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Hugh Hendry: Europe Refused Financial “Chemotherapy” And Is Now In Fatal Condition

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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 tax cuts is the chosen route to expand and accelerate this wealth transfer. I suspect the American patient is well positioned to recover from the political fissures brought on by QE.

The unknown factor is how the current phase of private sector tightening of monetary policy will conflict with this ambition. We have often pointed out how difficult it is for central planners to generate inflation. The

problem is the colossal size of publicly traded sovereign bond markets and freely floating exchange rates; the private sector tightens monetary conditions in response to an expected pickup in inflation. Previous periods of hyperinflation many decades ago occurred owing to the absence of such constraints. The power of this automatic stabiliser can be seen when 10-year rates almost doubled during 2013’s taper tantrum, closely followed by a 25% rally in the US dollar index. I believe this pernicious repricing of credit almost certainly contributed to the US economy’s subsequent sluggish performance and the continued slide in inflation expectations. There will surely be a debate as to whether something similar might happen again. However, this time the market’s hand brake is likely to be less effective given the imminent tax cuts, repatriation of stranded corporate cash balances from overseas and fiscal spending. In short, the US seems to have the political resolve and capacity to generate some momentum in economic growth.

Sadly the same cannot be said of Europe. The low growth and high government debt of significant European nations such as Italy requires decades of financial repression to be resolved. Instead, government bond yields have been dragged higher with global rates and, what is more, the German dogma of ‘good deflation’ seems as entrenched as ever with the first steps towards an exit from QE having just been taken as the ECB announced a reduction in the monthly asset purchases from April next year’.

And last but by no means least, there is simply no political resolve at the core of Europe to embrace a fiscal expansion to offset the dangers of this tightening on the continent’s weaker territories. The major northern countries tend to look at government budgets similar to households and favour balanced budgets; high spending policies involving more debt issuance from the core nations are simply unpopular with voters already angry about immigration and the effect of QE on the yields achieved on their savings. So I fear that Europe looks to set to flounder once more. And with Brexit, and now President Elect Trump, offering an appealing nationalistic growth alternative the fear must be that the popular vote in Europe’s busy election timetable will be galvanised into producing more shocks in the year ahead. Remember, as we discussed in our July 2016 Commentary, it was the successful precedent of an alternative economic policy following the UK’s decision to leave the gold standard in the early 1930s that led to the demise of the previous regime.

Japan is a different proposition. The Bank of Japan’s momentous decision to target zero 10-year JGB yields was itself an open admission that the private sector pricing of sovereign bond markets can scupper the nflationary zeal of the central bankers: by front running the bureaucrats and raising bond yields at the earliest indication of inflationary pressure, the markets have successfully kept a lid on such ambitions despite huge central bank bond purchases. But in comparison with Europe, Japan is an oasis of political consensus and stability. In five short years the country’s elected leaders have removed hawkish Bank of Japan governors, wound back fiscally regressive tax hikes and now have ‘sacked’ the bond market. Their inflationary intent is now almost unencumbered.

So if Trumpian policies lead to higher inflation globally, this could be the long-awaited moment when inflation finally makes an appearance in Japan. And with nominal bonds yields held at zero, the outlet valve would be a sharply weaker yen.

In short, a European macro storm is brewing and the yen slide seems likely to persist.

Mad Policy, Mad Men or Mad Max?

“Tomorrow we wake up – I mean, I would jump out of the hotel window if this was the scenario – but we wake up and China has devalued 20%. The world is over…”

This is how I rather colourfully elected to share my thinking in an interview on RealVision back in February. My usual hyperbole aside, why was I so at odds with market fears that a renminbi devaluation was imminent?

