Hugh Hendry November 2009 commentary - The deflation argument [very long]

This month I will attempt to answer the entrance examination for the Chinese civil service. That is to say, I will attempt to tell you everything that I know. In doing so, I will argue that this year's rally in inflationary assets, from emerging stock markets to industrial commodities to the fall in the US dollar, could be a FAKE. Let me explain why.

— Hugh Hendry, Nov '09 Eclectica Fund Manager Commentary

One of the difficulties with contrarianism is that it is never clear whether you are being contrarian for the sake of being contrarian; or if you are actually right and the crowd is wrong.

Such is the case with Hugh Hendry of Eclectica Asset Management. Whenever I look at his comments, it is hard to tell if he is going overboard by taking an extreme contrarian stance (I have a habit of doing this too :( ). His latest commentary touches on all sorts of issues and is an interesting read for macro-oriented investors (if link doesn't work, try the posting at Zero Hedge). There are a lot of seemingly differing topics covered in the letter but it should be obvious to macro investors how everything is all inter-connected. Hugh Hendry basically lays out his case for deflation. If you are a contrarian or interested in an extreme contrarian stance, I highly recommend the commentary.


Hugh Hendry is one of the few remaining deflationists. There are many who claim to be scared of deflation, and even expect it in the short term, but do not put their money where their mouth is. Those people cannot be taken seriously. Hendry is betting heavily on deflation and has positioned his portfolio as such. Such a stance bets against the consensus, as well as prominent investors such as John Paulson, David Einhorn, Marc Faber, and Jim Rogers.

As you will see below, when I discuss them in more detail, Hendry's stance makes sense from a contrarian point of view. For instance, it is very hard to debate the point that nearly all investors are underweight goverment bonds from a long-term historical point of view. I have covered this in the past but almost everyone—pension funds, retail investors, corporate investment funds, commercial banks—have a smaller percentage of their assets in government bonds than they did 30 or 40 years ago. The logical contrarian position is to assume that portfolio allocation towards government bonds will increase significantly over the next 20 years. However, I am not quite sold on Hendry's newest revelation, a bearish bet on Japan.

The Big Picture

Sumner is able to take us from the Flemish forger, Van Meegeren, and his horrendous reproductions of the Dutch painter, Vermeer, to the notion that every recession seems unique and special to its protagonists. So just how did Van Meegeren fool the Nazis with paintings that today look so awful, so un-Vermeer? Jonathan Lopez, the noted art historian, argues that a FAKE succeeds owing to its power to sway the contemporary mind. Or in other words, the best forgeries tend to pay homage to the tastes and prejudices of their time. The present is so seductive.

What does this mean?

Controlling the psyche of this generation of investor is the indelible mark of the falling dollar and the associated fear of inflation. Monetary inflation has been the distinguishing feature of the last ten years, and it is now firmly embedded in the contemporary mind. I am sure I need not remind you that gold, along with just about every other commodity, has at least quadrupled in price since 1999. You already know my explanation for why this has happened.

The spectacular rise in the Chinese trade surplus, predominantly with America, to $320bn per annum at its peak in 2007, and the mercantilist desire to prevent currency appreciation drove the Asians and the sheiks to buy Treasuries and print their own currencies. The ability of fractional reserve banking to leverage this liquidity many times over provided the monetary mo-jo to instigate ever higher commodity prices. In other words, quantitative easing, masquerading as a cheap but fixed currency regime, has succeeded where Japan's orthodox version has failed. The QE succeeded because, amongst other features, it raised the velocity of monetary circulation.

However, it was not always like this. As an example, ten years ago it was unthinkable that the dollar would prove so fragile. Recall that back then, when the euro was first launched in 1999, it promptly lost 31% of its value against the greenback. The subsequent reconstruction of modern China, though, intervened. In order to finance the emergence of a new economic superpower, an abundance of dollars was needed. Have no doubt that had we not had the dollar as a reserve currency, the rise of China would not have been as swift nor as decisive.

