Barron's Interviews Hugh Hendry

Anyone that reads this blog knows I'm a fan of Hugh Hendry.

Eclectica's acquired a nice reputation among contrarian investors, thanks to some enviable results. The London-based Eclectica Asset Management saw a 12% return last year in its flagship Eclectica hedge fund, and an eye-popping 46% gain in a new fund that buys credit-default protection on Japanese corporations. Much owes to the relentless logic and cheeky inventiveness of Hugh Hendry, chief investment officer. The Glasgow-born Hendry tells Barron's why he expects a hard landing in China, and why hyperdeflation will precede hyperinflation.

Hugh Hendry of Eclectica talks about hyperdeflation, why China might have a hard landing, and his off-the-beaten tracks Japan plays.

Keeping an Eye on Wealth Creation

Barron's: What makes a great macro fund manager?
 
Hendry: First and foremost, an ability to establish a contentious premise outside the existing belief system, and have it go on and be adopted by the rest of the financial community. My great hero is [Caxton Associates' founder] Bruce Kovner, who was able to imagine the dollar falling to 100 yen—when the rate was 200. I am an existentialist. To my mind, the three most important principles when it comes to investing are Albert Camus' principles of ethics: God is dead, life is absurd and there are no rules. Of course, that's a doctrine of promoting the individual. You own your own decisions. As CIO of Eclectica, with $700 million [under management], I have no engagement with the sell side.

Where do you find yourself outside the existing belief system today?
 
In 2009, I made a YouTube video of the empty skyscrapers in Wuhan, China. Goldman Sachs and others articulate a very reasonable and compelling argument of being invested in China. With the evidence of my own eyes, I concluded that China had a very robust system of creating gross-domestic-product growth, but forsaking the creation of wealth.

When America was having its China moment in the 19th century, it occurred against the backdrop of a gold standard, a hard-money regime, with a public sector that was minuscule versus the overall size of the economy. As an entrepreneur, if your project failed to generate a sustainable level of cash flow, you failed.

China's great opportunity is taking place within the U.S. fiat system, and so the consequences are perhaps less stark than in 19th-century America, which had stops and starts and many depressions, though with an overarching prosperity. China has not had that volatility.

If you talk about a hard landing in China, you talk about GDP growth of 5%, not minus 5% or minus 15%. The Chinese government prints money. It can build superfast railways and overbuild airports, because the rest of the economy can subsidize it. China's swollen public sector is directing asset allocation, rather than pursuing profit maximization. They see [their system] as a success. But it creates a bubble, which can prove quite damaging.

You've already had a hard landing—in the Chinese stock market.
 
I should add something else that is contentious—U.S. quantitative easing [that eventually sent more money flowing to China], promoted because America had two sharp recessions and pursued orthodox policies, and had very little to show in the creation of jobs.


The policy was very successful. China now has inflation. Minimum wages have grown 20% annually for the past three years. This has encouraged the Chinese to tighten monetary policy. When you have bubbles and you tighten, bad things happen. China's stock and property markets are weak, a side-effect of quantitative easing. We may now have the pricking of the Chinese bubble. A year or two down the line, it could have enormous repercussions for the global economy.

How does one play it?
 
The world is very fearful of hyperinflation. Pension schemes have a preponderance of real assets, from forestry to gold to TIPS [Treasury inflation-protected securities], because they are very fearful. The road to hyperinflation is via hyperdeflation. That is why it's proving so difficult for hedge funds to make money. How does the rational mind that anticipates hyperinflation own 10-year government Treasuries yielding less than 2%? It can't. That's why people are struggling. To lay the seeds of hyperinflation, you need really, really bad things to happen. I thought the U.S. housing market having a massive crash would be hyperdeflationary. But then my Chinese friends pumped $1 trillion of credit into their $5 trillion economy, and created a global recovery, which has just come to an end. I'm speculating that hyperdeflation happens before hyperinflation. What's the worst that could happen? But the sum of all my fears would be China having a real hard landing of minus 5% or minus 10% GDP growth. If we had that—and Europe—the Fed would be printing $20 trillion, and I would have gold at $5,000. You can have a modest amount of gold, but you can't have all your assets in real assets, in case we get that hyperdeflation event.

That view would be consistent with interest rates staying low forever.
 
Last year, our fund made 12%, mostly from investing in the short end of interest-rate curves, on the presumption that rates will remain low forever. The risk premium in fixed income was huge, but the performance of global macro last year was quite disappointing. Most people understood Europe, but chose to bet on the euro being weak, which is a hard trade, because there's no risk premium or carry in foreign exchange.

This time last year, British interest rates were at a 300-year-low at 0.5%, and if you asked an investment bank to guess where rates would be in three years, it was betting above 4%. The figure today is more like 1.3%.

So how do you make money?
 
