Friday, September 15, 2017

Are Markets or Hugh Hendry Wrong?

Zero Hedge posted a comment yesterday that caught my attention, "Markets Are Wrong": Hugh Hendry Shuts Down His Hedge Fund; Here Is His Farewell Letter:
In the beginning, Hugh Hendry was the consummate contrarian bear, which helped him make a killing a decade ago when everyone else was blowing up. Unfortunately for him, he did not realize just how far the central planners were willing to take their monetary experiment, so after the market troughed in 2009, he kept his bearish perspective, which cost him dearly in terms of missed gains and lost capital under management, until one day in November 2013, he capitulated and turned bullish, infamously saying "I cannot look at myself in the mirror; everything I have believed in I have had to reject. This environment only makes sense through the prism of trends."

Since then, the reborn Hendry who would never again fight central banks, gingerly made his way, earning his single digit P&L...(click on image)

.... even as many of his formerly loyal LPs deserted the former bear. It culminates with July and August, when Hendry posted some of his worst monthly returns on record which ultimately sealed his fate, and as he writes in a letter sent to investors today, Hendry decided to shut down his Eclectica hedge funds after 15 years, following a 9.8% YTD loss and massive redemptions, which left the fund which as recently as a few years ago managed billions with just $30.6 million as of August 31. As he best puts it "It wasn’t supposed to be like this."

The final P&L (click on image):

So what is Hendry's parting message to his investors and fans? Surprisingly, perhaps, he disavows the original Hugh Hendry, and goes out long (if not quite so strong). Below we repost his full final letter in its entirety, and wish Hendry good luck in his next endeavour.

CF Eclectica Absolute Macro Fund

Manager Commentary, September 2017

What if I was to tell you I wasn’t bearish on anything? Is that something you would be interested in?

It wasn’t supposed to be like this and it is especially frustrating as nothing much has gone wrong with the economy over the summer. If anything we feel more convinced that our thesis of a healing global economy is understated: for the first time in an age all parts of the world are enjoying synchronised economic momentum and I can’t see it ending for some time. It’s just that our substantial risk book became strongly correlated over the short term to the maelstrom of President Trump and the daily news bombs emanating from the Korean Peninsula; that and the increasing regulatory burden which makes it almost impossible to manage small pools of capital today. Like I said, it wasn’t supposed to be like this…

But let me bow out by sharing my team’s views. For the implications of a sustained bout of economic growth are good for you. It’s good because it should continue to underwrite a continuation in the positive performance of global equities. I would stay long. It’s also good because I can’t see interest rates rising abruptly to interrupt the upward path of equities. And commodities have already acknowledged the upturn in the fortunes of the global economy and are likely to trend higher still. That’s a lot of good news.

But it is bad news for me because funds like mine are required to demonstrate negative correlation with risk assets (when they go up like this I go down…), avoid large drawdowns and post consistent high risk adjusted returns.

Oh, and I forgot, macro fund clients don’t like us investing in the stock market for the understandable fear that we concentrate their already considerable risk undertaking. That proved to be an almighty puzzle for a fund like mine that has been proclaiming the stock market as a “safe-ish” bet ever since 2013.

Let me explain the “markets are wrong and we boom now” argument. To begin with, and for the sake of clarity, I think we have to carefully go back and deconstruct the volatile engagement between capital markets and central banks for the last ten years for an understanding of where we stand today.

The first die was cast by the central bankers in early 2009: having stared into the abyss of a deflationary spiral in 2008 the Fed and the BoE announced a radical new policy of bond purchases named Quantitative Easing. The bond market hated the idea as it was expected to cause a severe inflation problem.

Thankfully Bernanke, a student of the great depression knew better.

Markets primed themselves for inflation yet even with a ripping stock market in 2009/10 they were disappointed. QE rescued the financial system but the liquidity created was distributed to the very rich who have a very low monetary velocity and so the expected inflation fillip never materialised as the liquidity injection came to be stored rather than multiplied by the banking system.

