Hugh Hendry’s The Eclectica Fund commentary for the period ended May 31, 2015. Big comeback and lots to digest here (also those china futures probably not looking too good right now) so stay tuned for more coverage.
Hugh Hendry’s The Eclectica Fund – Discretionary Global Macro
The investment objective of the Fund is to achieve capital appreciation, whilst limiting risk of loss, by investing globally long and short mainly in quoted securities,
government bonds and currencies, but also in commodities and other derivative instruments.
Hugh Hendry’s The Eclectica Fund: Performance Attribution Summary
- The Fund recorded a loss of -0.8% for May.
- Equities, which presently comprise the largest component of portfolio risk, gave back -1.1% as stock markets fell across Europe and China.
- Gains from holdings in Italian banks added to profits from broader index exposure in the region, but were outweighed by losses on Chinese index futures, property stocks and shorts on iron ore producers and oil services companies.
- Fixed income positions were flat in aggregate over the period as positive returns from Mexican interest rate receivers and Eurodollar call spreads were neutralised by losses on European inflation swaps and a short on Italian BTPs.
- Our relatively modest FX book generated a gain of +0.2%, with CNH call options the main contributor.
Hugh Hendry: Ten Year Bond Bull Has Second Thoughts
The key question for the Fund right now is whether we are at a structural turning point in terms of global interest rates. I attempted last month to set out the case for why this might be the case. The argument rests on the notion that Europe, Japan and China have all now adopted the same monetary policy as the US. No longer is it a case of competitive devaluation where one block of countries eases policy and effectively pushes structural disinflation onto the others. Now everyone is fighting the same global disinflationary force together.
The following argument is by its nature mainly qualitative, and can present no hard conclusions as to whether “we are there yet”. Nevertheless I hope it illuminates the progression in our thought process since last summer’s Jackson Hole meeting, and the recent decision to remove our long dollar and long Treasury positions. Our triple play strategy proved successful from last August to the end of March. But now, after so many years, we favor non-US equities as the Fund’s largest risk allocation.
Our present risk alignment rests on a particularly remarkable aspect of the last thirty years that seems largely neglected by the investment community and may suggest that stocks are more attractive than you think. As I see it, there are two mysteries that no one really discusses. Why, on a risk adjusted basis, have equities proven such an abysmal bet versus simply holding a lot of Treasuries, especially when one considers the great innovation and prosperity of the period? And why were borrowers unable to pay back enough debt from their commercial endeavours to prevent global debt to GDP ratios from soaring?
I can only conclude that interest rates were set too high for the period. Initially, the enduring shadow cast by the inflation from the 1970s motivated cautious investors and policy makers to persistently overstate future inflation. But this structural mis-pricing of inflation didn’t just stay around for the 1980s. The opening up of global labor markets after the end of the Cold War allied with the radical leaps in productivity made possible through information technology added huge deflationary pressures to the global economy which were consistently underestimated in forward looking models. The rise of China over the last decade only added to the confusion; rising commodity prices stoked fears of broad-based inflation but in reality only served to deflect central bankers’ attention away from the real story of disinflation, at least until the supply response finally caught up with demand in the oil market in 2014.
This three decade long overestimation of inflation meant that interest rates were set too high for the real economy. Excessive real rates meant that productivity gains could not
be adequately captured by those who made them in the first place; businesses struggled to pay down their debts whilst the bondholders got richer and richer. In effect, the global financial system managed to inadvertently transfer an inordinately generous amount of the real economy’s entrepreneurial gain from its debtors (the risk takers) to its creditors (the bankers).
It might seem counterintuitive that debtors should continue to take on debt when its price is too high. However, with such attractive returns available from lending it could be argued (like a hackneyed version of Say’s Law) that supply created its own demand, and a bubble emerged from the world’s banking system seeking to capture the excess returns on offer by issuing ever more loans rather than businesses aggressively pursuing them. The illusion of ever lower nominal rates no doubt helped persuade the debtors that taking this debt on was a good idea; in real terms they were getting a terrible deal. And as we know, creditors’ desire to lend ever increasing quantities of money was taken to its limits in the US mortgage market in the 2000s. Risk analysis went out of the window, good and bad loans became indistinguishable and this precarious financial engineering, which became so instrumental in driving global GDP growth, led to and ended abruptly with the financial crisis in 2008.
Of course this is ex-post rationalisation but I believe it allows for a more balanced discussion regarding recent central bank intervention. As you know, I have changed camp from those grumpy investors that constantly pour scorn on our monetary policy makers and implore that you own gold. From my interpretation of recent history it is quite reasonable to commend the Fed’s policies since the crash, especially the policy of abolishing the high carry on fixed income.
Logically, it seems, they have sought to redress this enormous transfer of funds from those that have an excess of money to those that have an excess of ideas (but which actually led to a flow of wealth in the opposite direction). In doing so they have truly distanced themselves from their policy errors in the late 1920s when interest rates were raised to clamp down on wage growth and protect corporate profit margins. Today, with prospective returns on sovereign western debt seemingly eviscerated and equity values having risen significantly relative to the levels of global indebtedness, the global economy is heading towards a more stable equilibrium between the risk takers and the bankers.
However, whilst the system has stabilized somewhat we are still laboring under the shadow of the secular stagnation thesis. Globalization has produced soaring income inequality across continents as the wealthy have become ultra-wealthy rapidly, and with their lower marginal propensity to spend, a yawning expenditure deficit has emerged as the gains from international trade have been captured by fewer of the economy’s participants. And, in the absence of the credit bubble which kept things stumbling on in the last decade, we have been unable to rebalance the system and reignite economic growth. Perhaps this is why we are seeing the emergence of what might be described as the “Henry Ford” option at both the sovereign and corporate level.
See full PDF below.