Risk Latte - History can Repeat Itself with a Vengeance

History can Repeat Itself with a Vengeance

Aditya Rana
May 23, 2010

Yet great news letter from the maverick, and always thought provoking, hedge fund manager Hugh Hendry who runs the Eclectica fund out of London. Hugh Hendry has an uncanny ability to spot market changing events well in advance of the multitude – to highlight a few of his notable successes: he anticipated the financial crisis early and 2008 was his best year- he was up over 50% in just the month of October 2008, he foresaw the European sovereign crisis two years ago and is likely to have done rather well in recent months, and lastly-he correctly anticipated the deflationary trend in the developed world and has profited well from central bank monetary easing policies. While you might not like what he says (there is no diplomacy here!) but it would pay to listen carefully to what he says!

To briefly summarise his views:

  • The dollar is likely to have formed a bottom over the last few months ending a historic decline which began in 2001, leading to further monetary tightening in china which in turn could presage a host of difficulties down the road –and this will be a repeat of similar patterns in history – “little is ever new in the world of finance. The public has a euphoric desire to forget”-J.K. Galbraith, 1929.

  • “Water doesn’t boil if its heated to 99 degrees, but it will boil if it is heated by one more degree”- vice commerce Minster Zhong Shan who made this statement in the context of the less than 2% margins of Chinese exporters and their vulnerability to a yuan appreciation.

  • The sharp dollar depreciation after the plaza accord in 1985 fuelled the boom of the Asian tigers, and the subsequent appreciation of the dollar in the mid-nineties directly led to the Asian crisis as dollar liquidity was withdrawn from the Asean economies.

  • China produces GDP growth without per capita wealth creation – which is analogous to a cocktail party without the cocktails; what’s the point?!

  • An economic reversal in china will have especially ominous repercussions in japan – which has a trillion dollar foreign exchange reserve hoard to support massive domestic liabilities making Japan effectively short its own currency (and thereby replicating the hedge fund carry trade).

  • An unforeseen event like a slump in Chinese growth causing a fall in the price of its overseas assets, will trigger a significant demand for yen to cover this loss leading to sharp yen appreciation which would destroy its export industry.

  • China’s current reliance on exports to create resources to fund its industrialisation is a pattern repeated by other countries before - most notably Japan during WWI when its export industry got a huge boost from allied war demand and from the removal of warring European nations as competitors.

  • China’s transformational event came with its entrance into WTO in 2001, and the coincident easy monetary policy pursed by the fed to tackle the fallout of the burst of the internet bubble causing lower interest rates and excessive leverage which fuelled the demand for Chinese goods.

  • Japan suffered a lost decade in the 1920s, as it continued to invest in overcapacity even though demand for its exports slumped as ww1 ended and European nations became more competitive after the end of ww1.

  • China seems to be repeating Japan’s mistake by continuing to invest in its overcapacity and with only 7% of world GDP it now has 30% of global aluminium consumption, 47% of global steel consumption and 40% of global copper consumption.

  • The goal of economic policy should be to maximise the household sector’s reoccurring income as evidenced by high levels of consumption to GDP - the lack of consumption in china , which has fallen from 45% of GDP 10 years ago to a current 35%, is the principle cause of concern.

  • The household sector in china, has and continues to provide an enormous subsidy to banks and the manufacturing sector through artificially held low interest rates and rolling over of bad loans.

  • At some point the world will be confronted with a hyperinflationary event allowing sovereign debts to be repaid, but only after a deep deflationary event which will provide the legitimacy for such extreme action.

  • To take advantage of the two game changing events - a slump in Chinese growth and a sudden sharp appreciation of the yen, he is shorting the credits of a portfolio of global industrial cyclical businesses in the U.S., Europe and Japan with high leverage and overdependence on Asia and commodities.

  • This position should do well even if china succeeds, and continues to generate high GDP growth rates of 8-10% and increase its overcapacity, as this group of Corporates are unlikely to survive the continued supply of cheap goods from china.

  • Te also finds corn to be vastly undervalued, with a wide discrepancy between local Chinese and world prices, as china has entered the global grain and corn markets for the first time in a decade to fill the domestic shortfall caused by severe recent droughts in the country – despite rosy agricultural data (like the economic data!) released by the government!

This is an absolutely fascinating piece, particularly the parallels drawn with the Japan experience in the 1920s (and not the late 80s which others have done!) and the linkage between previous periods of dollar depreciation (causing booms) and appreciation (causing crises). So in some sense, its not really about hard work and sacrifice driving national booms (as we would all like to believe!) but its more about changes in macro economic variables (like currencies and rates) and the generosity of strangers (i.e. buying your goods) which really triggers national booms! coming to think of it, i am hard pressed to find a single example of a country which has experienced a sustained economic boom without a burgeoning export sector (if you know of examples please forward them to me-with supporting reliable data!).

While I agree with Hendry’s analysis, as I have mentioned previously, we are unlikely to get a big slump in china’s growth for a while. What we are likely to see are range trading markets for 3-5 years, with periodic crises being met with significant government bailouts causing cyclical bull markets followed by sharp reversals. This process will eventually cause “the mother of all crises” likely triggered by a developed sovereign debt restructuring and the commencement of a period of high inflation and currency devaluations. This period will likely coincide with a write down of china’s overcapacity, eventually ushering in the commencement of a new global bull market (in 2016?). So the best way to play these markets is to trade the ranges, but with a cautious stance as downside risks abound.

Turning our attention to current markets we note that while the outlook is uncertain I don’t think this is the anticipated 20-30% correction which is more likely to occur later in the year - probably triggered by either a surprisingly low 3rd quarter GDP number in early October or renewed mortgage credit concerns in the u.s.. i have taken some profits on my treasury and gold holdings given their large recent moves, and actually went long euro as the sentiment is excessively bearish.

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