In the final part of Hugh Hendry's 3-part (part 1 and part 2 here) interview with MoneyWeek's Merryn Somerset Webb the sanguine Scot, perhaps surprisingly to some given his previous negativity - though fitting with his world view of fiat currency destruction - believes "to bet against China or Chinese equities, or the Chinese currency is to bet against the omnipotence of central banks. One day that will be the right trade, just not ready or sure that that is the right trade today."
Merryn Somerset Webb: That brings us, I guess, to China. You were one of the first to point out the native problems in China. Your rather amazing video wandering around empty housing estates, etc, which I think was pretty well watched. What’s your view now?
Hugh Hendry: I think my view would surprise you. Before I surprise you, I would like to seek legitimacy of my view by telling you that I have made money. It’s been my most successful profit centre in the year to date, and we’ve made over 5% trading in China-related macro themes. In terms of surprising you, I am more sanguine about China. Actually I’ve been rather impressed by their policy responses over the last two years.
When I look at China, China has got two components. It’s got this manic investment gross capital formation and in something which has been deepening these global deflationary fears, because they kept expanding over capacity industries such as cement and steel and undermining prices in the rest of the world. That in itself lowers these inflation figures below Central Bank targets. It becomes reflexive and then the central bank says “Crikey, I’ve got to be radical here. I’ve got to buy equities”. So there’s been that going on.
On the other hand, there’s been a robbing Peter to pay Paul, and China’s had a decade which has been very, very similar to that of the US in the 1920s. The US, people forget this, but Liaquat Ahamed – I’ve just destroyed his name, forgive me, but the Lords of Finance author – I reread it recently and I was very taken by the notion of how mean the Fed had been in the 1920s.
Again, I say it to you with cathartic crisis, the response of the rest of the world is to be long dollars invested in America and that was certainly the case in the 1920s. But America was recovering nicely from the Great War and it had this incredible productivity revolution. There was great demand for credit and so it was fine on its own.
But the rules of the gold standard meant that, as Europe pushed all this easy credit to America via the manifestation of these gold bonds, the US growth should have been even more intense. But the Federal Reserve had a moral obligation, as part of the game of the gold standard, to let loose that gold into the economy via bank lending. It didn’t. It was very, very ‘hard money’ doctrinarian and it withdrew that gold and it buried it deep in the vaults.
It’s never really been reflected upon. Because we just know that America boomed. The argument is it should have boomed even more, and if it had done so with even greater ferocity, and this is counter-factual, Niall Ferguson will kill me, but…
Merryn: It’s all right. He’s not here.
Hugh: …but if it had, then perhaps it could have resuscitated, especially poor old England or Britain, which had got on the gold standard in 1925. A desperately poor moment. It would have given it the rationale that you went on for the rules and the other guy, the big guy who didn’t play the rule, he got squashed. So counter-factual. And, I think it would have created more price inflation. So the US race would have spent a decade on the floor, and asset prices, they would still have bubbled, but I think the bubble would have been earlier and it could have been dealt with. Counter-factual.
Merryn: We’ll never know about that. But how is that connected to China?
Hugh: So the meanness… China’s had a very similar decade where such were the huge returns on investment on offer because land prices are low, labour’s low. You can borrow money. The currency’s cheap, so you wanted to manufacture. You want to have business in China. So the rest of the world en masse, it’s like that gold transfer from the 20s, this time there’s going to be a fiat money in institutional portfolio allocations into China. So China should have boomed.
Yes, it did. It boomed. But it should have boomed even more. Rather than growing at 10%, it should have been 20%. I’m making these figures up. The reason it didn’t was that they, as I said, they rob Peter to pay Paul and they took the great bounty of the productivity leap that their household sector, their workers were achieving, they got paid more. But they should have got paid way more and their currency appreciated, but it should have appreciated way more.
And they’ve got negative interest rates when they put this hard-earned capital back into this system. So they got screwed, if you will, on three fronts. As a result consumption declined. It didn’t decline because they were just more cautious and these incredible Asians that just want to save. Nonsense. Their income got constrained versus its capability. So consumption incredibly lowers the potential GDP and this manic deflationary Capex boom, very high. The last three years it looks as if they’ve sought to challenge them.
