Hugh Hendry: Investment Outlook August 2009

Thursday, August 27th, 2009

Hugh Hendry, CIO, Eclectica Asset Management, has recently published his investment outlook for August 2009. Since the Summer of 2008, Hendry has been a strong proponent of deflation, and continues so, even though his thesis has been getting a thrashing lately. Hendry has discussed investing in long bonds fervently in the past, but had no choice in Late March to reconsider his positions and sell them off, as yields on long term government paper started to climb sharply and the recovery rally of the last 5 months began to take shape. Hendry’s flagship fund was up 40% for the calendar year in 2008, and most of that came from his bets in long term government bonds.

We would note that Hendry is the first to pull the plug when he is wrong in the short term, as he did in March-April. He is no buy and hold investor, nor does he wish for the economy to enter a depression, but he does feel that it is inevitable given the debt deflation that he believes is ahead. One of Hendry’s main assertions is that it will take many years for the developed world to correct its over-indebtedness.

Having said that, here are the first 4 paragraphs from his letter:

Good people are becoming desperate. I know a man who is planning to capitulate and buy stocks. He cannot comprehend what is happening today. He is, to employ Churchill, a fanatic; he won’t change his mind and he can’t change the subject. But, fearing the loss of his franchise, he will change his portfolio. He laments that it is as though last year’s events never happened. Rhetorically, he asks whether we have all been sent through time to invest in equities at the end of the 1970s when stocks were cheap and society had thoroughly deleveraged (the opposite of today). “Why do other investors not contemplate the prospect of further household deleveraging when building their profit forecasts?” he fumes. “Can they not see that the private sector’s deleveraging is more than offsetting the public sector’s expansion?” Despite such ranting my Minskian friend remains a most entertaining and charming individual.

Now I know I have not covered myself in glory these last few months. Stock markets have gained 50% from their lows and the Fund has little to show for it except a modest reversal and no wild swings in our monthly NAV. Nevertheless, I would contend that this game of playing “chicken” with the market is not for us. Our ambition has been modest. To survive the onslaught of a positive change in social mood without being forced to capitulate in the face of a frenzy of optimism; so far so good, I think?

In this regard we have been helped immensely by a quote from Robert Prechter in early April. Having correctly called for a counter-trend rally in stock prices in late February, he then described the most likely nature of the advance, “…regardless of its extent, it should generate substantial feelings of optimism. At its peak, the President’s popularity will be higher, the government will be taking credit for successfully bailing out the economy, the Fed will appear to have saved the banking system, and investors will be convinced that the bear market is behind us.”

So far his prophecy reads well. It is reminiscent of Warburg’s line that the business cycle is “a subject for psychologists” rather than economists. Bernanke is already being compared favourably with Volcker. Continental Europe has apparently “escaped” from recession. Positive economic growth across the world for the remainder of the year seems certain. And yet Prechter went on, “Be prepared for this environment: it will be hard for most investors to resist. But beware… [the next move] will be the most intense collapse in stock prices”

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Tags: 1970s, 5 Months, Assertions, Bets, Calendar Year, Churchill, Deflation, Eclectica Asset Management, Flagship, Franchise, Government Bonds, Government Paper, Hugh Hendry, Indebtedness, Investment Outlook, Paragraphs, Private Sector, Profit Forecasts, Proponent, Public Sector, Rally
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Is US hyper-inflation a clear and present danger?

Friday, August 21st, 2009

We hear a lot of concern that the Fed’s mushroomed balance sheet over the past two years is setting the stage for a 1970s style inflation here. So long as we have a fiat (a.k.a. Chrysler?) monetary standard, the threat of hyperinflation always lurks. But is the stage currently being set for such an eventuality? I do not think so.

