At one time a critic of central bank market manipulation, Hugh Hendry now thinks it is a “grubby” solution as he discusses a major behind the scenes hedge fund topic, the world debt crisis, and says China should have boomed more than it did.
Hugh Hendry: Quantitative easing the only solution left for world governments
Apparently heading the old trader advice “don’t fight the Fed,” hedge fund manager Hugh Hendry now acknowledges quantitative easing might be the only solution left for world governments left significantly in debt that have borrowed growth from the future.
“I see (QE) is a grubby solution, but it’s closer to being a solution than anything else that I conceive of,” he said in a recent Money Week interview. The problem, he says, is that economies across the world were allowed to take on too much debt and in doing so they were borrowing from the future, essentially stealing future consumption to spend it today. “I ate your sandwich yesterday,” is how he describes the difficulty in generating true economic demand. “It’s not there.”
Hendry predicts that QE could continue indefinitely because there are few choices, saying “we barely scratched the surface in terms of what will happen.” In the future QE will spread to support “higher government budget deficits to sponsor public work projects or favourably to sponsor tax cuts.” He thinks this is 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.”
Hugh Hendry takes a look at deficits in Europe
Looking at Europe from the standpoint of an economic laboratory, Hendry considers struggling economies from France to Italy that have been unsuccessful in bringing their ballooning deficits below 3 percent, thus imposing further austerity measures which are toxic in the political/social space. This in turn is driving a “radicalization of policy.”
And it is here where Hendry starts to approach the time bomb: rising interest rates.
We can’t live in a world with high interest rates and government debt. In 2012, after the “taper tantrum and ten-year bond use went over 3%,” the economy slowed. This is part of Hendry’s explanation of why he was long the 30-year U.S. Treasury bond over the summer. The government can’t allow interest rates to go much higher.
Quantitative easing, Hendry points out, is as much about keeping a lid on the value of the U.S. dollar as it is about stimulating the economy, although the two work hand in hand. And this leads to Hendry addressing China.
Yes, China boomed. “But it should have boomed even more,” Hendry said. “The reason it didn’t was that they, as I said, they rob Peter to pay Paul. “Their workers were achieving, they got paid more. But they should have got paid way more and their currency appreciated, but it should have appreciated way more.” People put their money back into the system, but in a negative interest rate environment “they got screwed, if you will, on three fronts.”
Part Two of the Money Week interview can be found here.
Part Three of the Money Week interview can be found here.
Also below is a recent letter which Hendry sent to investors.
Despite running a net long equity book that has exceeded 1x NAV for the past few weeks, we succeeded in weathering a particularly volatile October with rather dramatic intra month price declines in the major equity indices to post a gain of 0.6%. Contrary to what you may have heard, our spirits are high and our risk taking is increasingly paying off.
My premise hasn’t really changed since I published my paper explaining why I had become more constructive towards risk assets this time last year. That is to say, the structural deficiency of global demand continues to radicalise the central banking community. I believe they are terrified: the system is so leveraged and vulnerable to potentially systemic price reversals that the monetary authorities find themselves beholden to long only investors and obliged to support asset prices.
However, I clearly confused everyone with my choice of language. What I should have said is that investors are perhaps misconstruing rising equity prices as a traditional bull market spurred on by revenue and earnings growth, and becoming fearful of a reversal, when instead the persistent upwards drift in stock markets is more a reflection of the steady erosion of the soundness of the global monetary system and therefore the rise in stock prices is something that is likely to prevail for some time. There is more to it of course, as I will attempt to explain, but not much.
This should be a great time to be a macro manager. It is almost without precedent: the world’s monetary authorities are targeting higher risk asset prices as a policy response to re- stoke economic demand. Whether you agree with such a policy is irrelevant. You need to own stocks. And yet, remarkably, the most contentious thing you can say in the macro world today is
In a world dominated by the existentialist angst of identifying and trading qualitative value, there is profound mistrust of equity values today; macro investors see prices as overvalued and few are willing to capitalise on the opportunities to make money. This angst and fear of big drawdowns in risky assets in part reflects astonishment that policy makers were able to rescue investors from the folly of their misallocations in the years preceding 2008 and that stocks have massively outperformed the modest rise in global nominal GDP. I should know. I, like others, became a moraliser who just couldn’t forgive the Fed for bailing out Wall Street. I read one “death of money” polemic after another and luxuriated in the work of people like Marc Faber, James Grant, Nassim Taleb, Raoul Pal and Albert Edwards. I became a moral curmudgeon rather than a money maker.
As you know, I have sought to overcome this deficiency. However my risk controls, or rather my procedures for dealing with big monthly losses, seemed to anchor me to the bearish camp (against my better wishes). No-one wants to lose more than 5% in any one month (for the record, we have recorded only one such month over the Fund’s previous 58). But typically this has entailed selling when there has been a spike in volatility; since the end of last year I have been a bull that had to sell for lower prices. No wonder I couldn’t make you money. But perhaps you don’t need such reactive stop loss policies when the world’s central banking community is intent on protecting you; which is to say, I needed to apply greater risk tolerance and intervene less often.
