Wednesday, July 8, 2009 4 comments ++[ CLICK TO COMMENT ]++

I found a deflationist... Hugh Hendry of Eclectica Asset Management

Yes, this is like a major discovery to me :) One of the endangered species these days seems to be the deflationists. Sure, you have a bunch of amateurs on message boards, or blogs, or whatever, claiming to lean towards deflation but there are very few professionals I see investing with a deflation outlook. The only two major individuals in the deflation camp (that I know of) are Gary Shilling and Mike Shedlock. Well, I found another guy who runs Eclectica Asset Management. I don't know anything about his fund or his record—for all I know he could be the 2nd worst investor in the world, right behind me—but I share his thinking so I thought I would point it out to my readers. Regardless of what one thinks of Hugh Hendry, he seems to be a true contrarian. He reminds me of the first time I encountered another contrarian, Marc Faber, who was so shocking that my view of the world completely changed. I'm actually quite impressed with Hugh Hendry and will try to follow him in the future.

Here is a 3-part Financial Times interview with Hugh Hendry that you should check out (thanks to Infectious Greed for original mention):
Financial Times July 5, 2009 Interview - Part 1 (it automatically goes to parts 2 and 3 if you let it play)

User Namazu at Infectious Greed also linked to the following post at self-evident:
CNBC Europe June 30 2009 interview

The trader-oriented and controversial blog, Zero Hedge, posted Hugh Hendry's fundholder letter a while ago as well:
The Eclectica Fund Fund Manager Commentary - June 2009


If you don't have much time or are pretty certain inflation is around the corner, I would recommend the Financial Times interview, which is short, to the point, and presents his views. The interview covers deflation, bonds, whether stocks are attractive, China, and gold. The longer interview posted by Self-Evident is broader in scope. I read his fundholder letter a while ago and wasn't that convinced with some of his comments (particularly the chart purporting to correlate the US$-Renembi against oil prices).

Click through for my opinion on some of his thinking...


On Bonds

Hugh Hendry, like all deflationists, is bullish on government bonds. Gary Shilling, the other prominent deflationist is also bullish on US Treasuries, but, unlike Shilling, Hugh Hendry expects bond yields to decline significantly. Shilling, in contrast, seems to think that capital gains from bond will be minimal, but favours them due to their wealth-preseving ability (i.e. under deflation, almost all assets will collapse except the strongest debt and cash.)

Bond yields declined in Japan over the last decade and they also declined during the Great Depression (except for a short period in late 1931 when there was concern over devaluation and the strength of the US balance sheet). So, what Hugh Hendry is saying has some historical backing.

There is also some impetus for falling bond yields if you believe in the savings glut theory. This theory, first popularized by Ben Bernanke, but also seem to be supported by Paul Krugman and others, suggests that there is an excess of savings in the world (mostly from East Asia and OPEC countries). Given how returns from stocks, commodities, and real estate look poor, all this capital can keep flowing into government bonds, as they have been for years. A lot of people suggest that China and others will shift their capital into something else but I am not sure what can produce a higher return right now.

I'm still not convinced that bond yields can fall far enough to be considered as an investment. We'll see how things evolve.


The bond debate is very important even if you are not investing in bonds. Long term bond yields significantly impact the economy. In fact, I would even argue that they matter more than what the FedRes does (certainly the actions of the FedRes have limited impact in a liquidity trap). If yields fall, they will cushion the economy. If they rise, the economy will slow down materially.

What About Gold?

Hugh Hendry is bearish on gold and shares similar views as me. You might want to go through my posts on gold but to put it bluntly, if gold has gone nowhere while the whole financial world is falling apart, governments are printing money, and solvency of some nations are called into question, then there is something wrong there. It is likely that the deflationary forces are pushing down on gold. It is also not very contrarian so I have little interest in it. Similar to commodities, it has been in a bull market for more than a decade and I would rather invest in something that is out of favour than one that has been going up for roughly 11 years.

If you are bullish on gold and want to maintain exposure to the sector, I would favour bullion over mining companies. Although mining companies can rise spectacularly (especially if we get high inflation), they are far riskier if deflation sets in. A lot of mining companies have horrible returns on capital, their margins are really thin (many were losing money even when gold was near $1000), and some have debt. Although I expect bullion to fall during deflation, it is possible that it may remain largely flat whereas gold equities will likely collapse, along with the rest of the stock market.

China

Hugh Hendry's concerns about China are similar to mine, although he seems more bearish than me. Hugh points to a huge risk that I have been calling the 'overcapacity problem'. He does an excellent job teasing out the problem and explaining it clearly from a macro point of view. I recommend everyone check out the 3rd Financial Times clip.

Hugh points out that China has capacity not just to cover demand from last year's US GDP, but also to cover potential US GDP for the next, say, 7 years. He gives the analogy of Japan in the early 90's to illustrate how projected GDP in 1989 may have been 5%/year for the next 10 years but it actually turned out to be 1%/year. Hence leading to overcapacity in various Japanese industries and severely pressuring corporate profits for years. I never thought of the situation quite as Hugh does but it is an insightful way of thinking about it. For instance, I never thought of current US consumption as being equivalent to Americans moving their future consumption to the present. This makes sense but I just never looked at it that way.

If Chinese businesses did overbuild, in anticipation of a larger foreign GDP in the future, the overcapacity problem is worse than I thought. But it's not clear how bad the situation really is. China may have been overstating production numbers, especially at the SOEs, so it may not turn out as bad as if the numbers were real. So far, the unemployment numbers in China, which admittedly are just as unreliable, do not indicate any serious overcapacity issue. If what Hugh Hendry suggests were true, there would literally be thousands of factories going bankrupt every few months. Yet, outside of some industries like toys and clothing, I haven't seen mass bankruptcies being reported in the press.

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4 Response to I found a deflationist... Hugh Hendry of Eclectica Asset Management

synchro
July 9, 2009 at 1:50 AM

I am in the usual position of having to wait for my wife to finish using the bathroom before I can use the toilet for a long-awaited bowel movement, so I decided to check on my favorite inconsequential blogger on contrarian investing and deep macroeconomic thoughts and spewage.

I must say I am disappointed, as your long posts seem quite and remain derivative and unimaginative.

Btw, YMM (Your Main Man) seems to be making something of a comeback.    The question is whether the recent outperformance is of the dead feline sort, or something more long-lasting.

Time to go.  Good luck on your continuing investing adventure.

Sivaram
July 9, 2009 at 10:55 AM

Bill Miller is very optimistic so if the economy and the markets recover, he will do well... otherwise, he may struggle for a while...

ian
July 9, 2009 at 1:21 PM

Check out the Van Hoisington site below for other views on deflation.

regards,

ian
http://www.hoisingtonmgt.com/hoisington_economic_overview.html

Sivaram
July 9, 2009 at 1:49 PM

Thanks... I remember reading one of their pieces a while ago but haven't read anything recently...

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