Would you believe that the AIG strategy of selling too much credit protection in risky assets like mortgage-backed securities is alive and booming today in Japan? It doesn't concern mortgages. It is credit-default swaps on individual Japanese corporations.

Do you seriously believe Japanese corporations are going to fail?
 
Clearly, they can and do go bust. I'm buying the CDS on investment-grade Japanese corporations because of the overpricing anomaly. Japan had a bust 20 years ago, and yet today the banking stocks, relative to [Japanese bourse] Topix, are making fresh lows.

If I'm a Japanese bank and I lend money to a new business, I get 1% on 10-year paper. Then the bank gets a call from me, and I'm willing to pay 50 basis points for five-year protection on this same company. So suddenly, the yield has gone from 1% to 1½%. Compare that to five-year Japanese government bonds, yielding 30 basis points. The bank thinks: This is a great trade! Japanese steel companies are investment-grade and won't go bankrupt. So, the bank gets this huge yen yield, and thinks it is not taking any risk. You'd better believe it will sell way too much of that good thing.

One of my partners told me about Japanese steel: Here is a country with no energy, no iron ore or coal, yet it's the largest exporter of steel in the world, exports half its output. To put that in context, China manufactures 700 million tons of steel and exports perhaps 30 million. Japan produces 110 million tons and exports 40 million. As long as Asia is strong, they are fine. But if Asia hiccups or reverses, plant-utilization rates go from very high to very, very low very quickly.

Then we discovered that Warren Buffett owned shares of South Korea's Posco [5490.S. Korea], and that Korea was the biggest importer of Japanese steel, but Posco and Hyundai [5380.S. Korea] are building huge, integrated steel plants. They have a surplus of steel capacity and—guess what?—they're exporting to Japan, because the yen is so strong.

Initially, I wanted to buy a three-year, out-of-the-money put on Nippon Steel. My broker said, "I've been in a 20-year bear market; my boss will kill me." Then I thought, being long credit protection is being long volatility. I redialed his credit counterpart. I said: "I'm thinking of purchasing up to a billion yen of five-year credit-default swaps in Nippon Steel." The first thing he said was, "Would you consider 10 billion?" So one part of the bank is banned from selling volatility, and the other part is having a party. I bought reams of the stuff.

In August 2010, we set up a stand-alone fund to buy this credit protection. You no longer pay 50 basis points, you pay 130 basis points. U.S. Steel credit protection is more like 650 basis points, because in America, people are cautious on selling protection on such volatile businesses. They don't share that worry in Japan. It could make them very, very vulnerable.

Any other potential disaster catalysts? 
 
Continuing yen appreciation; an exogenous shock—like a run on the Italian bond market; a slowdown in China; a sharp Asian recession. Japan is confronted by a European sovereign-type loss of confidence in the JGB market. We bought protection on steel names, and also on businesses with a huge sensitivity to the yen. I think the yen could soar from these levels [about 79 to the dollar] into the 60s, if not the 50s, with further dislocation in European sovereigns or a China hard landing.

From the early 1960s almost, Japan began recording current-account surpluses. Unlike Germany, it always invoiced in dollars.

So Japan is short its own currency, and has an enormous private-sector hoard of foreign assets. If the Nikkei falls, and your hedge and private-equity funds fall, pension funds in Tokyo will have fewer yen assets, but their liabilities will be the same. So they'd have to sell some overseas dollar assets and retrade them back to yen. If we have a series of bad events from China to Europe, that will express itself in a very strong yen rally.

What other names have you bought protection on?
 
Shipping companies, such as Mitsui OSK [9104.Japan]. The only place in the world one can buy credit protection on the shipping industry is Japan. These are very leveraged businesses, and there was overbuilding. We have protection in Nippon Sheet Glass [5202.Japan], which bought Pilkington. We have protection in trading companies like Sumitomo[8053.Japan] and Marubeni [8002.Japan]—companies leveraged, opaque and very geared to the global economy.

We've barely discussed Europe.
 
We are partly playing it through Japan. If events kick off again in Europe, the correlation across all [global] asset classes will go to one. So the steel CDS is 130 basis points, while to insure against default by the French government, I'd be paying the same amount. Which is riskier? A very leveraged steel company that can't tax you? Or a government that can? Our bearish bets are largely outside Europe. As for Greece, the end game will be the Greeks rejecting austerity. The euro is nothing but a gold standard lacking flexibility, and all the onus is on private citizens to take the pain. Eventually, a Greek politician will say, 'Vote for me, and I'll get us out of this system.'

What else do you own?
 
In the next 12 months, we'll see further pathological swings in investor sentiment. Despite my reservations, I'm modestly long equity-market futures, some nonindustrial commodities, and some bullish fixed-income positions. We are very bullish agricultural commodities and agricultural equities, and hold a global basket of businesses—with interests ranging from fertilizer to farm equipment.