Yesterday I had the great honor and opportunity to sit courtside for a live one-hour presentation from our favorite contrarian, irreverent hedge fund manager – Hugh Hendry himself. What a thrill!
Hendry, as you may know, is partner and Chief Investment Officer at Eclectica Asset Management. While his claims to fame are numerous, his two most notable (for those getting to know him for the first time) are:
- A 31.2% *positive* return in 2008
- Some truly hysterical TV clips (See: Hugh Hendry’s Greatest Hits for four minutes of financial bliss)
Hendry is a big favorite of ours at ContraryInvesting.com. I also just learned that he was “The Plasticine Macro Chapter” interviewed (at the time) anonymously by Steven Drobny in his excellent recent book Invisible Hands: Top Hedge Fund Traders on Bubbles, Crashes, and Real Money – which profiles a select group of hedge fund managers (all “off the record”) that made money in 2008. I went back and re-read this chapter the night before Hendry’s preso, to re-familiarize myself with his investing/trading philosophy.
The Power of Irony and Paradox
Rather than trying to compete pure “intellect-for-intellect” with the likes of George Soros, Julian Robertson, and the other great minds of the hedge fund world, Henry instead relies upon what he calls “the power of irony and paradox” to foil the logically minded and deliver his superior returns.
In other words, he bets on strange events happening – those not anticipated by the mainstream.
This strategy paid off in a big way in 2008, when his out-of-the-money options hit big, and his fund returned 31.2%. It has tended to underperform, though, when (to paraphrase Hendry) “bad stuff doesn’t happen.” Fortunately for Eclectica investors, he sees a bad moon rising once again.
Why China is Not 19th Century America
While many economic observers have drawn an analogy between China’s ongoing industrialization and that of America’s, Hendry sees a critical difference.
In the US, he says, capital has always been allocated where it could achieve the highest return. In the 19th century, when America was the economic upstart on the block, it was also on the gold standard. Which is very important, according to Hendry, because it allotted entrepreneurs one – and only one – chance to succeed. It was not a time of bailouts and multiple bankruptcies!
China is different, he believes, because it is industrializing with a fiat currency. Thus they fall into the trap of misallocating capital – building bridges to nowhere, towers for nobody, and so on. China’s goal is similar to that of 1980’s Japan in his opinion – full employment, rather than maximizing return on capital. A critical, and even fatal, difference, in his mind.
The New Model for the Global Economy
You know the old drill – China and Asia produce, the US consumes. They cycle their greenbacks back over this way, finance our debt, we buy more of their stuff, and the beat goes on.
This model officially stopped with the launch of QE2, Hendry says, as the US officially started rejecting the globalization that had made the global economy hum (perhaps largely at the expense of US employment and manufacturing). With QE2, dollars were printed and exported – along with inflation – to Asia.
This led to the countries in Asia – and Europe, too – raising rates to combat inflation. The result, he says, is that global economic growth has essentially ground to a halt.
So what’s next?
A crash, of course.
Europe’s Debt Spiraling Out of Control
Hendry then pulled up a chart of US and Europe non-financial debt to GDP, illustrating that Europe’s debt has been spiraling out of control ever since the formation of the European Union.
Participant nations, he puts it, received initial “ALT-A” rates – nice low German interest rates – for signing on. But the fixed exchange rate that the euro imposes on the peripheral nations started the time bomb ticking.
Hendry, in fact, is very down on fixed exchange rates, and believes the euro and the dollar/renminbi peg are at the heart of global economic insecurity today.
He believes the recent referendum in Greece could be a very significant event, likening it to a 1931 mutiny in England that forced the Brits off the gold standard. He things the Greek referendum could be the trigger to disengage from their fixed exchanged rate (and cited everyone’s lack of anticipation for the referendum as a classic example of irony in finance).
Stage Not Yet Set for Hyperinflation and Gold $3000
The high CPI numbers being reported in the UK and other Western nations are “meaningless”, Hendry says, because in today’s economic environment, it does not translate into wage growth. (In the 1970’s, it did).
Because wage labor is approximately 70% of total business costs, he does not see meaningful inflation without wage inflation.
He’s also down on gold because it is not a contrarian investment today as it was 10 years ago (he had a nice year in 2003 buying gold and gold stocks when nobody wanted them).
The widespread belief among the greatest financial minds today that hyperinflation is inevitable greatly disturbs him.
In the Western world, he sees hyperinflation as a political choice – one that requires the will of the populous. (Forget Zimbabwe, he says – that might as well be Timbuktu. It’s not our culture.)
He sees society’s current mood as “dark” (Tea Party, Occupy Wall Street, and social unrest in Europe to name a few), and believes this makes bailouts and money printing very hard. The only environment that makes hyperinflation possible is “the mother of all depressions” he says.
In keeping with his anticipation of paradox, he quipped that if you believe in hyperinflation, then you should be levered up long on 10 and 30-year Treasuries…because in order for hyperinflation to become a political reality, deflation must arrive first.
2012 Economic Outlook and Investment Positions
Of the many places Hendry doesn’t want to be long, China is near or at the top of the list. He thinks China could be subject to a 25% (!) decline in GDP over the next five years.
How is that possible?
He draws an interesting analogy: “UK GDP fell 8% in the Great Depression, while US GDP fell 25%.” Inferring, of course, that today’s China is the upstart US to our current “UK peak empire” role.
In what he calls “the great unwinding”, the strongest economies in the world are also – ironically – the most vulnerable.
But that doesn’t mean he’s bullish on the developed world, either. He has an aversion to just about everything.
“It’s checkmate. Everywhere it’s checkmate.”
He believes Italy is insolvent, citing their huge borrowing binge over the last ten years that has only achieved 0% growth.
He loves Japan – as a culture and place to visit – but is especially bearish on several Japanese sectors. He’s long credit default swaps with respect to cyclical, leveraged Japanese businesses. He’s also bearish on Japanese utilities, which have issued tremendous amounts of debt since the Fukushima disaster.
Hendry’s favorite sacred belief – which he’s betting against, of course – is the fact that no one believes the ECB will ever cut rates below 1%. He’s made bets that he says will deliver a 40-to-1 return if the ECB cuts rates below 1% next year.
Big thanks to the CFA Society of Sacramento for hosting the event, and to my pal Jonathan Lederer for landing Hugh and letting me crash the event as his guest!
Need more Hugh? Check out our recent Hugh Hendry coverage.