Here, without comment is Hugh Hendry's Letter to Investors for Q1 2013:
The Eclectica Fund - Q1 Review 2013
The Fund returned 3.5% (net) in Q1. The main positive contributors to this performance were equities and FX. There were gains from long positions in consumer staples and Japanese stocks, as well as gains from shorts in industrial commodity related stocks. In FX, the Fund profited from being long the US dollar. Offsetting losses came primarily from long positions in commodity futures, spread across gold, oil and softs.
Long Consumer Staples
Given our longstanding caution regarding the prospects for the global economy we have looked to express equity risk by being long cash generative businesses with the strongest balance sheets and the least economic sensitivity. This served us well in the first quarter when the performance of the S&P consumer staples index defied recent convention. Such stocks tend to under-perform their industrial brethren given the seasonal optimism that tends to surround the global economy at that time of year.
This time around however they out-performed by rallying 13.8%. But with the annualised Sharpe ratio on our basket looking unsustainably high, we took a tactical decision to realise profits towards the end of March. An unresolved but pertinent question is whether this price action might mark the start of the next asset bubble? Consider the plight of a conservative investor: concerned about the risks to the global economy and hence cyclical equities; fearful of financial repression in Treasuries; trapped (possibly unfairly) by the prejudice of the ten-year bear market in US dollars; scared that governments may have to haircut his savings account in the bank; and now terrified by the sudden price collapse in gold. It could be argued that for such an investor all roads lead to the safest, least volatile, most liquid consumer non-discretionary blue chips on Wall Street, which provide a 3%dividend income payable in dollars.
Long US Dollar
The second of our major investment themes is the likely durability of the US economy relative to the rest of the world,and the impact this may have on the US dollar. Unlike the rest of the world, America has dealt with the overhang of bad debts from the housing bubble through a vicious house price correction and resulting bust and the recapitalisation of its banking system. Wages have come down sharply relative to Asia, the shale gas boom means energy is now far cheaper as well, and the resulting lower cost base is allowing the US to reclaim market share within the global economy. As such, US real GDP is 3.3% above the pre-crisis high of Q2 2008,whereas the European economy is still languishing 3.1%below the all-time high recorded in Q1 2008.x As measured by the DXY Dollar Index, the dollar gained 2.5%for the first quarter, and seasonally recorded one of its best monthly performances on record for the month of February. This strength was partly attributable to investors' perception that American economic conditions are improving, and also partly helped by the continuing crisis in Europe. Perhaps more interesting was another break from recent tradition, as the US dollar proved less negatively correlated to the performance of the stock market. It is early to draw anything firm from this, but the sight of the stock market and the dollar rising in tandem looks more like the regime which accompanied the last two dollar bull markets of 1980-85 and 1995-2001.
Long Japanese Equities
Another investment theme we have been leaning toward ever since the end of 2012 is a long position in Japanese equities.Back in 2008, we purchased a ten year 40,000 Nikkei one-touch call option. We had been struck by the historical observation that it had taken the Dow Jones Industrial Index twenty five years to recover from the nominal price losses of the Great Crash of 1929 and make new price highs. The gold price had required twenty-seven years to overcome its previous bubble high. Was Tokyo somehow different or would the persistent inflationary threat of a fiat currency and social democracy's abhorrence of deflation be such that dire economic circumstances could once more persuade them to elect public officials intent on repealing the nominal loss?In order to turn bullish, we had to see a further deflationary shock. And as we examined Japan's economy we conceived of a catalyst. As a consequence of the mercantilist policy of seeking an external surplus with the rest of the world through resisting the yen’s strength, the Japanese economy had built up a huge short position against its own currency. This left them, we reasoned, vulnerable to exogenous shocks similar in nature to the Lehman crisis, when the currency strengthened as foreign denominated assets had to be sold to make good yen losses registered back home. We reasoned that further exogenous shocks were likely to produce yet more yen strength.2011 saw not one but two huge shocks. The global economy weakened as a result of the European crisis, and Japan was struck by a catastrophic earthquake. The yen strengthened sharply. We had posited that further FX strength would create duress at the corporate level and sure enough credit spreads soon widened. By the start of 2012 we had witnessed the nation's two largest manufacturing debt restructurings, and atone point it seemed that the impossible was becoming a reality as household names such as Sharp, Panasonic and Mazda looked likely to go bust. Even Sony only just managed to hold it together by issuing a large and very dilutive convertible.
We reasoned that such was the corporate pain that the political class would be forced to intervene more directly in the policies of the Bank of Japan. And, sure enough, as the economic conditions worsened last year, we saw a newly elected government fire the institution's two most senior decision makers and embark on a policy shift on the scale of the Plaza Accord. This dramatic regime shift and the resulting 20% depreciation of the yen is very bullish for Japanese assets(denominated in yen terms) and so with our catalyst in place we started buying TOPIX index futures and shares in Japanese property companies.
Receive Rates
However, we also caution that Japan's monetary pivot towards QE will not create economic growth out of nothing. Instead it seeks to redistribute global GDP in a manner that favours Japan versus the rest of the world. This is the last thing the global economy needs right now. For as we have moved into spring, business activity appears to be slowing as the inventory cycle brought about by
Draghi’s speech and the re-opening of Chinese liquidity taps last year fades away. Reported PMIs are rolling over, and a destocking cycle combined with a resurgent and competitive Japanese export industry does not bode well for economies in Europe and the rest of Asia.This slowdown is occurring at a time when better global economic statistics over the last six months had served to enrich the risk premium available at the front end of sovereign bond curves, US dollar 3y1y rates backing up from 95bps to150bps as an example. We judged that the combination of richer rates and weaker economic data justified a much greater and wider fixed income exposure. Accordingly, since the end of the quarter, we have initiated positions split geographically across Australia, Europe, Korea, Switzerland and the US.
Conclusion
In summary, as we move into the second quarter the key elements of our portfolio are as follows: long the Tokyo stock market trading just barely greater than its 50 year moving average (comparable to where gold traded ten years ago and where the Dow Jones traded shortly after the attack on Pearl Harbour in 1941), long low variance US equities, long the US dollar and receiving fixed income at the short end sovereign curves.
Hugh Hendry, CIO
Q1 Review 2013 Hendry by ValueWalk.com
