Hugh Hendry: How We Learned To Sop Worrying And Love ” the Brexit bomb”VW Staff
Hugh Hendry's Eclectica Fund commentary for the month of July 2016.
“This is not how I woke up
But it's how I look now
If you leave with me
We'll be on till morn
Then we rinse and repeat
And it just goes on”
I did not see Brexit coming, but my team and I were prepared for it nonetheless and the Fund has responded favourably with a bounce in the final days of June.
Surprisingly, the five stages of my own mental anguish (denial, anger, bargaining, depression and acceptance) passed rather quickly; it only required a weekend of reflection to allow us to take stock and enter July with a positive disposition towards our risk book, invigorated by the expanded opportunity set to make money.
Put simply, prior to Brexit, we believed that the Fund had a high probability of making a modest return. But now with the UK set to follow a divergent and unexpected economic policy, certain scenarios ranging from the questionable viability of the euro to the prospect of a major economy rejecting fiscal balance to pursue an expansionary fiscal policy and the likelihood that other nations will copycat this policy in the future no longer appear so extreme. It feels like we have returned to the dysfunctional logicality that reigned prior to the crash of 2008: if you think the future is inflation, prepare to profit now from the deflationary-like catalysts. For the latter scenarios appear the most likely within our investment time horizon.
Our current enthusiasm for our book therefore is predicated on the notion that our investable universe has just expanded greatly as certain events have moved from the uninvestable shadows of tail-like probability into the realms of investable profit opportunities. This has enabled us to expand our risk taking meaning that the Fund, in our view, now also has a reasonable probability of making rather a lot of money.
First, however, let me explain a curious historical precedent which, if I adopt my mantra from an earlier report, allowed us to stop worrying about the present and learn to love the Brexit bomb. For it may be that having spectacularly failed to anticipate the outcome on the 23rd of June the markets may be just as wrong with their revised forecasts of what this means for Britain and Europe.
Hugh Hendry – The Invergordon Rebellion
Founded in the 16th century, the Royal Navy doesn’t do mutiny. However the events which took place on the west coast of Scotland in mid-September 1931 came perilously close. Returning from manoeuvres at sea, the sailors were horrified to read in the newspapers that their wages were being cut yet again, this time by as much as 25%. Enraged, they refused orders to take the fleet back to sea. The stand-off lasted 48 hours but this was long enough to turn the tide of confidence against sterling. For when the news filtered back to London it destroyed the market's prevailing belief that the politicians of the day could credibly pursue further austerity measures and so, after six long and miserable years, Britain came to reject a fixed exchange rate regime, the Gold Standard, and the pound fell 25%. Plus ca change..?
The new policy regime, haphazardly shaped from the emotions of anger and resentment, flew in the face of accepted economic wisdom. It was immediately deemed by the commentariat to be a tragic mistake. The economy would crash and London's financial centre was doomed. Again, sound familiar..?
Of course we know that things got better. For shorn of the cult of austerity, and riding on the crest of a huge stimulus delivered by the currency devaluation, the British economy recovered quickly. To quote a common refrain from the time, nobody told us we could do that, and yet within two years most other countries had adopted the same policy.
We have discussed this period of history previously. It persuaded us not to wager on a euro break up too early back in 2011 when markets questioned the resolve of Greece to remain. The UK generations earlier, and Italy since the passing of the lira, have grimly and with some resolve trudged through the economic sludge of a decade or more with no growth in nominal GDP. This seems to demonstrate that people can be stoic and hardy as long as they feel hope that their standard of living might improve. And so five years ago, and with a likely economic recovery imminent, it felt too early to radically challenge the perception of prosperity; the system was safe.
Today however, following Britain's announced departure, the equation has changed. Previously with 28 members and no history of exit the system's gravitational pull was immense. But it was vulnerable to just one defector weakening the system. This is where we are now. We believe that the UK has the upper hand. Political commentators may be in revolt, but the combination of higher gilt prices and the sharp drop in sterling mean that the British need not fear the passage of time.
Recall that there were 45 member countries committed to the gold standard prior to the UK’s departure in 1931 but just 12 by 1933. How many of the remaining 27 European member countries will there be in 2018?
The modern EU has always seemed quixotic. On the one hand we have the wistful and laudable romanticism of the principle of the free movement of people between member states. On the other, an avowed German inspired obedience to the tenants of “hard” money much beloved by the architects of the gold standard. It was always questionable just how long this curious mix would last.
