Part One of MoneyWeek's Interview with Hugh Hendry, November 19, 2014
For the full transcript, visit here.
And his most recent letter to investors:
*******
Eclectica Asset Management, Letter to Investors Q3 2014
by Hugh Hendry, Eclectica Asset Management
The Fund is now up 2.6% on the year and, despite running a net long equity book that has exceeded 1x NAV for the past few weeks, we succeeded in weathering a particularly volatile October with rather dramatic intra month price declines in the major equity indices to post another gain of 4.0%. We have now made money in each of the last three months. Therefore, contrary to what you may have heard, our spirits are high and our risk taking is increasingly paying off.
My premise hasnāt really changed since I published my paper explaining why I had become more constructive towards risk assets this time last year. That is to say, the structural deficiency of global demand continues to radicalise the central banking community. I believe they are terrified: the system is so leveraged and vulnerable to potentially systemic price reversals that the monetary authorities find themselves beholden to long only investors and obliged to support asset prices.
However, I clearly confused everyone with my choice of language. What I should have said is that investors are perhaps misconstruing rising equity prices as a traditional bull market spurred on by revenue and earnings growth, and becoming fearful of a reversal, when instead the persistent upwards drift in stock markets is more a reflection of the steady erosion of the soundness of the global monetary system and therefore the rise in stock prices is something that is likely to prevail for some time. There is more to it of course, as I will attempt to explain, but not much.
This should be a great time to be a macro manager. It is almost without precedent: the world's monetary authorities are targeting higher risk asset prices as a policy response to restoke economic demand. Whether you agree with such a policy is irrelevant. You need to own stocks. And yet, remarkably, the most contentious thing you can say in the macro world today is āIām bullishā.
In a world dominated by the existentialist angst of identifying and trading qualitative value, there is profound mistrust of equity values today; macro investors see prices as overvalued and few are willing to capitalise on the opportunities to make money. This angst and fear of big drawdowns in risky assets in part reflects astonishment that policy makers were able to rescue investors from the folly of their misallocations in the years preceding 2008 and that stocks have massively outperformed the modest rise in global nominal GDP. I should know. I, like others, became a moraliser who just couldnāt forgive the Fed for bailing out Wall Street. I read one ādeath of moneyā polemic after another and luxuriated in the work of people like Marc Faber, James Grant, Nassim Taleb, Raoul Pal and Albert Edwards. I became a moral curmudgeon rather than a money maker.
As you know, I have sought to overcome this deficiency. However my risk controls, or rather my procedures for dealing with big monthly losses, seemed to anchor me to the bearish camp (against my better wishes). No-one wants to lose more than 5% in any one month (for the record, we have recorded only 9 such months over the Fund's previous 144). But typically this has entailed selling when there has been a spike in volatility; since the end of last year I haveĀ been a bull that had to sell for lower prices. No wonder I couldnāt make you money. But perhaps you donāt need such reactive stop loss policies when the world's central banking community is intent on protecting you; which is to say, I needed to apply greater risk tolerance and intervene less often.
You are not convinced? Japan was down 16% from its highs earlier this year. I was particularly long Japanese equities at the start of the year and so at some point, fearing greater losses, I swallowed my pride and booked a loss. However, the ongoing policy intentions of the BoJ meant that the stock market clawed back all of its losses. Why did I sell?
European stocks fell almost the same over the summer but again the ECB upped its ante, pushed short term rates negative, tolerated a weaker currency and promised to re-stock its balance sheet with more local risk asset purchases. Lo and behold, European stock prices recovered sharply in August and early September. So why did I reduce my holdings?
October is simply another example. US stocks fell over 10%. I don't really know why. Was it the threat of the end of QE or a global pandemic or more misgivings as to the state of affairs in Greece and Europe's enduringly weak economy? It doesn't really matter. Such is the perceived risk in the financial system that enough investors now anticipate a policy response whenever the S&P falls more than 10%. This ensured that shorts were covered and volatility sold in mid-October. The fixed income market's expectations for hawkish future Fed rate hikes evaporated with stock price weakness and other risk markets soon rallied; the S&P is now back to its all-time high.
Pity the macro manager then who had to stop loss mid-month; that used to be me. But I widened my tolerance for loss. We have no desire to lose money but unless something tangible happens to challenge our narrative we are less willing to automatically reduce our risk taking in response to modest, if rapid, short term market gyrations. Making money requires making the right calls of course but just as importantly it necessitates that we provide trades with enough breathing space to develop and hopefully prosper.
So why all this enthusiasm for upside equity risk?
To my mind the current period is analogous to the Plaza Accord of 1985 when central bankers agreed to intervene in the currency market to drive the value of the dollar lower. The fast moving world of FX was deemed a more expeditious way of correcting for the huge US current account deficit than the laborious and slow process of waiting for the totality of countless micro wage and productivity deals to rectify the yawning trade gap. No one really knew for sure how high the yen or Deutsche Mark should trade back then but this didnāt stop macro managers from being very long such positions.
The FX market tends to take the US Supreme Court view. Overruling an obscenity charge for showing a salacious French movie in Ohio in 1964, Justice Potter Stewart wrote that the Constitution protected all obscenity except hard core pornography. Unwilling to define the latter, the judge maintained that he would know it when he saw it. And likewise currency values; you just know the wrong ones when you see them. This is to say that the market becomes more treacherous once the imbalances of the primary economic transactions (the US current account) show signs of improving from the remedy of the price changes engineered via the relative currency movements.
Which is a rather long preamble to describe what I believe is a very analogous central banking intervention in today's financial markets. It would take just too long for the Fed, ECB or the BoJ to rely on a return of animal spirits in the real economy to lift their flagging economies. They need the remedy of fastĀ moving risk asset prices. By using QE to promote more risk taking, asset values in the US have risen faster than fundamentals and, with better perceived collateral and more confidence, the demand for risk taking in the real economy has recovered somewhat. At a lag, the theory runs, so will the rate ofĀ expected inflation.
So I think we find ourselves especially in Europe (and Japan) with a situation whereby the central bank has to use all of its powers to engineer higher stock and bond prices. And I think the precarious nature of France and the election timetable in 2017 means that they need higher European stock and bond prices NOW or there will be no economic recovery, budget deficits will continue to overshoot 3% and the Euro area will get trapped in the poisonous and perpetual cycle of having to demand more and more unpopular austerity measures. This is high stakes: boost European stock prices or risk losing France and the euro. To my mind the message is simple: donāt short French bonds, buy European stocks and short the euro.
It will only become a bubble when slow moving price inflation and real wages start moving; weāre obviously nowhere close to that just now in Europe (or in Japan) and hence my large net long.
Copyright Ā© Hugh Hendry, Eclectica Asset Management
*******
(h/t: Zerohedge.com)
