Hugh Hendry: ‘Desperate times breed desperate measures… QE is a grubby solution’

 

In the second of three interviews, Hugh Hendry tells Merryn Somerset Webb why central banks will go even further than anyone expects to keep the global economy afloat. 

If you missed the first instalment, watch it here, and see part 3 here.

Transcript

Merryn: Okay. Let’s move on to looking at markets more specifically.

Hugh: Yes. Because on that, really and again, in sort of, trying to get away from the cabaret of bull or bear, the thing that excites me, that’s really got me engaged . . .  and again, it’s like “Okay. Hendry, the market, you have to wait five years. You have to have the market double. You have to have the market become qualitatively kind of expensive, and then you get bullish? I mean, really?” So let me kind of kick back on that.

Merryn: You can see that point from this side of your critics perhaps . . . ?

Hugh: I am certainly sympathetic to that take, and we’ve just discussed it. The travails of making money in the global macro community. What I want to say, again, is contentious. I want to say this is almost unparalleled in being the most exciting moment for global macro today. And I predicate that upon making an analogy with the Central Bank coordinated policy intervention, in the foreign exchange markets, after the Plaza Accord in, I believe, 1985. There was a profound unease at the current account and particularly the trade deficit that America was running up, especially against the Japanese, which was deemed to be contentious. The real economy is composed of slow-moving prices, wages are slow and the notion of having to wait for productivity improvements and wage price negotiations to work their course, via the U.S. corporate landscape in Japan, such as those deficits would be resolved successfully and become less politically contentious. It was just too long. Politicians just don’t have that time and so they jumped into the world of macro. Macro’s all about fast-moving prices. Foreign exchange is fast. Stock markets prices are fast.

So the notion then was that the Yen and the Deutschmark would appreciate. Now for hedge funds that was amazing. This is the period of the alchemy of finance, as George Soros has celebrated in very successful financial adventures. They just run the biggest long positions. No one stopped to say “Well, the Deutschmark’s getting expensive.” It didn’t really enter into the vernacular of trading in that market. It was macro, there was a policy impulse, a sponsorship by the world’s monetary authorities and you were trending and you had to have that position.

By and large it succeeded. So what I would said to you today is that the policy response can’t be found in foreign exchange markets. It’s been muted somewhat by the “Beggar thy neighbour” way that everyone can pursue the same policy. So currencies, up until very lately, haven’t really moved that much. Instead the drama is unfolding in the stock market.

I would say to you that policymakers are so absolutely beside themselves with regard to how structural these deflationary forces are, and that they recognise that they really have very little to offer once policy rates are at zero, the zero lower band, that they have to stave this crisis off. They cannot have deflation today.

I believe they are now responding to the fast-moving circuit of the stock market and clearly America’s demonstrated something. That policy response underwrote a very virtuous cycle of higher asset prices. There’s also the shale oil gas revolution and the weakness of the dollar of the period. But the U.S. Today, is deemed to be the most robust economy, with the greatest probability of escaping the stall speed.

Merryn: You’re telling us that QE worked.

Hugh: It’s all about to which degree does it work? Now if you wish to take the other side and say “QE doesn’t work.” It worked by redistributing but it doesn’t create wealth, clearly.

What it aims to do, is redistribute economic growth from one part of the global system to another. So as the U.S. has come to the forefront in the last five years, China’s found its growth rate has, from this perpetual notion of 10% GDP expansion, is now 7%, and everyone’s scratching their head and has great doubts that 7% can be maintained.

Merryn: Seven? Do you really believe it’s 7%?

Hugh: It’s fugazi, pugazi, whatever. Yeah. It is what the market is willing to entertain and presently that’s somewhere around 7% level. So QE has succeeded in that redistribution away from the Chinese mercantilist axis back into the American axis. Look back to what happened in Japan – that’s the trick they missed –  the fast moving reaction of equity prices. Sponsoring higher equity prices would be a means for companies issuing equity, reinvesting in their businesses, employing people, raising prices, and getting this thing moving again.

Merryn: So you see the Japanese coming round to the American’s stand on QE, but wanting even to do it in double time?

Hugh: Yeah, absolutely, to catch up for 25 years from behind . . .

Merryn: There’s this sudden huge catch up.

Hugh:  . . .  a huge, huge catch up. Now the problem, or the perception that I have of the problem, is that that’s when the moral curmudgeons step in and say “This is all crazy. I disagree with this. I’m not playing.”

Merryn: So they made their disapproval a reason not to play the game?

Hugh: Yeah, they say it won’t work, so they don’t participate. “Equities are overvalued and I’m going to tough it out. I’m just not going to be in that market.” As I say there was a time in my life when the sun only rose to humiliate me, where perhaps I shared that. Its bunkum. It’s nonsense.