There are two non-mainstream claims Hugh Hendry makes here. Both go against conventional thinking of academia and the Street (as far as I know, I haven't heard anyone else say this before.) Hugh Hendry is claiming that the fixed exchange rate policy is actually quantitative easing (QE) on a grand scale. Unless I'm misunderstanding his point, I believe the QE he is referring to is the period before the current crisis and one should not confuse what happened pre-crisis with the current QE being undertaken.

Another claim is made in regard to the growth of China. Hendry claims that China wouldn't have risen as quickly if it weren't for the US$. I think most would agree with this view to a large degree. If USA didn't run very large current account deficits, it would have been difficult to successfully carry out the fixed exchange policy pursued by China (the fixed rate refers to the exchange rate between the US$ and the renminbi.)

The US Dollar

...they required the willingness of their trade partners to run trade deficits. The US delivered and, partly as a consequence, the Fed's broader trade weighted dollar index has now fallen 20% since its peak in 2002 (the narrower DXY index compiled by the Intercontinental Exchange has fallen more, but excludes the renminbi and overstates the role of the euro). In return, the world has a new $4trn trading partner: China.

Heady stuff, but not without precedent: recall the Marshall Plan, a watershed American aid program that assisted the reconstruction of the Western European economy during the 1950s and 60s. This was further augmented by America’s willingness to run trade deficits, the modern day equivalent to a gold discovery, which became necessary to sustain the emergence of the new economic trading bloc . This resulted in the dollar's huge devaluation versus gold in the 1970s. However, back then, the broad trade weighted index kept rising. This time it has fallen sharply.

...

Do not forget that the Chinese could replicate equivalent currency baskets to SDRs at any moment. Instead, they continue to recycle almost three quarters of their trade surplus back into dollars. This is not coercion but simple commercial pragmatism. They know full well that neither Europe nor Japan nor Britain nor Switzerland nor the rest of Asia are willing to sacrifice the implicit loss of manufacturing jobs. They understand that it is only the US that is willing to embrace the benefits of comparative advantage that arise from international trade. Have you ever asked yourself why car prices in America are so low compared with those in Europe? This is my point.

I keep hearing that a dollar devaluation would help matters. I agree; it has. Let me say it again; we have already had the devaluation. That is what the last five years were all about. Now with China rebuilt, and the trade deficit in full retreat (note the -47% contribution from net exports to China's GDP growth in the first 9 months of this year), there are less dollar bills being exported overseas to ungrateful recipients. Is it not time we drop our fascination with the present and consider the future? Is it really inconceivable that the dollar could now strengthen?

I lean towards Hugh Hendry's stance but anyone going long the dollar has been burnt very badly this year. But from a contrarian point of view, a bullish US$ bet is very attractive. The vast majority of investors have placed large bearish bets on the US$—another way of saying this is that the majority have placed a bullish bet on inflation. The question is when will the US$ stop sliding?

The Overcrowded Inflation Trade

The trouble is that we are so anchored to the recent past. Investors are fearful of what now seems so familiar and recognisable; at what they perceive as the reckless behaviour of our monetary authorities. "Inflation is a monetary phenomenon" is their Friedmanite dogma. Their salvation can only be found in the safe sanctuary of gold and the embrace of risky assets, but are they truly safe?

This is my home. Don't be so sure about anything, Big Horace. Not about anything in this world.

—The Orphan's Home Cycle
Horton Foote

And so, just as the Church of England commissioners became convinced by the cult of equity way back in the whimsical days of 1999 and went 100% long the stock market, investors today recant a new mantra of, “anything but the dollar (A-B-D)”. Inflation bets are all the rage. Some would insist that it is their fiduciary duty to protect their clients' capital; I say tell that to the Church of England pension fund, whose assets today are just £461m against liabilities of £813m. Austerity beckons for the clergymen; heaven will have to pay their stipend.

But the spell cast by a contemporary cult is hard to resist. Take another august body, the Harvard Endowment Fund. Not typically renowned as a hotbed of reactionary fervour, the fund is nevertheless radical in its construction and has come to typify the A-B-D stance.