The bullish take on China is this 35% of DP, through proper husbandry, that could continue to expand 10% per annum. That underwrites a 4% floor to the Chinese economy if you do the maths. So how would you do that? Well, you would take away these negative interest rates. Tick, they’ve done that. Either in the misfortunate means of the higher risk from these wealth management products, but with these internet platforms offering money market rates.
So there is a movement. The currency has appreciated, much to the chagrin of those at the beginning of the year who said, “Well, it’s going to devalue” and they’re going to tell you that it’s going to devalue.
On the currency, again valuations, fugazi, pugazi. When I look at it, I see an economy where the urban population’s fully employed. I don’t see an inflation problem and it seems to be able to compete in the world and it’s finely balanced. So is the currency overvalued, undervalued? It’s kind of close to fair value, yeah. We’re long in the currency usually.
Lastly, just on that, wages. Wages have grown at a tear. So the consumer is enjoying a dramatic relative improvement in its lot. I think that’s one argument that doesn’t get a mention. So the notion of a Chinese devaluation would be exactly the wrong policy. Because, of course, you would then be killing the household sector again. The goose that could lay the golden egg has to be cherished, and it needs a rising currency, I would argue.
Merryn: But you’re assuming that the correct policy will be followed.
Hugh: Well, it has been to date. That they haven’t panicked and gone into that crazy splurge in 2009-2011, they haven’t done that. Then the other point with China it’s a bit like the US It’s had its excess. The problem in the US was it was felt intently with the private banking system which went bankrupt. But, and this is not counter-factual, what if you owned, what if the state is the banking sector? Does it have a Minsky moment? I’d say it doesn’t.
So the whole game with Fed QE was to underwrite the collateral values, to keep the credit system moving. So it aimed its fire at mortgage obligations more than Treasuries. The whole deal with LTROs in Europe has been again when investors at volume banks at 40%-60% discounts to asset volume, the central bank’s coming in and saying, “Actually we’ll buy it from you at full value or something higher. So we are going to endorse the collateral of your assets.”
In China it’s the same deal. They’re fiat currency and they can get away with this. So to bet against China or Chinese equities, or the Chinese currency is to bet against the omnipotence of central banks. One day that will be the right trade, just not ready or sure that that is the right trade today.
Merryn: So yes, what are your China trades now? This is a technical trade, but we have been paying interest rates in the offshore market.
Hugh: So interest rates, the Chinese currency for many, many years has appreciated at an incredibly un-volatile manner. So you’ve been able to borrow money very, very cheaply by going long with CNH. Then through surreptitious means, such as the over-collateralising of bills of credit, or using commodities. But, through guile, if you can take that cheap money and get it onshore, then you can invest in a wealth management product from the guy down the street at 15%.
So it costs you, it costs the capitalists 1%. It’s 15% when you go to pay it back in a year’s time your liability’s been diminished because it was the biggest, biggest carry trade of all time.
Our argument was, you know, China, still has this insatiable desire and indeed requirement for capital. It needs money. So it made sense as we looked at it at the beginning of the year. They had to form a legitimate bridge to tap this cheap money that was residing offshore and bring it, through a legitimate manner, onshore. And if you can do so and the latest incarnation of that would be this ‘Connect’ scheme, between the Shanghai and the Hong Kong markets.
But they’ve also developed enterprise zones where you can do that free exchange from the offshore to the onshore and a host of other developments. The net result of that is that you would get a rates convergence and a great, great macro trade of 15-20 years ago was the European rates convergence. They were very high in the periphery and you’d come down to the centre.
There was a notion that these very low rates in China offshore would come up to the levels that prevailed domestically. That’s pretty much come to pass. We’ve made money from that trade. But why we’ve especially liked it, is that because you’re paying rates, if I’m wrong with my sanguine take on where China is today and there truly is a liquidity crisis and a banking crisis, what do you get? You get these shy bodies inter market rates. They shoot up, and the liquidity gets withdrawn from the offshore market. I’m paying those rates, so if they go up… I made a lot of money.
Merryn: So the trade works either way.
Hugh: Either way. Which is, really if we started this conversation define what makes it either macro or a good macro it’s finding trades of that nature.
Merryn: Okay. And other trades in China?
