless valuation measures
The reality is that with public and private debt levels having peaked, the "deflation genie is out of the bottle and bad things happen to equities when deflation is out there". So no new bull market then? Hugh doesn't quite tell me to wash my mouth out. But he does make it clear that the general public needs to think through its expectations of investment returns. Back in 1974, the Dow Jones had halved in two years to 475. In 2008 it peaked at 14,700. That's a 30-fold increase. "That's the South Sea bubble," says Hugh.
But the days when it was perfectly reasonable to expect 10% a year forever are long gone. So much so that if anyone offered you 5% or 6% a year guaranteed you'd want to jump on it. And as for valuations? Meaningless. Fund managers go on about stocks being cheap based on book value. But "just before a business goes bust, do you know what it's as cheap as it has ever been". And valuing things with p/e ratios is a nonsense too. Why? Because the price of a market isn't about value and it isn't about growth.
The real "calibrator of turning points" is social mood. "Stocks trade at incredibly low valuations when the social mood is unforgiving and at very high valuations when the social mood is forgiving." Bull markets are about forgiveness and bear markets are about vengeance. Anyone feeling forgiving about finance at the moment? Quite. Odds are that from here on, equities just get "cheap, cheap, cheaper".
The story ends with hyperinflation
I want to know what the end game is. I keep asking people this, but it isn't easy to get clear answers. Except, of course, from Hugh. From day one, he says, his story has been that the final outcome will be hyperinflation. He sees the current deflationary shock deepening and then creating "the political legitimacy to go nuclear with hyperinflation" via the printing presses.
I agree. But what's the timescale? "The past is certainly no longer now and the present is simply the now that flows from the past to the future," says Hugh. That doesn't really help, I say. It turns out that what Hugh means is that hyperinflation is some time off. The US President doesn't press the nuclear button as soon as the missile leaves Tehran. He waits until it is in US airspace and all interventions from space stations have failed. Then having given up hope, he presses the button. Central banks are much the same they'll have to have given up hope (as China blows up, for example) before they get their printing presses into real overtime.
That said there is a possible way out one I have to say I had never thought of. China could simply write off the Western debt represented by their "huge pools of foreign exchange reserves" (China has $3trn). Why would they do that? Several reasons, says Hugh, but mainly because US debt is a "subprime asset" that the Chinese can't do much with as it stands.
But write it off and at a stroke they will have secured the "health and vitality" of their biggest customer. They'll have enhanced its credit rating, made it less indebted and allowed it to be a bit more self-financing, to the extent that it might even be able to improve its own infrastructure. I'm not going to hold my breath for that one. I don't think Hugh is either. So hyperinflation it is.
So far so scary. But then comes something unexpectedly conventional. When we get to the end of our chat, I ask Hugh what on earth is the ordinary investor to do? His answer? Buy the largest and safest stocks: businesses with very little debt and "balance sheets which are far more secure than sovereigns". Think Nestl, Unilever and Procter & Gamble. Otherwise, given that hyperinflation is still some way off, you buy 30-year US Treasury bonds or gilts. It is, says Hugh, the one thing most of us can't bring ourselves to do. But it is also the one thing that, pre-hyperinflation, "makes a lot of money".
At this point Hugh starts talking about interactions between Jesus and Peter in the Garden of Gethsemane, I look confused and we call it a day. Then he gives me a lift to the station in his G-Wiz.
Who is Hugh Hendry?
Glasgow-born Hendry graduated from Strathclyde University in 1990, after studying accountancy. An interest in investing led him to turn down a job at KPMG to work for Edinburgh investment manager Baillie Gifford, becoming one of their first non-Oxbridge recruits. He went on to join Credit Suisse before making his name at leading hedge-fund group Odey Asset Management. In 2005 he left to form Eclectica Asset Management with former Odey partners. His hedge fund, the Eclectica Fund, returned more than 30% in 2008, while the FTSE 100 fell by 31%.