Harvard’s position could well be construed as a one-way bet. Almost half of the fund is invested in emerging market equities, commodities, real-estate, private equity and junk bonds. It is as though the rap artist 50 Cent has taken over the advisory board. The fund is going to, “get rich or die tryin’".

We, on the other hand, approach risk by considering the worst possible outcome. For a current pension scheme the greatest torment would be a repeat of last year's final quarter when 30 year Treasuries yielded just 2.5%. This would require a CAGR of 20% or more from the fund's riskier assets at precisely the time that their future returns would seem most questionable; insolvency would beckon. And yet, they blithely run the risk of ruination.

Harvard Endowment Fund appears to the whipping boy of critics, including me (in Canada, another unfolding disaster is Quebec's Caisse du Depot pension fund, which I haven't covered, or criticized enough ;), on this blog.) Eclectica produces the following graphic breaking out Harvard's portfolio, which Hendry characterizes as akin to 50cent's strategy of get rich or die tryin' (as usual click to enlarge graphic.)



I'm not going to go into the Harvard situation because I have covered it before and I was already shocked when I first realized how vulnerable their portfolio was. Suffice to say, they are representative of the heavily-crowded inflation bet.

The key thing to note from their portfolio is that they have only 6% in high quality bonds!!! Perhaps inflationists would consider it prudent to hold so little in high quality bonds—inflationists such as Marc Faber have suggested that US Treasuries are in a huge bubble, and other government bonds aren't that much better—but if the inflation call is wrong, this fund is going to blow up very badly. A small whiff of deflation will likely topple this portfolio.

China Inc. = Commodities Inc.

Hugh Hendry makes the controversial charge, denied by many commodity bulls, that China is pretty much gambling on commodities and doubling up on winning bets:

Is this not a reincarnation of the 1980 trade of the brothers Hunt? It is hardly an exaggeration to suggest that China, for all intents and purposes, is already the commodity market. For despite providing less than 8% of global GDP, China accounts for more than half of the world's steel production and more than half of global seaborne iron ore freight. Indeed, this peculiarity is circular in nature. Consider that a modern aluminium plant requires 25% of the project's cost to be spent on buying aluminium in the first place. And remember that investments in fixed capital formation (think new aluminium plants et al.) have made up 95% of Chinese GDP growth this year. China Inc. is Commodities Inc.

...

Surely, the Chinese stash of Treasuries is a prudent elimination of the fat tail risk that private sector deleveraging in the west ends up killing the golden goose of the trade surplus. But instead, in exercising good ol’ Texan tradition, they have opted, like the Hunt brothers did, to double up.

...

Despite their bubble never coming close to matching China’s prominence in industrial commodities, the loss of Japanese economic growth in the 1990s was nevertheless a major factor in the waterfall crash in commodities. This plunge ultimately saw oil trade for as little as $10 per barrel in the next decade. Just consider how much more devastating the experience would have been had they gone very long the commodity market in 1989 rather than golf courses and Rockefeller Centre. At least the Harvard endowment scheme did not share their enthusiasm for golf. But, this time around, I fear a Mort Subite beckons for the losers in Asia and the pension market.

All sorts of controversial views... I'm not sure what to say about these points.

I think Hugh Hendry needs stronger arguments. The anecdotal or specific examples about aluminum and steel may be misleading. Maybe there is overcapacity in aluminum but how about copper? Or oil? Or how about cement production?

If Hugh Hendry is reading this (I doubt it :( ), I would suggest that he dig up some information related to retail. I think the overcapacity in manufacturing is beaten to death but the question is whether retail consumers are buying any finished goods. There are all sorts of contradictory views out there—some say retail stores are empty and shutting down while others say they see strong consumption trends—and a good, contrarian, thinker like Hendry can probably dig up important insights.

Overall, I share similar views as Hugh Hendry. In the past, I have mentioned my concern with overcapacity in manufacturing and Hendry's points support that view. But I'm not as bearish as he is. Comparing China to the Hunt Brothers seems a bit extreme. The Hunt Brothers were speculators while China isn't quite a speculator like those two brothers.