It may not work, but presently the perception is that it will work and those asset prices are trending and you should participate. Then within Europe, such is the political timeframe and the stakes are so enormous, that is has to work now and we have the French elections, national elections are in 2017. Europe has been slow to this game of quantitative easing. As a result they are clearly behind the curve.

So economies from France to Italy and others have been unsuccessful in bringing these deficits below 3%, which of course, then imposes further austerity measures which are toxic in the political/social space, and we’re seeing radicalization of policy.

It may be contentious to say, but if the French election was held today, I would worry that Marine Le Pen’s party would win. That’s not to say, necessarily, to cast aspersions on that side it’s just to say that I think the thrust of her policy would be to take France out of the Euro.

 

MY point is that we’ve had this year, this further year of deleveraging the European banking system, deleveraging the commercial space and of these very slow-moving prices.

Wages are still not moving. Prices are still not moving. If anything they’re moving the wrong way. Europe needs high equity prices and high animal spirits and 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 – that it can’t not.

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. Europe is the most contentious because politics enters the arena and will the Germans allow it? I have two points there. First of all, Angela Merkel back in the day had the chance to appoint Axel Weber as Chair of the ECB, so, a good German. The German orthodoxy would prevail.

There’s one thing that characterizes Merkel, she is a pragmatist, and she doesn’t have that same ideology that we see from other parts of the German church. She passed him over in favor of Draghi. I think that’s huge. I think she recognised that if Weber had been in charge the Euro would not have survived.

Merryn: She would have taken away the options.

Hugh: Yeah. So she’s already, if you will, on the political side, I think, shown a willingness to endorse this . What the ECB’s gone on to do is remarkable in terms of what we thought it would be capable of doing. But of course, we keep hearing Schaeuble, the German Finance Minister, ranting that QE is either injustice or it  doesn’t work. Again, maybe he’s right. Maybe he’s not, but I think we have to try anyway.

Now the point is Merkel is more popular than her party. I think she’s more popular because she has that pragmatic European view rather than the ideology that we hear, and of course, is disseminated through the financial press.

Merryn: Go back a bit to the moral imperative. The people who very angry about QE – who disapprove of it. They would say the moral imperative is not to do QE, but you suggested that for you the moral imperative in Europe is to do proper QE.

Hugh: Well, desperate times breed desperate measures and the fatal policy errors are I believe, all in the past. Economies across the world were allowed to take on so much debt, and taking on debt, you’re borrowing from the future. You’re borrowing consumption to spend it today. So we overinflated the GDP growth rate. There’s no surprise to me when people are disappointed by today’s growth rate. Because it’s like “I ate your sandwich yesterday.” It’s not there. So I don’t see this as a clean solution.

I see this is a grubby solution, but it’s closer to being a solution than anything else that I conceive of. With QE, again, I say I think we barely scratched the surface in terms of what will happen. 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. I think that is in the future, because we have not resolved that deficiency of demand. Which, of course, is a function of having over-borrowed from the future to spend yesterday.

Merryn: Okay. So more complicated, if it can get more complicated, how does it end? We can talk about the money breaking down forever. We can talk about the different ways it can be used by central banks to try and stimulate demand, etc. But one day it has to come to an end.

Hugh: Indeed.

Merryn: What makes that happen?

Hugh: So I may segue into that answer by challenging the notion, the popular notion, that quantitative easing has distorted and manipulated public markets. Again, I think I use the term earlier, bunkum. Absolute nonsense. Absolute nonsense.

JGB’s, if we take an example, are fairly valued. The economy just failed 7% in the last quarter on an annualised basis. There is no inflation. They’ve had 25 years of no real GDP growth. Where would you expect JGB’s bond use to be for a fiat currency that can issues its own paper currency. U.S. Treasury Bonds, where should they be?

I think Dylan Grice was the great architect of the notion that you can define the upper bound to today’s interest rates by trying to determine society’s capability to meet those interest rates at higher and higher levels. What you find is we cannot live with a Paul Volcker putting interest rates at 15%. It doesn’t work. There’s so much debt that if you reprice debt, the economy slows down. We saw that I think in 2012, after the taper tantrum and ten-year bond use went over 3%. What happened next? The economy slowed down. If anything I would be a buyer of U.S. Treasuries and I’ll come back to that.

Merryn: What about U.S. equities?

Hugh: U.S. equities, some of the best companies in the world who have exceeded all expectations, both in regard to growth and returns on capital and we just had another quarter of earnings and we continue to do. Valuations again, fugazi, pugazi. When it comes to valuation one man’s high valuation is another lady’s low valuation, or what have you.