You are not convinced? Japan was down 16% from its highs earlier this year. I was particularly long Japanese equities at the start of the year and so at some point, fearing greater losses, I swallowed my pride and booked a loss. However, the ongoing policy intentions of the BoJ meant that the stock market clawed back all of its losses. Why did I sell?
European stocks fell almost the same over the summer but again the ECB upped its ante, pushed short term rates negative, tolerated a weaker currency and promised to re-stock its balance sheet with more local risk asset purchases. Lo and behold, European stock prices recovered sharply in August and early September. So why did I reduce my holdings?
October is simply another example. US stocks fell over 10%. I don’t really know why. Was it the threat of the end of QE or a global pandemic or more misgivings as to the state of affairs in Greece and Europe’s enduringly weak economy? It doesn’t really matter. Such is the perceived risk in the financial system that enough investors now anticipate a policy response whenever the S&P falls more than 10%. This ensured that shorts were covered and volatility sold in mid-October. The fixed income market’s expectations for hawkish future Fed rate hikes evaporated with stock price weakness and other risk markets soon rallied; the S&P is now back to its all-time high.
Pity the macro manager then who had to stop loss mid-month; that used to be me. But I widened my tolerance for loss. We have no desire to lose money but unless something tangible happens to challenge our narrative we are less willing to automatically reduce our risk taking in response to modest, if rapid, short term market gyrations. Making money requires making the right calls of course but just as importantly it necessitates that we provide trades with enough breathing space to develop and hopefully prosper.
So why all this enthusiasm for upside equity risk?
To my mind the current period is analogous to the Plaza Accord of 1985 when central bankers agreed to intervene in the currency market to drive the value of the dollar lower. The fast moving world of FX was deemed a more expeditious way of correcting for the huge US current account deficit than the laborious and slow process of waiting for the totality of countless micro wage and productivity deals to rectify the yawning trade gap. No one really knew for sure how high the yen or Deutsche Mark should trade back then but this didn’t
stop macro managers from being very long such positions.
The FX market tends to take the US Supreme Court view. Overruling an obscenity charge for showing a salacious French movie in Ohio in 1964, Justice Potter Stewart wrote that the Constitution protected all obscenity except hard core pornography. Unwilling to define the latter, the judge maintained that he would know it when he saw it. And likewise currency values; you just know the wrong ones when you see them. This is to say that the market becomes more treacherous once the imbalances of the primary economic transactions (the US current account) show signs of improving from the remedy of the price changes engineered via the relative currency movements.
Which is a rather long preamble to describe what I believe is a very analogous central banking intervention in today’s financial markets. It would take just too long for the Fed, ECB or the BoJ to rely on a return of animal spirits in the real economy to lift their flagging economies. They need the remedy of fast moving risk asset prices. By using QE to promote more risk taking, asset values in the US have risen faster than fundamentals and, with better perceived collateral and more confidence, the demand for risk taking in the real economy has recovered somewhat. At a lag, the theory runs, so will the rate of expected inflation.
So I think we find ourselves especially in Europe (and Japan) with a situation whereby the central bank has to use all of its powers to engineer higher stock and bond prices. And I think the precarious nature of France and the election timetable in 2017 means that they need higher European stock and bond prices NOW or there will be no economic recovery, budget deficits will continue to overshoot 3% and the Euro area will get trapped in the poisonous and perpetual cycle of having to demand more and more unpopular austerity measures. This is high stakes: boost European stock prices or risk losing France and the euro. To my mind the message is simple: don’t short French bonds, buy European stocks and short the euro.
It will only become a bubble when slow moving price inflation and real wages start moving; we’re obviously nowhere close to that just now in Europe (or in Japan) and hence my large net long.
September’s gains were retraced. In Europe losses were incurred on holdings in banks (1.0%) and pharmaceuticals (0.9%) as the MSCI Europe finished a volatile month down 1.9%, having fallen as much as 10% at one point. Performance, however, was enhanced by not capitulating at the price lows; indeed the Fund’s DAX index futures made 0.1% following a well-timed intra-month addition. There was also a gain of 0.5% from holdings in tobacco stocks.
Elsewhere, our holding in the US 30-year Treasury made 1.3%.
Performance Attribution Summary
The Long Japan theme was the most significant contributor to positive performance during October, with a gain of 2.3% coming from Nikkei index futures and Japanese robotic names as the BoJ launched further QE and the government pension investment fund simultaneously announced a proposed increase in its equity allocation that exceeded expectations.
Outside Japan, Long DM strategies cost 2.8% in aggregate. Our long position in the US dollar gave back 1.5% as September’s gains were retraced. In Europe losses were incurred on holdings in banks (1.0%) and pharmaceuticals (0.9%) as the MSCI Europe finished a volatile month down 1.9%, having fallen as much as 10% at one point. Performance, however, was enhanced by not capitulating at the price lows; indeed the Fund’s DAX index futures made 0.1% following a well-timed intra-month addition. There was also a gain of 0.5% from holdings in tobacco stocks.
Elsewhere, our holding in the US 30-year Treasury made 1.3%.