Several years later, in 2013, the Fed suggested a reduction in the pace of its QE program. They wanted to tighten credit conditions gradually. However, capital markets beat them to it and the ensuing “taper tantrum” tightened monetary policy on their behalf. Within four months the market had taken 10 year treasuries from a yield of 1.6% to 2.9%, a move of far greater impact, and much more rapid, than anything the Fed had contemplated doing.

Markets initially thought the US could cope with this higher level of rates, but with a slowing economy, an unfortunately-timed oil price crash, and persistent ghosts in the machine (like the substantial Yuan devaluation fear which never materialised) they were proven wrong. Back then, with a 7.6% national unemployment rate and tepid wage inflation, this tightening always looked a little premature to us and so it proved with the rate of price inflation inevitably sliding lower to present levels.

And so last year, following many years of berating the Fed for its easy monetary policy regime, investors collectively threw in the towel. This rejection of the basic tenets of the business cycle by those who direct the huge pools of real money is proving particularly onerous to attack as it seems that the basic macro fund model is broken: there are just not enough “coins in them pirates’ chests” to challenge the navy of this flawed real money doctrine. Managers, and I must count myself in this camp, feel compromised by our poor absolute returns since 2012 and we find ourselves unable to put up much resistance to this FAKE NEWS.

Why should you fight it? Well let’s look at the last few times American unemployment dipped below 4.5% like today. I would largely ignore 2000 and 2006 when monetary policy was tightened and the economy buckled under the duress of the dramatic reversal in what had been credit fuelled misallocations of capital in the TMT and property sectors. No, for me 1965 is far more illuminating. Then, like today, there was no epic bubble or set of circumstances whose reversal could cause a slump; people forget but recessions don’t come out of thin air. No, in 1965, economic growth got choked by a tight labour market; a market as ominously tight as today’s.

In the middle of 1964, CPI core inflation was running at 1.7% and indeed dropped to just 1.2% in 1965; unemployment was 4.5%, the same as today. And yet by the end of 1966 inflation had essentially got out of control and didn’t dip below 2% again until 1995, almost 30 years later (click on image).

It seems to me that wage or cost push inflation is far more difficult to prevent and contain than asset price inflation. It tends to bear comparison with how Hemmingway described going broke: slow at first and then devastatingly quick. It may prove especially potent right now as the labour market is tight and there are no catalysts to generate a self-correcting US recession with both central bankers and markets now united in their desire for loose policy.

Look at the graph below, the unemployment rate (red) is at lows, job openings (blue) have increased beyond the hiring rate (teal) and are now approaching the unemployment rate for the first time since the Job Openings and Labor Turnover Survey data began. Ultimately robust GDP growth plus this labour tightness will lead to wage hikes and conceivably a self-sustaining inflationary cycle.

This is all the more ominous as the Fed has been reluctant to unwind its balance sheet. The largesse of this program fell to those already wealthy (“the global creditor”) and who had a low propensity to spend: financial markets boomed, less so the real economy. However the legacy of QE plus wage gains would turn this equation on its head. It would distribute incremental dollars to those with a much higher propensity to spend. The boost to monetary velocity from widespread wage increases would start to look much more like the helicopter money that Chairman Bernanke promised back in 2002 and subsequent central bankers dared not distribute.

The macro shock would not necessarily be the subsequent inflation but, that by waiting to respond until later, higher policy rates might fail in the first instance to induce a recession setting off a loop begetting higher and higher rates. Let me explain: companies will continue to employ staff, and with wages increasing, it is likely that sales will hold up and, depending on whether they achieve productivity gains or not, corporate profitability might also remain firm. So companies will commit to pay staff more whilst raising prices to meet higher wage and interest payment demands where possible. Like I said, wage or cost push inflation is a very different beast to contain.

I have to say that should this scenario unfold then capital markets will be as culpable as the Fed. This year, bond investors have aggressively flattened the US yield curve. The clear message is that 1.25% overnight rates threaten to pull the US economy into recession. I disagree. I think they are undermining the ability of the Federal Reserve to respond proactively; the Fed is simply not going to hike rates under such conditions having learnt the hard way back in 1999 and 2005. But what if such flatness has more to do with the commercial investment pressure brought on by QE rather than a genuine recession threat? Could it be that the bond market’s cautionary recessionary indicator is stuck flashing RED whilst the US economy goes from strength to strength? I fear so.

