Hugh Hendry Slams The Investment Industry: "I Don't Sell Dreams, I Live In The Real World"

 

Hugh Hendry's interview on Investment Week:-

Hugh Hendry is not one to mince his words. The outspoken hedge fund specialist, formerly a partner at Odey and more recently a co-founder of investment boutique Eclectica, has previously appeared on Newsnight and presented a Channel 4 documentary on the banking crisis. Here he explains why he has been punished for good performance, why China could be the next Japan, and why he would insure you against the UK defaulting on its sovereign debt 

Do you think China is a bubble waiting to burst?

I fear it could be, because it has not demonstrated an ability to create wealth. It has demonstrated an ability to create GDP growth, which is a function of spending money. The priority of economic management at the macro level should be to have a high re-occurring level of household disposable income, which manifests itself in a high level of consumption as a percentage of GDP.
The scorecard for China using that metric is really bottom of the class. Over the last 30 years, that ratio has almost halved and we are talking about consumption being 35% of the economy. Now when I say that, people scoff and ask, how can you celebrate the venality of consumption?  Isn’t there nobility to building bridges? However, infrastructure projects and steel plants that are publicly commissioned and have very uncertain economic paybacks ultimately require a subsidy from the household sector. If you build a high-speed rail link and anticipate it improving the productivity of the economy over the next 10 years, but actually it does not, it means you will have to raise Government borrowing or tax the population to sustain the negative cashflow.

But is this all about producing more of everything and increasing their economic footprint?
Well, yes. They are pursuing an Asian model and at the forefront of that model is Japan. My interpretation of all of that is, again at the macro level, profit has been displaced by the notion of sovereign power and accumulation.
If you define success on those criteria, they are clearly top of the class. But then we have witnessed Japan fall from being the unquestioned economic superpower – as it was in the 1980s – and it has now suffered two decades of profound reversal. I think the Chinese have to be concerned about that, because it has a portent their model is so similar.

Turning to specifics, will the distortions in Chinese foreign exchange rates based on the renminbi cause much of the pain to come?

Two precedents seem to describe a situation evident in China today. The experience of the US in the 1920s was one of economic disequilibrium and the economy became the world’s largest creditor nation, but at the same time had the ability and the insistence, that it would run persistent trade surpluses.
That does not wash in the world of equilibrium analysis of economics. Trees do not grow to the sky and the fact everyone owes you money means they require the resources and the ability to repay you your money. They can only find that resource to repay you by trading back with you and earning a trade surplus in return.
It takes the world into conflict and typically liquidity is used as a balm to keep an unstable world together. But that balm of liquidity finds its way into speculative asset prices and therefore makes the society vulnerable to reversal. It found its way into Wall Street, which crashed and the US went from first to last. It took 50 years before we saw the world repeat that folly, and that folly was demonstrated in Japan.

2001 is the fulcrum point where things really started to go right in China – they gained entry into the World Trade Organisation [and this coincided] with America really stepping onto the gas with regard to household debt and financing and mortgage market. And that was very much to the benefit of the Chinese.

Looking specifically at those equity markets – they do not appear enormously overpriced at around 20 times earnings do they? Especially if earnings power ahead in the next few years?
This is back to the silly Slater notion of PEG ratio analysis, which has the flaw that it is not predicated on the accumulation of wealth. This saw Next become a retail empire in the 1980s by having not one but three stores in every high street. The same applied to Starbucks. Again it is this mechanistic notion of generating incremental revenue or earnings growth or GDP growth – at the expense of declining returns on marginal investment, which sows the seeds of its own destruction.

Let’s switch now to some of your own funds and what you are doing with them? We hear a lot about your high profile funds but one of your first was your European unit trust, which has in absolute returns terms been a success, but we do not hear much about it.
I set this up in 2005. In 2007 we made 5.5%, which was nothing to write home about to be honest, as the market was up over 10% that year. But in 2008 in sterling terms, our fund only lost 5% and the stock market lost 25%.
In 2009 our fund made 7% – so we went plus five, minus five, plus seven, which is a remarkably robust performance. Yet the assets invested in that fund have fallen from $80m to £3m. So I have been punished but I am not quite sure why I have been punished. The answer to it reveals the malaise that exists in the investment industry.

What has gone wrong with the investment industry in your view?
It is a malaise and the end of an era. We have leveraged society – in the 1970s total debt to GDP in the US was 1.3. Today it is 4. So leverage has gone up a factor of three.

Equities are a real asset and the subject of a very positive spin on that leverage and therefore it is no surprise stock markets have typically gone up in real terms by a factor of nine. That is without precedent in the 400 years of economic history we have of available.