Largely it was the severe implications of such a unilateral step. I felt aggrieved that those pursuing the logic of a large one-off devaluation were ignoring some serious and negative consequences. The big issue was political. China is officially monitored annually by the US Treasury department, on behalf of Congress, to determine whether at the prevailing rate of exchange the country is deemed to be a currency manipulator. That is to say, the US government stands constantly vigilant and ready to impose trade tariffs should it deem that China is using an under-valued exchange rate to support its exports. It is therefore inconceivable to us that an immediate and sharp devaluation from officially designated “cheap” levels would not be met, even by the liberal style of the outgoing Obama administration, by harsh new tariffs on Chinese exports making redundant most of the trading advantages from a lower renminbi. Most likely US allies such as Japan and Korea (and maybe even the ponderous Europeans) would follow suit resulting in an inevitable tit-for-tat by the Chinese who would in turn impose import tariffs on access to their lucrative domestic market and make it much more difficult for foreign businesses to operate in China. Global trade would tank, the WTO would likely collapse and fresh waves of nationalism would sweep over the global political landscape, pulling the world economy into a deeper contraction than last seen back in late 2008 and early 2009.

Taking a step back from my incendiary comments made in February, I think it was not necessarily the magnitude of the purported devaluation that upset me so much but rather the “how” and “when” it would happen. For as we have seen this year, with the finetuning of the prevailing capital controls, and perhaps the officially sanctioned weakness in the renminbi versus a basket of its global trading partners, a moderately weak yuan is proving far less contentious or dangerous to the world than the swift one-off devaluation envisaged by the markets at the turn of the year.

Perhaps the macro risk from China is less to do about leverage and more about the scale of uneconomic lending? China and the West dealt with the slack that arose from the Great Recession in different ways. China was defiantly Keynesian, over building infrastructure, whilst the West chose to scale back on capital spending. It might be argued that the West subsidised people to do nothing, leaving itself with a huge government burden, whilst China subsidised people and companies to build capacity, some of which will be used to further expand the economy and some of which won’t. The optimum position is probably somewhere closer to the middle but to say that China got it more wrong than other countries seems premature. Indeed I suspect in our post-Brexit Trumpian world, we are all moving closer to the Chinese doctrine and so once more I find I have no appetite for the Chinese apocalypse narrative.

As I see it, we are in a long term cycle where Chinese GDP growth decelerates from 10% per annum to the current 6% regime and then inevitably to low single digit rates of expansion. Today, within that longer term cycle, China is approaching the end of a mini cycle of monetary and economic expansion; if anything I believe China is in the midst of shifting to a tightening bias rather than further easing. And I do not anticipate a sharp sell-off in the renminbi; a currency devaluation would be politically counterproductive, especially in light of Trump’s contentious trade posturing.

Instead I can envisage a situation where the PBOC prefers to keep the currency relatively stable. However, in a new Trumpian world with a rising US dollar, the mechanics of their supporting the renminbi will yield profitable trade opportunities. Government intervention will remove liquidity from the offshore market, whilst the incomplete capital account liberalisation prevents onshore Chinese moving their money into the offshore market at will to take advantage of higher rates, causing a shortfall of liquidity offshore. This phenomenon will only become more acute should pressure on the renminbi intensify. In such a world, a trade paying offshore CNH rates carries positively and acts as a long volatility position should market fears about China re-assert themselves.

So, to conclude, you might say that we are running a Trumpian portfolio. With the economy’s debtors finally in the ascendancy Eclectica is positioned for an anticipated mean reversion, being long the US debtor community and short the rest of the world’s creditor class. The portfolio hangs on this one narrative with three thematic risk expressions.

• In Europe we anticipate further duress in the political commitment to the European project as the success of Trump’s economic stimulus plan keeps US growth humming along leaving the continent badly exposed as a politically fractured economy without the resolve to implement successful growth strategies.

• The combination of Trumpian economics producing the long sought-after lift in inflation expectations globally and Japanese 10-year nominal yields being trapped at zero by the Bank of Japan should mean the yen continues to weaken.

• And finally, there are appealing opportunities in Chinese fixed income markets arising from the flows of liquidity between the onshore and offshore markets, trades which generate positive carry should the status quo persist yet remain long volatility should pressure on the renminbi intensify in the face of a strengthening US dollar or slowing Chinese economy. Long live the revolution…in Europe it will almost certainly be political!

Hugh Hendry, George Lee, Tom Roderick

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