Our editor-in-chief interviews Hugh Hendry, the famously contrarian founder of Eclectica Asset Management.
Merryn Somerset Webb: You have a reputation as being pretty bearish on markets and economies. But last year you wrote a letter to your clients telling them you had turned bullish on the markets. Do you still feel like that?
Hugh: If I had my time again, I would have said not that I was a bull, but that the ongoing degradation in the soundness of the fiat monetary system would look like a bull market. We experienced a substantial number of redemptions from the fund [after the letter].
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I had been considering a bearish diversifier to an investors' portfolio. After all, I was the guy who made 30%-odd in 2008. But the letter brought the notion that rather than a diversifier, I was a concentrator.
Merryn: There was also, slightly, the idea that you had capitulated given in to a bull market you had refused to accept.
Hugh: Mea culpa. The weirdest element of my professional career is that I need a fight. I cannot engage, unless I get angry. Possibly it's back to my Scottish roots, and the weather.
The last time I was angry was late 2010-2011, when the market thought the Western economy was recovering. The fixed income markets were pricing in a probability that central banks would raise their overnight rates the European Central Bank (ECB) actually raised rates.
I thought that was insane, given the deflationary zeitgeist approaching. With that anger I took on a lot of risk. I had a large fixed-income bet, which said "these rate rises will have to be rescinded".
That proved to be correct and that was my last moment: when I look back over the last three years, after that point it feels as if the sun only rose each day to humiliate me!
I found myself unable to forgive the central banks for bailing out Wall Street. I just couldn't get over it. I luxuriated in the polemics of Marc Faber, James Grant, Nassim Taleb, Albert Edwards, et al.
But I am charged with the responsibility of making money, not of being a moral curmudgeon. I had to get over that. So I wrote that letter last year. It was cathartic for me to say "You know what? I get it".
Merryn: But you don't disagree with these people on economic fundamentals, do you? You just disagree on the effect on the markets of central bank behaviour and on the longevity of that behaviour.
Hugh: Increasingly, I just disagree with them. I've turned the volume to zero. Previously they were like sheet music. When I read it, I could see the trades appear in front of me. I just don't hear the sound of music today.
Merryn: Well, let's talk about your view of the world now.
Hugh: Macro hedge funds are struggling to make money. Macro is distinguished, I believe, by superior risk control. It's a disaster insurance programme. In 2008, all the good macro managers made you money. The world became profoundly unsettling and you cashed in your insurance policy.
Today, I question the relevancy of that disaster insurance. In a world where the central banks seem to have your back underwriting global asset prices do you require that intense scrutiny of risk? Do you want it? Risk controls can force you to sell the things you like when they go down in price.
This year, I had constructed this argument that I wanted to be bullish. Yet, with risk control, I found myself a seller at lower and lower prices. Look back to Japan. I started the year hugely bullish.
Not qualitatively I'm not convinced by the three arrows' [the strategies behind Abenomics'] but I do see persistent failure in achieving growth, which leaves no recourse but to intervene again and again. So I see a weak yen and the stockmarket being higher and higher.
But four months in, the Japanese market had fallen 16% from its high. I had to sell at lower prices. Then the Nikkei went back to its previous highs. The same happened in Europe. Why did I sell? It became impossible to fulfil my mandate and to make money.
I have concluded that my risk tolerances were creating too much intervention in the portfolio, and it was damaging performance. So I've widened the tolerance of the portfolio.
Merryn: If central banks have your back, there's no need for the same risk controls?
Hugh: There is less need. I was at a conference with some global macro managers in September in New York and I asked: "If the S&P is down 12%, what do you do?" Guess what? They buy. Central banks have created a behavioural tic [buying on the dips], which is becoming self-reinforcing.
You only make those mistakes a few times so when we came into October, I got it. We stayed invested and were able to buy more equity risk towards the middle of the month. We made money in October. We made money in September. We made money in August.
Merryn: So in a market like this never sell anything and you'll be fine?
Hugh: You can say that, but I cannot.
Merryn: Let's look at specific markets.
Hugh: This is almost unparalleled as an exciting moment for global macro. I'd make an analogy with the central bank co-ordinated policy intervention in the foreign exchange markets, after the Plaza Accord in 1985.
There was a profound unease at the current account and trade deficits that America was running up. It would have resolved itself in time, in the real economy. But the real economy is composed of slow-moving prices, wages and productivity improvements.
Politicians just can't wait for those to move. So they jumped into the fast-moving world of macro with a plan to get the yen and the deutschmark appreciating. For hedge funds that was amazing.
No one stopped to say: "The deutschmark's getting expensive". That wasn't the point. It was a macro policy impulse sponsored by the world's monetary authorities. It was trending and you had to have that position.
Today it isn't about foreign exchange markets everyone can pursue a weak currency, so it can't be. Instead, the drama is unfolding in the stockmarket. To avoid deflation, bankers are using a policy response [quantitative easing QE] that underwrites a virtuous cycle of higher asset prices. That's why the US now has the greatest probability of escaping stall speed.
This is the trick Japan missed at the start of their crisis. Higher equity prices would have been a means for companies to issue equity, reinvest in their businesses, employ people, raise prices, and get things moving again.