Argument Against Bond Bears

My intellectual foes, on the other hand, are adamant that long duration government bonds are a short. I even hear that some Wall Street legends are so convinced of the argument made by the likes of Niall Ferguson that they personally own Treasury put options and are actively counselling others to do the same. The argument can be condensed into just two fears.

First, they will suggest that 4.5% is not an adequate return for lending your money to the profligate United States for 30 years. I agree wholeheartedly. Again, I fear it is my accent, but let me stress once more that I do not propose that anyone adopt a buy-and-hold policy for the next thirty years in bonds. However, a nominal rate of 4.5% might prove very profitable over the coming year should breakeven inflation expectations head south again.

Second, the bears contend, a lower Chinese trade surplus will eliminate a very large source of Treasury buyers at a time of burgeoning supply. Again, we find ourselves agreeing vigorously. However, it is our contention that US savings are heading north over the months and years to come. And an America that saves is an America that does not run a current account deficit. It is an American that can finance its own spending domestically. The US produced a small surplus back in the 1990-91 recession, so why not again?

Hugh Hendry goes on to elaborate on issue #2:

I have quoted Don Coxe's definition of a bull market before and I intend to do so again. “The most exciting returns are to be had from an asset class where those who know it best, love it least.” On this point, America has fallen out of love with its own currency and bond market. Foreigners own over half of the outstanding Treasury stock. But, like I said, I think events could reignite some of the natives’ old amour.

...

...where will the demand for all of this additional government debt come from? Let us review the Fed's Z1 numbers. The US has household wealth of some $67trn. Of that, $20trn is accounted for by real estate and is perhaps out of bounds for our purposes. But $8trn is held in the form of private pensions and insurance funds. And yet, remarkably, these institutions presently allocate just $630bn to Treasuries et al. Households have a further $22trn in time deposits and other financial assets. But again they own just $500bn of Treasuries, and commercial banks own a tiny $130bn or, 1% of their total asset base of $12trn.

Consider that in 1952, at the very end of the supernova bond bull market formed from the ashes of the Great Depression and the Liberty Bonds that financed the Second World War, US banks held 40% of their gross assets in Treasuries. That is a potential $5trn of demand from this one source alone, albeit spread out over a number of years. And again, the Japan experience lends support. Japanese financial institutions have quadrupled the percentage of their assets held in JGBs.

Furthermore, their households have lifted their government bond weightings five-fold over the last ten years. Should the same pattern repeat itself stateside, American households would need to buy another $2.5trn, but again, over ten years.

I have suggested similar thoughts in the past. In fact, anyone following the data would have seen how US households ratcheted up their savings over the year, and commercial bank holdings of US debt had either risen or held steady. I don't think financing the US deficits will be much of an issue.

On Economic Growth

Again, it all really comes down to your take on the ratio of total debt-to-GDP. If you believe, like I do, that it peaked in 2007 then the repercussions are enormous. The leverage does not necessarily have to come down (after peaking in 1932 at 300% it troughed 20 years later at 150%). Rather, it may well be that low interest rates allow the mountain of debt to continue to be serviced. This has been the Japanese experience to date. However, everything in our economic life exists at the margin, and the consequences of just maintaining the leverage constant would be a very low delta in nominal GDP growth. Consider that the Japanese, under these very circumstances, have managed to grow nominal GDP at just 1% compound since 1990.

I think Hugh is correct in speculating that debt-to-GDP may have peaked in 2007. The numerator, debt, likely peaked without any doubt in 2007 (recall that this was right before the massive markdowns of real estate and stocks.) The denominator, GDP, probably didn't hit a bottom in 2007 but probably did so in 2008. It is likely that the GDP will increase going forward (it has already risen in the last quarter) so the debt-to-gdp ratio will shrink.

USA is following the Japan strategy—they have no other choice—and, as Hugh Hendry suggests, the low rates will help immensely with paying down debt.