Chart 1 shows the behavior of changes in the M2 money supply over the past 50 years on a year-over-year basis. After the Lehman crisis in the summer of 2008, M2 growth accelerated sharply. By January 2009, the year-over-year growth in M2 reached 10.1%. Although not quite matching the 13-1/2% M2 growth often reached in the 1970s, if sustained, 10% M2 growth certainly would have the potential to push inflation significantly higher. Although the year-over-year growth in M2 has decelerated to 8.4% in July, that rate of growth if sustained, could still pack plenty of inflationary punch. So, why am I still not worked up about the potential for a 1970s’ style of inflation?

Take a look at Chart 2, which plots the behavior of the M2 money supply on a six-month annualized basis. After the spike to 15.2% annualized growth in February of this year, in the six months ended July, annualized M2 growth was only 2.7%. Barring another surge in M2 growth, this sharp six-month deceleration in M2 growth implies a continued deceleration in year-over-year M2 growth and, thus, a reduced likelihood of a repeat of the 1970s high-inflation environment.

How is it that the explosion in assets on the Fed’s balance sheet from approximately $901 billion at the end of July 2007 to approximately $2 trillion at the end of July 2009 (see Chart 3) has not resulted in a sustained explosion in M2 money supply growth? Because of the extraordinary increase in excess, or idle, cash reserves on the books of banks. As shown in Chart 4, banks’ excess reserves soared from only $1.6 billion in July 2007 to almost $733 billion in July 2009. So, about 64% of the increase in Fed assets in the two years ended July 2009 was accounted for by the increase in idle cash reserves sitting on the books of banks. A further 8.5% of the two-year increase in Fed assets was accounted for by an increase in currency in our pockets and/or squirreled away in our safe deposit boxes (see Chart 5). This dramatic increase in the demand for “folding money” was likely the result of an extreme case of risk aversion rather than a preparation for a shopping splurge (other than for canned goods and ammo, perhaps).

Why have banks allowed idle cash reserves to pile up on their balance sheets? Several reasons. For starters, the Fed now pays them a nominal rate of interest to hold these idle reserves. But this is not the main cause of soaring excess reserves. The principal reasons are lack of capital and lack of demand from borrowers who might be able to stay current on loans. The banking system has experienced sharp losses in the past year and is about to experience a second wave of losses. These losses deplete bank capital. Without adequate capital, the banking system cannot create new credit. At the same time that banks are strapped for capital, they also are strapped for loan customers who are judged creditworthy (see Chart 6).

But, a year from now, the banking system is likely to be better capitalized and the demand for bank credit from creditworthy borrowers is likely to be rising. This is when we will have to start to be more concerned about that mountain of excess reserves sitting on the books of banks being “activated” to create new credit to the nonbank sector. If the Fed does not take steps to adequately neutralize these excess reserves, then the inflationary game will be on. I do not currently know how adroit the Fed will be in neutralizing excess reserves. Evidently those who are forecasting a return to 1970s style inflation do know. More power to them.

Source: Paul Kasriel, Northern Trust Daily, August 19, 2009.

*Paul Kasriel is Senior Vice President and Director of Economic Research at The Northern Trust Company. The accuracy of the Economic Research Department’s forecasts has consistently been highly-ranked in the Blue Chip survey of about 50 forecasters over the years. To that point, Paul received the prestigious 2006 Lawrence R. Klein Award for having the most accurate economic forecast among the Blue Chip survey participants for the years 2002 through 2005. The accuracy of Paul’s 2008 economic forecast was ranked in the top five of The Wall Street Journal survey panel of economists. In January 2009, The Wall Street Journal and Forbes cited Paul as one of the few who identified early on the formation of the housing bubble and foresaw the economic and financial market havoc that would ensue after the bubble inevitably burst.

Tags: 1970s, Balance Sheet, Cash Reserves, Chrysler, Clear And Present Danger, Deceleration, Eventuality, Excess Reserves, Explosion, fiat, Hyperinflation, inflation, Lehman, Likelihood, M2, Monetary Standard, Money Supply Growth, Punch, Spike, Trillion
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