Merryn: You’ve just lost interest in valuations, haven’t you?

Hugh: It’s a bit like the Supreme Justice . . .  what’s he called, Potter? In 1964, there was a successful prosecution of a cinema owner in Ohio for showing a French movie. It’s always a French movie. He was charged for the notion that there was pornography. He was charged under the Obscenity Act. It was overturned. Justice Potter went on to explain that the Constitution allowed for obscenity, except for hardcore pornography. He didn’t feel capable of defining hardcore pornography, but he felt sure that he’d be able to recognise should he see it. And that’s my take on valuation. I’m pretty sure I’ll recognise it when I see it, but today, I don’t see it.

Merryn: Okay. Tell me about US Treasuries. You said you’d be a buyer of U.S. Treasuries today. That’s a pretty contrarian view.

Hugh: Well, we are long on 30-year Treasury bond use and this year we have, I think, been among a select group of macro-investors who have actually made money being long U.S. Treasuries. It’s been a very popular trade being short. It’s particularly relevant since the Jackson Hole Central Bank soiree in late August. That there seems to have to come out of it, some tolerance that the dollar would rise.

Typically that’s the fiefdom of the Treasury and not the Central Bank. But I’ll let that pass. The dollar has been on a tear ever since that meeting. My take on that is that I think America looks at it and increasingly feels confident, rightly or wrongly. I’d err on the side of caution. But when it looks to the global theatre, it’s desperately concerned about China, desperately concerned about the Europe. So the last five years were, if you will, it redistributed global growth and by “redistribution” bear in mind, I’m saying that quantitative easing as pursued by the Federal Reserve had the explicit policy aim of ensuring that the dollar would not rise.

The dollar always rises when there’s a deflationary crisis in the marketplace. The dollar index was trading at 80 pre- the events of late 2008. It briefly flared and then you had . . .  Immediately you had quantitative easing and it sat at 80 for five years. That’s about America being determined that dollars earned in America create jobs and prosperity in America.

Whereas in the last 10-15 years the mercantilist axis of Europe, and of course, China has meant that those dollars were exported via the trade deficit to elsewhere. That just couldn’t be allowed to happen. That hasn’t happened, which is to say that again, boosted by shale oil, of course, the trade deficit has been falling.

Merryn: So the growth has remained in America?

Hugh: It has remained in America. But I think America now is willing to be less curmudgeonly, more generous with that.

Merryn: They’re willing to share that growth.

Hugh: That smaller pot, it may not be a great expanding pot, but it’s kind of buggin’s turn. It’s time for the other guys to get some.

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  • Emailonly

    So obviously the central banks are desperate (and very able to) to keep interests rates down in the current environment. Under what hypothetical circumstances would they possibly lose control? In otherwords what could possibly lead to 15% interest rates that we saw 20 years ago? A discussion of this would be good MW!
    (ps. good piece – don’t know too much about this chap, but he certainly has the gift of the gab!)

  • Rear Admiral Sir Vincent Smyth-Obleson

    If only Benjamin Strong had not passed away in 1928. He was an arch exponent of QE and would have used this “grubby solution” after the Wall St Crash of 1929.
    The World could have avoided 6 years of depression, 40 million unemployed, the desperate embracing of Nazism, Japanese expansion, 50 million dead within 15 years.
    Sometimes grubby solutions are a necessary evil, though I’m sure the hedgies disgree.

  • Pinkers Post

    A brilliant and most revealing interview, making all the relevant points. Proof in the pudding: The markets have long been completely detached from any fundamentals or, indeed, the rising threat of geopolitical risk. Herd instinct, or now more fashionably called ‘pro-cyclical behaviour, has prevailed since the collapse of Lehmans in 2008. But then, what’s all the fuss about?  After all, the world’s central bankers have once again united, reassuring investors they will keep the party going… whatever it takes! Interest rates are to be kept low, indicating a subtle switch from heroin to methadone. However, when the music does eventually stop, the Betty Ford Center will be a crowded place! Early booking strongly advised! Rehab?: https://pinkerspost.com/?p=518

  • Ivan Jankovic

    Don’t think he gets a hard enough time over his former position, particularly as he was incredibly patronising and scornful to those who were willing to be bullish at what turned out to be the right time. And why on earth would anyone who is bullish choose him to manage their money over a long only fund? Ah. Is that why we get the china part in which he gets to put forward a “contentious” view? Maybe I’m a bit thick, but what he says about china just doesn’t make any sense to me. He’s very good at sounding smart, but what’s he actually saying?