Hugh: Well, I guess the other prominent trade… Well, we have the currency. The currency we are in the grips of evaluating whether we are moving onto this, a new bull market for dollars and clearly the sensitivities, as we discussed on the renminbi. We’re long the renminbi via options, and again because vol was so low, I can get a big exposure. But should it be that the dollar begins to precede the crisis, the renminbi we can turn that into vol trade and vol is very low. So if you were to get an event… I don’t think you’ll get an event.
But if China was to have the misfortune of Korea or Thailand, etc, in the late 1990s and you had a 40%-50% devaluation, the volatility would go from like 2.50% to 82%, you’d just make a fortune. So we can tailor… so we have that. We don’t think that’s going to happen and we think the most likely path is the currency appreciates. But we can rapidly adjust it, if that view changes and suddenly there’s this huge vol and we’re protected.
Merryn: It’s another trade that works both ways really.
Hugh: Yeah. And then the last trade which works only one way is that if we are correct in our notion that the terms of trade are dramatically improving for the Chinese household sector. Then what’s your closest proximity to the household spending bonanza in China and it’s the Internet giants. So we’re in long the Baidus and Tencents of this world, we just think, and again, valuations are high, but the growth rates are high.
Merryn: It’s another area where you don’t care about the valuations at the moment.
Hugh: Not at this moment. No.
Merryn: OK. Tell me what your favourite of all those trades are? Not just the Chinese ones, every one. Everyone has a most loved trade and a most loved market.
Hugh: I don’t. That’s a hard question.
Merryn: Okay. Let me turn it round. What would make you saddest if it failed?
Hugh: I deal with failure all the time. Failure is part and parcel, it’s moving on from failure. What would make me saddest and again it’s this notion of good hedge funds is that you never fear that the consequences of your risk taking. You don’t fear the consequences of being wrong. And such is the way we put our book together that’s the space I am in.
So I struggle to answer the question because a failure for me is not being contentious. It’s not being actively engaged because if you can put it together properly in your portfolio, who cares if you’re wrong? It’s boring. Move on to the next. There’s always another trade.
Merryn: There’s always another trade. Thank you, Hugh.
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The thoughtful, wordy Scot has given investors a lot of contrarian food for thought so we figured a re-reading of his "throw in the towel" letter to investors would be worthwhile...
To date, the experiment with economic growth in Asia has succeeded as an almost direct result of the re-leveraging of the American economy since interest rates began to fall in the early 1980s.
The Japanese authorities blazed a trail on this for everyone to follow. It kicked off with (yet) another credit cycle gone wrong. In the 1970s there was a bubble in lending to Latin American governments. That was popped by Paul Volker's tightening of US monetary policy. Latin American currencies tumbled and sound currencies soared. Except the yen. Japan had a central plan for economic self-sufficiency - one that required a positive current account and endless rounds of domestically funded investment. They did not want a strong currency, low cost imported goods and a consumer boom or anything else that might have risked future trade deficits. So they worked to keep the yen from appreciating too fast, too soon. How? The Bank of Japan created yen and bought Treasuries. This money found its way into the local banking system (as new money does) where it was soon turbo-boosted by foreign capital inflows: overseas investors were attracted by the corporate profits produced from the loose policy and pretty pleased with the way in which a persistently undervalued exchange rate made asset prices cheap to foreign investors. Chuck in fractional reserve banking, and risk-seeking bankers and it was inevitable that asset prices would surge. The rest is history. Equity prices, ignoring all qualitative objections to bubble valuations, quadrupled. Then they crashed.
First Japan. Now China.
To understand today's story we have to leave Japan (reluctantly — we'll come back to it), and travel 20 years later to China, where the same pattern has been repeating itself.
Just be long. Pretty much anything.
So here's how I understand things now that I am no longer the last bear standing. You should buy equities if you believe many European banks and their sovereign paymasters are insolvent. You should buy shares if you put a higher probability than your peers on the odds of a European democracy rejecting the euro over the course of the next few years. You should be long risk assets if you believe China will have lowered its growth rate from 7% to nearer 5% over the course of the next two years. You should be long US equities if you are worried about the failure of Washington to address its fiscal deficits. And you should buy Japanese assets if you fear that Abenomics will fail to restore the fortunes of Japan (which it probably won't). Hey this is easy...
And then it crashed
I have not completely lost my senses of course. Eclectica remain strong believers in the most powerful force in the universe - compounding positive returns - and avoiding large losses is crucial to achieving this.
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