I think the outcome in USA is more optimistic than in Japan. Japan grew around 1% but this was with real estate and stock market bubbles that were far larger than in America (relative to their economy.) Also, Japanese businesses were never as flexible and dynamic as American businesses—say what you will about America but the best capitalists and business executives are still working in America. Finally, and most importantly, Japan entered a serious demographic decline during that time period whereas America won't. Given all that, I think we can add at least 1% more to GDP growth to end up with an overall GDP growth rate of 2%.

China & Its Overcapacity Problem

I'm not sure if I dig Hendry's writing style of switching between topics almost at will but the points cannot be ignored. He summarizes the oft-repeated overcapacity argument by China bears:

This [low GDP growth in USA and others] is why China's mad dash for commodities and its investment splurge this year is so worrying...The Chinese are building capacity to meet a world where US nominal GDP is $25trn in ten years time. I fear they could be in for a nasty shock.

Now with China having been on such an expansionary tear, it may not surprise you to hear that finished Chinese steel prices today trade below their production cost.
Furthermore, import license applications to sell steel in the US, the world's largest export market, rose 24% last month. Now, mostly this comes from Mexican and Korean producers, but clearly there is the implicit threat that their Chinese competitors might also be tempted.

...It is quite chilling to note that steel production in America is on a par with output back in 1938, when GDP was a mere 7% of its current size. The industry's run rate dropped to a paltry 13% during the Great Depression. However, output only troughed at its 1908 level; a twenty year retracement that is a far cry from our 70 year retracement. So the physical developments in the western steel markets should raise some concern. However, with an active steel futures market in China turning over $15bn a day (consult the Bloomberg page ), speculative fears concerning the dollar have overcome the paucity of industrial demand in the west.

Of course, it is not just steel. Consider the aluminium market. We recently had a very bearish meeting with the Norwegian company Norsk Hydro. Admittedly, their strong petro-currency does not help and you have to discount the solace I seek in finding people even more miserable than myself. Even so, the aluminium situation mimics that of steel, but with an even mightier inventory overhang. Four and a half million tons reside at the London Metal Exchange, perhaps 20% of world ex-China annual capacity. It is probable that 75% of this surplus stock is accounted for by financial players exploiting a contango.

I think the steel example is inconclusive and possibly erroneous. American steel production cannot be compared to the distant past. The reason is because most of the manufacturing has been permanently lost, especially in the 80's. So, the fact that steel declined to 30-year lows during the Great Depression, while it declined to 70-year lows during the current implosion doesn't surprise me and may not mean much.

The aluminum situation is a better example but these contango arbitrage trades, if true, are complicated and hard to figure out. I have no idea if the implication is bearish or bullish. Recall how oil was in contango late last year to early this year but has rise substancially since then.

Hendry also refers to this interesting video clip showing Vladimir Putin bossing around Depriska, the billionaire power player out of Russia:

Furthermore, the big Russian players like Rusal are under intense pressure from Putin not to cut capacity (check out ‘Putin bitch slaps Deripaska’ on http://www.youtube.com/watch?v=PprlM5R3Hbg), and are rumoured to be surviving only by not paying their electricity bills.

It's hard to tell if this is for show (i.e. propaganda) or something real; but whatever the case may be, it shows how powerful the politicians, particularly the inner circle of Putin, the Siloviki, are in Russia. What Putin does to Deripaska solves a political problem but turns it into an economic problem. The political problem, obviously, is that workers weren't paid salaries, were unemployed, and were revolting; but by forcing factories to be run at losses, it misallocates capital and wastes resources in the long run. There is no easy solution for these difficult problems.

Hugh Hendry's Core Argument

So I fall back on my old argument. It is perhaps too subtle, but at its core lies today’s most pertinent question. What if Bernanke, the Chinese, Putin, Obama, his Congress, and all the other interventionists, are simply impotent? What if they do not matter? Perhaps it is the debt, stupid. Perhaps the incremental GDP from all of this additional stimulus spending is zero. And, as Japan has foretold, perhaps all of this year’s interventions will be unable to lift the global economy from its funk. If this is so, you will not require all those inflation hedges; you have been sold a FAKE.

