Hugh Hendry And The “Blue Pill”

Distorted Markets

We have always liked Eclectica fund manager Hugh Hendry for his sound views and outspoken manner. Below is a somewhat dated video compilation showing several moments in which he stunned his opponents in television debates by voicing uncomfortable and politically incorrect truths. Included in the video is a defense of speculators, entrepreneurs and other risk takers in the marketplace against statist interventionists and “champagne socialists”, which we wholeheartedly agree with. Speculators have a bad name, mainly because they always serve as a convenient scapegoat for politicians (in fact, speculators and merchants have served as scapegoats whenever economic policy failures became apparent since at least the time of the Roman empire). However, they fulfill an extremely important function, as Mr. Hendry points out to his debate opponents.

A few excerpts from televised debates with Hugh Hendry

Mr. Hendry runs the Eclectica Fund and in recent quarters has frequently stressed that being contrarian has been a losing bet over the past few years (there are a few notable exceptions to this, see further below), while investors and fund managers relying blindly on the “money illusion” provided by central bank interventions have done quite well.

This is undeniably true. A prime example of what absurdities have become possible is shown below. The chart shows the 10-year JGB yield; Japan’s monthly annualized CPI rate of change over the past year is also shown, as an inset in the chart. The red rectangle outlines the time period over which these CPI readings were reported. At no point over the past year was Japan’s CPI not at least more than twice as high as the 10-year JGB yield. Even if one disregards the fact that CPI has been boosted due to a sales tax hike in April, current JGB yields make no sense. Prior to the sales tax hike, CPI fluctuated between 1.4% to 1.6% annualized, or 1.5% on average. This would still be almost five times the current 10-year yield of 0.31%.

In past “reflation” attempts by the BoJ, investors tended to drive up JGB yields concurrently with stock prices. Reported CPI figures also happened to increase slightly on these occasions. Investors consequently demanded higher yields. However, nowadays the BoJ has “become the JGB market”. It is such a big buyer, that no-one dares to oppose it anymore. After all, it has theoretically unlimited amounts of money at its disposal, since it creates them with the push of a button. Trading volume in the JGB market has completely dried up. Shorting JGBs is still the “widow-maker trade” – for now, anyway.

10 year JGB yields since 2006 and Japan’s CPI rate of change over the past year (the period corresponding to the red rectangle) , click to enlarge.

We are mentioning all this not to pick specifically on Japan’s policy makers (most others are by no means better), but mainly to confirm that Hugh Hendry does have a point. The prices of financial assets have been and continue to be massively distorted by loose monetary policy, and fighting these trends, no matter how absurd they appeared, has hitherto been a losing game.

The Fund Manager Conundrum

As we recall, Hugh Hendry mentioned in one of the Eclectica Fund’s previous reports that he has not only fully embraced the trends set into motion by central bank policy, but that he has also altered his short term tactics, by becoming more tolerant of short term losses. This was done because in recent years, every short term decline in the stock market was immediately recouped, so that “stop loss” strategies resulted in selling of long positions at exactly the wrong moment.

Zerohedge has recently reported on Mr. Hendry’s commentary accompanying the fund’s most recent results. These results were quite good, confirming that the current strategy works well, or at least that it has worked well in the most recent reporting period. Here are a few selected excerpts:

“There are times when an investor has no choice but to behave as though he believes in things that don’t necessarily exist. For us, that means being willing to be long risk assets in the full knowledge of two things: that those assets may have no qualitative support; and second, that this is all going to end painfully. The good news is that mankind clearly has the ability to suspend rational judgment long and often.

[…]

However since Draghi spoke, the role of market Disneyland has increasingly been taken on by the equity and fixed income markets. So the S&P has massively outperformed what has proven to be a tepid recovery in nominal GDP and a global real economy that is beset by deflation; just this month, European swaps contracts began to price in near term deflation. Yet equity markets are ignoring that reality in favor of the idea that the deflationary fallout from the collapse in the oil price will almost certainly mean even more monetary accommodation. The worse the reality of the economy becomes, the more we take on the reflexive belief in further and dramatic monetary expansion and the more attractive the stock market looks.

What is one to do with such a situation? In my view there are really only two responses. On one hand we have today’s bears. Remember the film The Matrix? Morpheus offered Neo the choice of two pills – blue, to forget about the Matrix and continue to live in the world of illusion, or red, to live in the painful world of reality. They, as the “enlightened”, chose red, and so are convinced that they understand everything which has become illusory about today’s markets. Their truth is Austrian economics. They know that today’s central bankers are spinning a falsehood of recovery; they steadfastly refuse to be suckered in by the euphoria of a monetary boom; and they are convinced that they will therefore be spared the consequences of the inevitable crash. Everyone else, currently drugged by the virtual simulation of prosperity and its acolyte QE, will be destroyed, leaving them alone, to re-invest when markets finally get cheap. They will once again be masters of the universe.

This sounds good. Really good. I have long thought of myself as one of the enlightened. My much thumbed copy of Kindelberger’s Manias, Panics and Crashes aided and abetted my thinking as I correctly anticipated and monetised profits from the crisis of 2008 for example. But it isn’t always good. Kindelberger has been absolutely detrimental to my investment performance for the last six years and as a result I have changed. I still believe that the attempt by central bankers to prevent the private sector from deleveraging via a non-stop parade of asset price bubbles will end in tears. But I no longer think that anyone can say when. Look back on the last five years and I think that it is indisputable that mass injections of loose monetary policy have both fueled asset prices and staved off further crisis. I am also absolutely persuaded that the global economy remains so fragile that modern monetary interventions are likely to persist, if not accelerate. They will therefore continue to overwhelm all qualitative factors in determining the course for stock prices in the year ahead.

So I have come to embrace the French philosopher Baudrillard’s insight. “Truth is what we should rid ourselves of as fast as possible and pass it on to somebody else,” he wrote. “As with illness, it’s the only way to be cured of it. He who hangs on to truth has lost.” The economic truth of today no longer offers me much solace; I am taking the blue pills now. In the long run we will come to rue the central bank actions of today. But today there is no serious stimulus programme that our Disney markets will not consider to be successful. Markets can be no more long term than politics and we have no recourse but to put up with the environment that gives us; the modern market is effectively Keynesian with an Austrian tail.