We have created a hunger just to make money, speculative money and damn the consequences almost – we are either all investing in houses or stocks, soon to be Chinese stocks with Anthony Bolton. But, it has also created a Pavlovian response where every crisis was an opportunity to buy more. I think time is receding, it is passing, it is leaving us behind. My difficulty is that I do not sell dreams. I live in the real world.

How does this enthusiasm for debt and equities relate back to your European fund and its relative neglect?
At best we are agnostic with regard to Europe. In my darker moments when I drop my guard, I am profoundly concerned and troubled by the economic model Europe is pursuing, and that makes me a very good gatekeeper for managing European assets. It means I am very quick to sell things and therefore I can protect capital. It means I have to be convinced – I am sceptical.

I think it provides an edge but it not a marketing edge. In fact you cannot sell the European product clearly by saying Europe sucks.

I am keen to understand how you actually invest. Let’s take the European unit trust as an example. What goes on in the engine room?
In the engine room of the fund we develop a prejudice with regard to the colour and direction of the global macro economy. We think those weather patterns, if you will, actually influence companies.
With this in mind, how do you pick companies?I am concerned a society that has leveraged three times has therefore created a third presence – debt – within the economy and an inflated sense of the economy. There is a degree to which it has boosted the reputations of perhaps otherwise mediocre businesses.
As we take away this economic module the debt provided, it reveals a more sobering environment where actually it is just tough! So that manifests itself today in the sense we are concerned about the world being profoundly deflationary and therefore are reluctant to take a lot of economic risk. So the businesses we select to buy today are large-cap names, so I can sell them and not be trapped in them. They are businesses that have a lack of economic sensitivity. I have a tremendous amount invested in the tobacco industry. I think it could survive a consumer depression.

Let’s finish by looking again at the bigger, macro, picture. I suppose we could summarise your views thus – deflation is still a very real risk in the West. There is the real chance of asset bubbles, particularly in the East. What about sterling? Should we be selling it because of our indebted state?  
There is a hysteria concerning sterling with regard to other currencies, especially the euro, which I do not share. Our economy is troubled and thankfully we have an independent monetary policy that does not avail itself to places like Greece. So when people get very concerned about the sovereign credit risk of the UK, and they compare it to Greece, I think they are horribly wrong.
If you wanted insurance on the UK defaulting on its debt I would write you that insurance. The UK will not default on its debt. I think it is just a preposterous assumption.

You are asking me about currency however, and sterling continues to look as if it will weaken. Clearly, there is uncertainty with regard to politics – sterling will continue to weaken against the dollar and possibly to parity versus the dollar. The dollar will surprise people by being profoundly strong, but in the context of further deflation and further falls in asset prices.

Everyone’s favourite future bogeyman is inflation. Jonathan Ruffer, in an interview recently, suggested over the medium to long term, there is a real chance of inflation picking up sharply, with the RPI [retail prices index] back above 10% or even 15% – back to the 1970s and stagflation. I am guessing you do not think that will happen given your deflationary views on debt? 
If you want to create inflation, you will have to do away with free and independent capital markets. It is very hard to create inflation with free and independent capital markets because of people like me and Jonathan.

We have had quantitative easing, what has happened in the UK? Sterling has fallen and the existing stock of Government debt has fallen in price. So rates are going up. That acts as a counter and a check. We now have credit rating agencies, which come in and counter it, so it is very hard.

If you want to create inflation, what you will see is that we will have a ban on short selling. We will have a ban on naked credit default swaps. We will have the re-imposition of exchange controls. I think that could reside in the future.

So, you would put RPI in five years time at 15%?
If all of the things I say come to pass  I anticipate having a lot of inflationary traits. But some of the smartest minds in the marketplace have gone for logic rather than irony… what I am saying is you have to respect policy makers. They are wise, educated, hard working, and diligent. None of them wants to be the person who goes down in history as being the architect of hyper inflation. They do not want that. To get them to do it, to go nuclear, you have to press them to the edge and I think the place closest to the edge is Japan.

Japan? Are the risks of hyper-inflation really that great in an economy rocked by deflation?
Japan features prominently in a lot of the positions we are adopting today. Japan will of course reject the notion of overseas finance and therefore likewise could pursue fiscal austerity.
In that environment you would find Japan could print -5%, -6% nominal GDP very, very quickly. In that environment there is a paradox – the yen would appreciate, which runs very counter to most people’s logic. So I think you could have a coincidence of -5%, -6% Japanese GDP, you could have dollar/yen in the low 70s if not in the 60s. That would be an environment in which they would go nuclear.