Clearly of course no one knows. However if an inflationary path like 1966 is gestating then I fear there is very little chance that anything timely will be done about it. Rate hikes will continue to be sparse, we only have one quarter point hike predicted between now and the end of 2019, which if fulfilled will be highly unlikely to spark a severe recession. Most likely the US economy will continue to grow and the labour market will tighten making a larger adjustment to rates in the future inevitable.

And so QE could conceivably end up doing what it was always supposed to do in the first place: find its way through the financial system to increase, not decrease, interest rates. This scenario would diminish greatly if bond curves steepened a lot now and gave the Fed the credibility to hike. Sadly I just don’t see this happening. They will steepen of course but I fear only after the virus of cost push inflation is released into the global hothouse.

This potentially leaves us in a strange environment. In the absence of any recognisable asset bubble set to burst, and the Fed grounded, the US economy is unlikely to slip into recession. China continues to rip. And now the European continent is recovering. Risk assets should continue to trend positively. And with the bond market, wrongly in my opinion, infatuated with the likelihood of an approaching US recession, the Treasury market is unlikely to move much. This is simply not a good time to offer a risk diversifying portfolio.

However, perhaps being long fixed income volatility isn’t such a bad idea. It has not been persistently lower than this for almost three decades. And unlike equity volatility it does not tend to trade in lengthy and definable regimes; it is never a great idea to go long equity volatility just because it happens to be low. The same cannot be said of its fixed income counterpart.

The collapse in volatility since 2012 seems to resonate with the drawn out process of QE in the US and its slow spread across the world. However that era is clearly now abating as this year’s synchronised global growth gradually shifts the debate from looseness to gradual global tightening. And yet fixed income volatility resides on the floor…

Looking at the one year implied volatility on 10 year swaps, the cost of entry seems reasonable even compared to the narrow trading range we have seen this year. That is unless you expect volatility to crash and the trading range to contract even further. With only one Fed hike priced in until the end of 2019 any further contractions are likely to be driven by outright recession. In that case volatility will rise across all asset classes. On the other hand, if our thesis is right, and the market and Fed are too complacent on inflationary pressures, then it is likely that we see more hikes from the Fed alongside yield curves steepening from their currently very low levels. Fixed income volatility will surge. When the status quo priced in is this boring, fixed income volatility really has only one direction it can go (click on image).

With inflation still weak and government bond prices unlikely to crack just yet it is too early to seek a short fixed income trade in disguise. In the past, correlations have, just like in the stock market, typically been negative between the price (SPX or Treasury) and the implied volatility (VIX or swaption vol.). Now however the correlation is mildly positive. So being long fixed income volatility is not necessarily the same as being short fixed income. My contention is simply that fixed income volatility has over shot to the downside, that such moments are fleeting and that you are not necessarily dependant on a correction in treasury prices (click on image).

Sadly I will be unable to participate with such trades during the next upheaval in global markets with the Fund but I hope that this commentary has at least roused you into contemplating scenarios that are presently deemed less plausible.

It remains only that I thank you for the great honour of having been responsible for managing your capital and to wish you all great financial fortune.

Hugh Hendry and team
Before I get to Hugh to explain in detail why HE is wrong, not the market, I almost fell off my chair laughing this morning when I saw Brian Romanchuk's (publisher of the Bond Economics blog) tweet this in reply to the Zero Hedge post I tweeted to my followers (click on image):

Brian is right, if you're charging 2 & 20, you better come up with something better than that!

Now, Hugh Hendry, no relation to the great econometrician at Oxford, David Hendry, always struck me as a bit of an arrogant, smug, quirky chap who admittedly was posting ok (not great) numbers and loved to hear himself speak about how he's right and the market is wrong.

I used to allocate to top hedge funds in the directional portfolio made up of L/S Equity, Global Macros, CTAs, Short Sellers and a few Funds of Hedge Funds. I did this a while ago (2002-2003) working under Mario Therrien's group at the Caisse.