Merryn: So you see the Japanese coming round to US-style QE, but wanting to do it in double time?
Hugh: Yes, a huge, huge catch up. The moral curmudgeons step in here and say: "This is all crazy. I disagree with this. I'm not playing".
But those asset prices are trending and you should participate. It will be the same in Europe. Europe has been slow to this game of QE. So they are clearly behind the curve we've had a year of deleveraging and slow-moving prices.
Europe needs high equity prices and high animal spirits. Then you'll get people feeling more confident about the collateral. The banks will be more willing to lend, and slowly but surely we will re-engage and we will get growth, perhaps on a par with what we're seeing in America today.
Merryn: So you're pretty certain this is going to happen in Europe?
Hugh: One can't be certain about anything, but I'm certain that it's a policy underwritten by the central banks, and as a macro manager, I want to put myself alongside their impulse. What the ECB's already done is remarkable in terms of what we thought it would be capable of.
Merryn: On the moral imperative some would say it is not to do QE, given the risks but you suggest the moral imperative is to do it.
Hugh: Desperate times breed desperate measures. Economies across the world were allowed to take on so much debt, to borrow tomorrow's money to spend it today. That's why people are disappointed by today's growth rate because it's like, "I ate your sandwich yesterday".
It's not there, QE is not a clean solution. It's a grubby solution, but it's closer to being a solution than anything else. I think we've barely scratched the surface in terms of what will happen, given the deficiency of demand. I think it will spread into central banks essentially having to endorse higher government budget deficits to sponsor public work projects or favourably to sponsor tax cuts.
Merryn: And what of the concerns that this has distorted markets?
Hugh: Absolute nonsense. Japanese government bonds (JGBs), for example, are fairly valued. GDP fell an annualised 7% in the last quarter. There is no inflation; 25 years of no real GDP growth. Where would you expect yields to be for a country that can issue its own currency?
Merryn: What about US equities?
Hugh: US equities some of the best firms in the world that have exceeded all expectations, both in regard to growth and returns on capital. When it comes to valuation, one man's high valuation is another lady's low valuation.
Merryn: And the rising dollar?
Hugh: America, rightly or wrongly (I'd err on the side of caution) feels increasingly confident. But when it looks to the global theatre, it's concerned about China and Europe.
Over the last five years, QE as pursued by the Fed has had the explicit aim of ensuring the dollar wouldn't rise the idea was to keep growth in the US rather than let it be exported elsewhere by the trade deficit. Now they're willing to share that growth, which they can do by letting the dollar rise.
Merryn: Yes. Well, that takes us to China. You were very bearish here being one of the first to point out the problems with China's over-investment and debt.
Hugh: Before I surprise you on this one, I would like to tell you that I have made money trading China-related macro themes. I am more sanguine about China now I've been rather impressed by its policy responses over the last two years.
China has two components. It's got this manic investment that kept expanding overcapacity industries, such as cement and steel, and undermining prices in the rest of the world, which lowers global inflation figures below central bank targets. In turn, the central bank says: "Crikey, I've got to be radical here".
On the other hand, China has not boomed nearly as much as it should have over the last decade. What do I mean by that? Given the huge returns on investment on offer from cheap land, cheap currency and cheap labour, it should have grown at more like 20%, than 10%. It didn't, because so little of the great productivity leap went to households. Workers remained badly paid and got negative interest rates whenever they tried to put hard-earned capital back into the system.
So consumption fell, not because the Chinese love saving, but because their income was constrained versus its capability. That's now being challenged. Consumption should expand at 10% a year that underwrites a 4% floor to the Chinese economy, if you do the maths. How can you make it happen?
Take away those negative interest rates. Tick, they've done that wealth management or internet platforms offer money market rates. You'd pay people more and wages have grown at a tear. So the consumer is enjoying a dramatic relative improvement in their lot. I'm optimistic.
Merryn: So what's the China trade for retail investors on that?
Hugh: Your closest proximity to the household spending bonanza in China? The internet giants Baidu (Nasdaq: BIDU) and Tencent (HK: 700). Valuations are high, but growth rates are too.
Merryn: It's another area where you don't care about valuations right now?
Hugh: Not at this moment. No.
Merryn: Thank you, Hugh.
Who is Hugh Hendry?
Hugh Hendry was born in Glasgow in 1969. After studying economics and finance at Strathclyde University, he joined Edinburgh-based Baillie Gifford in 1991. He moved to Credit Suisse Asset Management in London, before joining Odey Asset Management in 1999.
At Odey, he ran several funds, including the Eclectica Fund, a macro hedge fund (macro managers speculate on big picture' trends in areas such as interest rates and currency markets).
In 2005, Hendry bought the management contract for the fund from Odey and set up Eclectica Asset Management. He did extremely well in the financial crisis, returning 31% in euro terms in 2008.
Recent results have been more patchy, with a cumulative gain of 6.8% between 1 January 2009 and 31 October 2014. The fund's assets under management have shrunk from $592m to $78m during 2014.
Watch the videos of Merryn's interview with Hugh.
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