Hugh Hendry’s Eclectica Fund commentary for the month of July 2016.
“This is not how I woke up
But it’s how I look now
If you leave with me
We’ll be on till morn
Then we rinse and repeat
And it just goes on”
Rinse and Repeat
I did not see Brexit coming, but my team and I were prepared for it nonetheless and the Fund has responded favourably with a bounce in the final days of June.
Surprisingly, the five stages of my own mental anguish (denial, anger, bargaining, depression and acceptance) passed rather quickly; it only required a weekend of reflection to allow us to take stock and enter July with a positive disposition towards our risk book, invigorated by the expanded opportunity set to make money.
Put simply, prior to Brexit, we believed that the Fund had a high probability of making a modest return. But now with the UK set to follow a divergent and unexpected economic policy, certain scenarios ranging from the questionable viability of the euro to the prospect of a major economy rejecting fiscal balance to pursue an expansionary fiscal policy and the likelihood that other nations will copycat this policy in the future no longer appear so extreme. It feels like we have returned to the dysfunctional logicality that reigned prior to the crash of 2008: if you think the future is inflation, prepare to profit now from the deflationary-like catalysts. For the latter scenarios appear the most likely within our investment time horizon.
Our current enthusiasm for our book therefore is predicated on the notion that our investable universe has just expanded greatly as certain events have moved from the uninvestable shadows of tail-like probability into the realms of investable profit opportunities. This has enabled us to expand our risk taking meaning that the Fund, in our view, now also has a reasonable probability of making rather a lot of money.
First, however, let me explain a curious historical precedent which, if I adopt my mantra from an earlier report, allowed us to stop worrying about the present and learn to love the Brexit bomb. For it may be that having spectacularly failed to anticipate the outcome on the 23rd of June the markets may be just as wrong with their revised forecasts of what this means for Britain and Europe.
Hugh Hendry – The Invergordon Rebellion
Founded in the 16th century, the Royal Navy doesn’t do mutiny. However the events which took place on the west coast of Scotland in mid-September 1931 came perilously close. Returning from manoeuvres at sea, the sailors were horrified to read in the newspapers that their wages were being cut yet again, this time by as much as 25%. Enraged, they refused orders to take the fleet back to sea. The stand-off lasted 48 hours but this was long enough to turn the tide of confidence against sterling. For when the news filtered back to London it destroyed the market’s prevailing belief that the politicians of the day could credibly pursue further austerity measures and so, after six long and miserable years, Britain came to reject a fixed exchange rate regime, the Gold Standard, and the pound fell 25%. Plus ca change..?
The new policy regime, haphazardly shaped from the emotions of anger and resentment, flew in the face of accepted economic wisdom. It was immediately deemed by the commentariat to be a tragic mistake. The economy would crash and London’s financial centre was doomed. Again, sound familiar..?
Of course we know that things got better. For shorn of the cult of austerity, and riding on the crest of a huge stimulus delivered by the currency devaluation, the British economy recovered quickly. To quote a common refrain from the time, nobody told us we could do that, and yet within two years most other countries had adopted the same policy.
We have discussed this period of history previously. It persuaded us not to wager on a euro break up too early back in 2011 when markets questioned the resolve of Greece to remain. The UK generations earlier, and Italy since the passing of the lira, have grimly and with some resolve trudged through the economic sludge of a decade or more with no growth in nominal GDP. This seems to demonstrate that people can be stoic and hardy as long as they feel hope that their standard of living might improve. And so five years ago, and with a likely economic recovery imminent, it felt too early to radically challenge the perception of prosperity; the system was safe.
Today however, following Britain’s announced departure, the equation has changed. Previously with 28 members and no history of exit the system’s gravitational pull was immense. But it was vulnerable to just one defector weakening the system. This is where we are now. We believe that the UK has the upper hand. Political commentators may be in revolt, but the combination of higher gilt prices and the sharp drop in sterling mean that the British need not fear the passage of time.
Recall that there were 45 member countries committed to the gold standard prior to the UK’s departure in 1931 but just 12 by 1933. How many of the remaining 27 European member countries will there be in 2018?
The modern EU has always seemed quixotic. On the one hand we have the wistful and laudable romanticism of the principle of the free movement of people between member states. On the other, an avowed German inspired obedience to the tenants of “hard” money much beloved by the architects of the gold standard. It was always questionable just how long this curious mix would last.
Ultimately, the failure to quickly recapitalise the region’s banks in the aftermath of the 2008 financial crisis and this year’s passing of the Bank Recovery and Resolution Directive insisting on creditor bail-ins to resolve further banking recaps, have succeeded in systematically breaking the credit system in a manner which is beyond the power of generous monetary policy provisions from the ECB to resolve. Combined with the perception of an unlimited supply of semiskilled labour from Eastern Europe the system suddenly swung violently in a direction which in my mind resonates with the hopeless and forlorn plight of the UK’s return to the gold standard in April 1925. Both were destined to fail. However, today feels more like 1931: a beginning, not the end.
The UK will, in our opinion, endure a recession. By rejecting an infinitively expandable and flexible labour force, the majority of the UK’s voting population has rejected the previous source of GDP growth. Income expansion can no longer come from expanding the number of people in work. Prospective economic growth now only has one realistic source: productivity gains. The boost to competitiveness from the sliding pound will help but ultimately productivity and GDP growth will require higher public and private investment. The later seems unlikely for now and hence the likelihood of a recession but in time a pivot to fiscal expansion will likely moderate and perhaps transform the outcome.
Uncertainty in the short term is therefore understandable yet it seems that markets are likely to make peace with this more nuanced reality far sooner than the political pundits. Just as the wisdom of the crowds led the way and more