Home Business Hugh Hendry Q3 Letter: Dramatic Fulcrum Point; Only Precedent Is 1930s

Hugh Hendry Q3 Letter: Dramatic Fulcrum Point; Only Precedent Is 1930s

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Hugh Hendry Eclectica Asset Management Q3 Letter

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We believe we are approaching a dramatic fulcrum point in public opinion in Europe which could deliver another bout of outsized positive returns from a unique Eclectica trade.

Since the Brexit referendum we have been developing our thoughts about what the Leave vote might mean, not just for the UK, but for the European project as a whole. An our main conclusion is that by doing the unthinkable and actually voting to leave, Brexit substantially increases the likelihood that other members of the European Union will also seek to break away. Remember, just two years after the UK similarly rejected the gold standard back in 1931 there were just 12 remaining members versus the 45 that had previously been committed. And the so far robust performance of the UK economy since the vote will do little to dissuade others from following suit.

So we have the precedent from a much earlier time (the 1930s) when the defection of just one member from a currency union caused the system to unwind rapidly. And we can clearly sense the seeds of another popular political revolt in other member countries; a flurry of upcoming elections and referendums provides an immediate catalyst.

First of all we have the still too close to call US presidential election where a Trump victory would be hailed as a triumph for the same arguments that led to Brexit. Closer to home there is the Italian referendum on constitutional reform set for the first week in December, where it looks increasingly likely the government will be defeated. Such a defeat would likely force Prime Minister Renzi to step down, potentially allowing populist parties to step into the resulting political vacuum and push a more nationalist agenda.

2017 is a big year for elections on the continent. In France both major parties have yet to decide on who will represent them in next year’s elections. But regardless of who the parties choose to run, both are likely to be pulled towards the distinctly anti-European nationalist agenda of Marine Le Pen who seems almost assured of reaching the second round run-off in the Presidential election next May.

And that will be followed in the autumn by federal elections in Germany, where recent regional polls saw a disastrous outcome for the once unassailable Chancellor Merkel. Moreover, the anti-immigration mood seems to be fuelling the rise of the right wing Alternative for Germany party, which is seeking amongst other things a referendum on going back to the fabled Deutschmark.

And that’s before we mention that Spain has yet to form a government despite two national elections; a third is deemed highly plausible for December. And that the passing of the Bank Recovery and Resolution Directive, making it illegal for any European bank to be rescued before 8% of their total liabilities have been bailed-in, ignores all of the lessons from the failure of Lehman Brothers and has effectively blocked urgent capital repair for systemically important institutions in Europe that find themselves dangerously undercapitalised.

The system simply isn’t working…we could go on and on but you know most of this already. I apologise; sometimes macro managers can be a little too self-absorbed by the intricacies of the chess like competition we find ourselves engaged in with other risk takers and policy makers. So instead let’s ask the “where are the customers’ yachts” question, which is to say that, knowing all of this detail, why would you put your money in a macro hedge fund like ours today?

In our view the answer is obvious: you seek low cost and high conviction convex trades that pay off should very bad events occur. With central banking actions having boosted all risk asset prices to (some would say) dangerously high levels, you might need something in your portfolio executed by an experienced macro fund with a track record in putting together bearish trades which are constructed in a fashion which provides asymmetric convexity rather than delta one noise, and which doesn’t cost the earth in negative carry or option premium decay.

The challenge of course is to find such convex trades thatnot only carry well but also work under scenarios which are identifiable and plausible, and this takes me back to the central context of this letter and all of these troublesome political developments in Europe.

What if we were to tell you we have an asymmetric crossasset trade that we believe underwrites what we perceive to be the most plausible downside European risk scenarios and has the potential to return multiples of the worst case loss scenarios? A trade that could capture the real and present danger of more members following the British decision to seek an exit from the political union as mass fears concerning immigration, unemployment and inequality seem set to define national elections in Europe and elsewhere.

But Europe isn’t just under threat from political upheaval. To best understand the mess the continent is in today consider that in September and the first weeks of October we have seen European banks outperform the stock market as the continent’s yield curve has modestly steepened. The absurdity of this demonstrates the problem of devising an appropriate monetary policy for the bloc. Put simply, keeping rates low enough to fix the economy under the current framework seems to consign the banks to the dust heap of meagre earnings in perpetuity. But any steepening of the curve sufficient to raise bank profitability would tighten policy in the real economy, kill off any nascent recovery and condemn the continent to further penury and the resulting surge in populism that a lack of economic hope engenders.

However we view the present monetary policy as being undoubtedly the worst of both worlds – we have populist rebellions and bad banks. And with the end of the current term of QE looming it could be set to get even worse. The monetary hawks seem to be growing more confident within the ECB. How else can we explain the absurd notion of QE tapering and Draghi’s recent dispiriting performances at the monthly ECB press conferences? He should quit now. He can always say he tried. But in the end it would seem that the monetary zealots from the insular German or Austrian schools were too obstinate and the public at large could not be persuaded of the merits of QE.

This shift in power at the head of the ECB brings into question the resolve of the central bank to act quickly to prevent future crises. With the banking system emasculated and governments’ bone-headedly pursuing fiscal rectitude, the ECB’s easy monetary policy has always been the only thing holding it all together. A policy error now could jeopardise the whole European project.

“There must be a threat, a risk, a price”
Francois Hollande, 6 October 2016

Without appropriate monetary policy, fiscal policy or bank rescue as an option, all the EU has left is fear to hold it together. It will inevitably buckle if it replaces the carrot with the stick. And so we fear a storm is coming. But don’t worry; with our current portfolio we believe we have the ability to generate gains of the magnitude that we have posted during previous crises.


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