Ultimately, the failure to quickly recapitalise the region's banks in the aftermath of the 2008 financial crisis and this year’s passing of the Bank Recovery and Resolution Directive insisting on creditor bail-ins to resolve further banking recaps, have succeeded in systematically breaking the credit system in a manner which is beyond the power of generous monetary policy provisions from the ECB to resolve. Combined with the perception of an unlimited supply of semiskilled labour from Eastern Europe the system suddenly swung violently in a direction which in my mind resonates with the hopeless and forlorn plight of the UK's return to the gold standard in April 1925. Both were destined to fail. However, today feels more like 1931: a beginning, not the end.
The UK will, in our opinion, endure a recession. By rejecting an infinitively expandable and flexible labour force, the majority of the UK’s voting population has rejected the previous source of GDP growth. Income expansion can no longer come from expanding the number of people in work. Prospective economic growth now only has one realistic source: productivity gains. The boost to competitiveness from the sliding pound will help but ultimately productivity and GDP growth will require higher public and private investment. The later seems unlikely for now and hence the likelihood of a recession but in time a pivot to fiscal expansion will likely moderate and perhaps transform the outcome.
Uncertainty in the short term is therefore understandable yet it seems that markets are likely to make peace with this more nuanced reality far sooner than the political pundits. Just as the wisdom of the crowds led the way and more rational minds were forced to follow in the vote, the markets will undoubtedly confound the many in the weeks and months to come. It is an investment environment ripe for barbell strategies.
Resting on a bed of nitroglycerine?
Amidst today’s hysteria concerning the drop in sterling, people forget that the pound dropped 36% in the wake of the collapse of Northern Rock in 2007 and by 15% in 2014 on fears of a triple dip recession, and the world didn’t come to an end. Again, plus ca change…it appears that the prevailing glut of global liquidity seems to act as a shock absorber; the money simply has to go somewhere, typically sovereign bonds and bond like equity proxies.
This has featured regularly in our recent commentaries. The incessant move lower in bond yields has dumbfounded the “Ring of Fire” prophecies of another great crash and in the process shifted the economic landscape perceptibly in favour of debtors and away from creditors. With prospective returns on sovereign western debt seemingly eviscerated, the global economy, perhaps with the UK now in the vanguard, seems to be heading towards a more stable equilibrium between the risk takers and the bankers.
So what happens next? The dominant probability favours the status quo: sovereign bond prices continue to grind higher, equity bond proxies continue to outperform the wider stock market, German stocks continue to outperform those in noncore European bourses and US equities likewise continue to outperform the rest of the world as both are boosted by having to import monetary policy conducive to supporting the dangers that lurk below the surface in large economies such as Italy and China.
We believe that we are well represented with this benign view of the financial world with significant holdings in German property and our European pharmaceutical and telecom stock baskets which, if I commit a gross injustice to the intellectual capital that formed our opinion in the first place, we can label as bond like proxies; likewise our Japanese equity strategies. All have performed well in the aftermath of last month’s shock. We also have a sizeable fixed income position where we receive rates at the short end of the Mexican and Swedish rate curves and also in 10-year gilts. Our Mexican rates position, the largest of the three, would in our view profit handsomely from the prevailing consensus of rates lower (forever).
However, our intrigue surfaces from the notion that we might see a core European country defect from the euro system and seek to emulate Brexit. Previously I viewed this as an improbably low possibility and therefore un-investable. However, to quote Bob Dylan, “times they are a changing” and our revised probability set has encouraged us to take a significant long position in the spread of Italian 10-year bond futures versus their German equivalent.
Back in 2007 the market priced in an almost zero probability of such a scenario and the spread traded as low as 30bps. In 2011 the clear and present danger of Greece leaving the system repriced the spread to 550bps. My interpretation is therefore that a 10% probability revision in favour of euro membership stability seems to move this spread by 100bps. Today it trades around 130bps. If the market were to again revise higher its probability of further instability in the euro towards its presumption back in 2011 then our position would imply a 16% of NAV profit potential, compared with a 4% of NAV loss should the probability revert back to a tail like scenario.
However, since the ECB reverted to looser policy the spread has failed to trade lower than 100bps and this constitutes our stop loss. And so we believe we have an inherently asymmetric risk opportunity that could certainly lose us the best part of 2% of NAV (including carry) but might make us 16% of NAV. In addition, our largest current risk exposure is actually to the less convex dollar so further disturbances which erode confidence in the euro would add to the book’s potential to make money. Remarkably, or so it seems, these markets allow for the potential of some outsized gains should probabilities continue to be reset with the fallout from the UK’s departure; we believe they will. For the flexible macro manager, this is our time.
Hugh Hendry, George Lee, Tom Roderick
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