Hugh Hendry’s Eclectica hedge fund latest letter to investors for December – some interesting commentary and while more bullish on America he is worried about China and Europe. See more below where he compares Europe to a patient dying of cancer.
As you know, back in late 2014 we were more constructive on risk taking opportunities as Europe prepared to launch QE, finally resetting monetary policy on a necessary looser course. And by early 2015 European stock indices had rallied 30% from their October low, despite the pervasive market view that QE had passed its sell by date. But the momentum passed and the continent’s equities have performed woefully ever since, giving back their entire advance. We use the discipline of time to regulate our risk taking behaviour; our thinking was re-appraised over the summer and we were out of the position completely by October
Here is what I think happened…
My team and I have grown tired of the demonisation of QE. We believe that the timely adoption of this policy in the US back in early 2009 was successful in that it staved off the very real prospect that the US economy would endure the hardship and misery of an economic depression comparable to that of the 1930s. Nevertheless the shock therapy of this radical new policy intervention had nasty side effects. Think of it as the financial equivalent of chemotherapy where the side effects of treatment can initially make the patient feel worse before allowing them to live longer. It’s just that Europe, by steadfastly refusing treatment for so long, may have irreparably weakened itself to such an extent that the side effects might end up killing the patient, in this case the EU project.
Let me explain. Our interpretation of the miserable performance of risk-adjusted equities versus sovereign
bonds over the last forty years can be construed as the hijacking of the market economy by creditors. The advent of hawkish inflation targeting by central bankers was a response to the exceptional inflation of the 1970s which had bestowed an embedded inflation risk premium into the term structure of interest rates. However, the disinflationary forces of globalisation and the internet a decade later arguably meant that interest rates were set too high for the period and creditors were overcompensated. This mispricing of credit effectively established an enduring rent transfer from the debtor constituencies of the household and corporate sectors to the rentiers, which is most clearly manifest in the outperformance of government bonds over the period (see our May 2015 Commentary for further explanation).
Following the crisis of 2008 the central bankers had no choice but to abolish this rent transfer, a challenge given the scope of their traditional role controlling short term rates. The advent of QE was an attempt to push the impact of monetary policy further along the curve, explicitly targeting lower 10-year rates. Many investors were and are sceptical as I believe they are largely ignorant of the policy objective: to eliminate the debilitating inflation premium embedded in real yields which was making it impossible for households and corporates to maintain spending and repay debts in the period from 2005 onwards. By driving 10-year rates close to zero the central planners hoped to re-price risk and thereby enable the debtors to keep spending whilst repaying more of their liabilities. The table below, comparing the real interest cost incurred by debtors in the economy with real GDP growth, demonstrates that this policy has succeeded: since 2010 real GDP growth in the US has exceeded the real interest cost, meaning that debtors have been able to earn enough from their economic activity over and above the cost of debt to reduce their liabilities. I wish a QE-sponsoring central banker would use this narrative to explain their policy intentions…
Regardless, the pinnacle of this policy was probably reached earlier this year when almost $11trn of sovereign 10-year money was priced at zero or negative nominal yields and the Bank of England’s benchmark ten year interest rate fell to its lowest level in 322 years. This much you know. What is less commonly understood is that this summer, in the aftermath of the surprise Brexit vote, nominal US Treasury yields converged with the rest of the world.
Real 10-year treasuries reached zero but this was nothing new as they had been deeply negative back in 2013 prior to the taper tantrum. The unreported and new factor was that nominal Treasury yields converged to the lower Japanese and European levels on a currency-hedged basis. That is to say international investors, who typically hedge their foreign exchange exposure, found they could no longer achieve a yield uplift relative to their domestic bond market by buying Treasuries as the widening of cross currency basis and dollar libor rates made hedging more expensive. This was probably the point when the great multi-decade bull market in bond prices reached its climax, when the economic ascendancy of the creditor class reached its high water mark and when the shackles on global macro performance were finally released.
For those fortunate to borrow at such low real rates the levy has reversed. Large businesses with solid ideas can now borrow money at the wrong price; creditors have no choice but to transfer their wealth to the economy’s entrepreneurial and household sectors. I think this is likely to persist. The benefits of this pivot have already taken root in the US where, with the wealth transfer now running in reverse as per the table above, economic growth has been superior to the rest of the world.
which continues to defy the Brexit Armageddon naysayers. So I am beginning to think the world is healing and in 10 years’ time we will look back and see that stocks have outperformed government bonds on a volatility-adjusted basis, similar to what we saw with gold versus the S&P at the turn of the century.
“I’m mad as hell, and I’m not going to take this anymore!”
The Network (1976)
However I fear this may not prove the case in Europe in 2017 owing to the afore-mentioned harmful side-effects on the political economy. In reality few debtors have been able to access this wealth transfer in the shape of cheap credit, whilst other assets re-priced higher to reflect zero yields. So the rich got much richer and ordinary folk became really annoyed, setting in motion the (thankfully) bloodless revolution of Brexit and Trump.
Trump succeeded by seizing on this discontent. He has now set out an agenda of fiscal expansion, exploiting the low rates. In other words, America has just elected a debtor president who will direct the government to borrow on behalf of his household and corporate constituencies at the rates previously only made available to the privileged few and the Fed will be pushed into a slow and predictable series of rate hikes that keeps real rates very low for years to come. Spending on infra-structure and financing substantial