This parallels my feeling, although I'm not as critical as Hendry is.

We must also ask the opposite question. Namely, why are all the inflationists, including successful investors like John Paulson, David Einhorn, Jim Rogers, and so forth, spending hundreads of millions on the inflation bets? Have they actually fallen for the fakery?

Or are the deflationists wrong?

What keeps me from doing anything is my uneasy feeling that I am missing something...something critical.

Bearish Bet On Japan

In a new development (at least to me), Hendry bets against Japan. Instead of betting against the country, he chooses to bet against Tokyo Electric Power (TSE: 9501):

But first, it may require the spectacle of seeing Japan implode and so we have been actively positioning the Fund to profit from such a scenario. As many of you know, the fiscal situation in Japan is rapidly rising out of control.

Government tax receipts are down 14% over the last 12 months; government spending is twice the receipts and the trade surplus appears structurally impaired. We have to go back to 1991 to find the last time they ran a primary surplus sufficient to meet their national debt’s interest payments. Today they would need the equivalent of 4.4% of GDP. Failing this, and assuming they do not shorten the debt maturity of the JGBs that they sell to the public, then the ratio of public debt to GDP is guaranteed to rise further. It is currently 196% of GDP with the IMF estimating that it will rise to 234% by 2014.

This situation has not gone unnoticed. The sovereign dollar default swap has doubled to 75bps since August, and Japan is now themost expensive credit to insure against a dollar default in the G10. However, we have been active buyers of corporate debt default swaps. We find it remarkable that one can insure highly leveraged utilities at 23bps despite their considerable yen debt. Consider the Tokyo Electric Power Co. (9501 JP) with a market capitalisation of $32bn and net debt of $81bn. The debt is 7x EBITDA, the interest cover is 1.9x, and the average interest cost for now is thankfully just 1.9% p.a.

The Japanese government has been sensible in one area; two thirds of all their JGB issuance has been in maturities of ten years or more whereas the US has a skew to shorter dated issuance. However, it is probable that the public sector in Japan is crowding out the private sector from the long end, for whilst only 24% of the government debt is of 2-5 year maturity, the corresponding figure for the utility company is 57%. Furthermore, they are dependent on 70% of their debt being sourced from non-banking sources, i.e., from the market place. Clearly there are two prominent risks: debt rollover and higher interest rates. The “cheap” risk is a normalisation of interest rates brought about by a dearth of buyers at these levels. Should Tokyo Electric’s interest cost double to 4.6%, the company’s EBITDA-less-CAPEX would just cover the interest bill. What cost would credit underwriters insist for the CDS in this scenario?

We have a notional exposure representing almost 40% of the Fund’s NAV. It represents a large notional risk exposure with a quantifiable and manageable downside loss of just 9 bps of the Fund’s NAV every year for five years. However, the potential return to the Fund in the event of a default would be 23% of NAV, or 250x our annual outlay. Whilst we would still make 1% point of NAV should it trade in line with the sovereign credit risk, or 10x our annual cost. We might get rich but we certainly will not die tryin’.

I have a bad feeling about this position. If I'm not mistaken, Tokyo Electric is one of the largest power providers in Japan. I have a feeling that the government may bail them out if the utility runs into problems. Perhaps Hendry can sell the CDS after it rallies during a crisis but if he is forced to hold it until default, I can see him losing money. After all, several American banks were in far worse shape and would have gone bankrupt but they never did (due to government support.)

Portfolio Strategy

Hugh Hendry finishes off his lengthy, and somewhat confusing, letter by laying out his present strategy:

The above is typical of our portfolio today. Gone are the cavalier days of large gross exposures across multiple asset classes and large monthly volatility. Instead we own a basket of cheap sovereign and corporate default swaps and the asymmetry of interest rate option packages which enjoy high pay-offs should the enormous debt load of the private sector keep rates lower for longer.

Many value investors would probably consider the above to be gambling, but it is par for macro investors. I've actually been thinking of either buying the long bond ETF (TLT) or options on the ETF.