I didn't stay long but I learned about constructing a portfolio of hedge funds, doing good due diligence, following up, adding and redeeming from managers and learned a lot from my discussions with all these managers.

The first thing I'm going to tell you, the market is never wrong, people who claim so are wrong. This doesn't just apply to Hugh, it applies to everyone from Steve Cohen, to George Soros, to Ray Dalio, to Ken Griffin, to Leo Kolivakis!!

Yes, I came out a couple of months ago with my top three macro conviction trades:
  1. Load up on US long bonds (TLT) as I see a US slowdown on the horizon, deflation headed to America, and the yield on the 10-year Treasury note plunging well below 1%.
  2. Start nibbling on the US dollar (UUP) and get ready for a major reversal of the downtrend as I still see deflation wreaking havoc in China, Europe and Japan and their economies are getting ready to roll over. This means their currencies will necessarily need to bear the brunt of this coming slowdown.
  3. Short oil (OIL), energy (XLE), metal and mining (XME), emerging markets shares (EEM) and short commodity indexes and currencies like the Canadian dollar (FXC).
I even shifted all my money out of biotech (XBI) into US long bonds two months ago, and even though bonds went up, the appreciation of the loonie took away all those gains and left me in the red (the Bank of Canada flirting with disaster only exacerbated the loonie's insane appreciation).

Still, I made money in the first half of the year trading small biotechs. And to my horror, one of them, Mirati Therapeutics (MRTX) which at one time I owned 5000 shares of at around $5, just popped HUGE this morning, up a whopping 150% at this writing on Friday morning (click on image):

I had bought it because one of the top biotech funds I track closely every quarter, Broadfin, took a big stake in it early in the year, as did Boxer Capital, a well-known activist investor.

Another small biotech stock that popped huge this week was Aldeyra Therapeutics (ALDX). The top institutional holder of that stock is Perceptive Advisors, one of the best biotech funds out there (they really impress me with their picks).

Honestly, I was kicking myself this week, asking myself WHY in God's name did I stop trading biotechs, why didn't I keep Warren Buffett's quote in mind: "The stock market is a device for transferring money from the impatient to the patient."

Then, I remembered, I had a terrible summer on the health front, was eventually diagnosed with Graves' disease which caused my hyperthyroidism, and this on top of dealing with Multiple Sclerosis  for twenty years. My thyroid completely screwed me up, was a lot weaker than normal, was ready to collapse after a few steps.

Luckily, it is treatable and I responded well to the medication (Tapazole) which I've been taking for a month. I'm still not 100 percent but I feel a lot better and my endocrinologist thinks I've had it for years and because of my MS diagnosis, I never got it checked out properly (always wrongly assumed symptoms were related to MS).

[Note: As an aside, to save on healthcare costs, the Quebec government doesn't include thyroid tests as part of a standard GP workup any longer because most people have a normal thyroid, but learn all you can about thyroid disease, especially if you're an older woman or are exhibiting unexplained weight gain or weight loss or many other symptoms, including depression or irritability.]

Now that I'm feeling better, I'm asking myself whether I should jump back in and start trading individual biotech names, take huge concentration risk, and roll the dice once more.

But I keep thinking about my macro concerns, and I ask myself whether it's worth the stress of living through huge 80%++ drawdowns that I lived through in the past, triple averaging down on Catalyst Pharmaceuticals (CPRX) before I got out of that name with a decent profit.

Traders will tell you, cut your losses quickly, never average down, and most of the time they are right. For example, look at the five-year chart of Mirati Therapeutics (MRTX) and you'll see those that bought at close to $50 a share and didn't average down, aren't rejoicing today's big pop (click on image):

Anyway, there is clearly A LOT of liquidity in this market which keeps driving risk assets higher and higher, but let me get back to Hugh Hendry's comment above.

Just like Ken Griffin, Hugh thinks there is too much complacency in the market and it's not discounting inflation risks properly. He even agrees with Alan Greenspan and others, that there's a bubble in bonds. Well, the Maestro is wrong on bonds, and so are Hugh and many others worried about the inflation boogeyman.

Go back to read my recent comment on deflation headed to the US, where once again, I highlighted the seven structural factors that lead me to believe we are headed for a prolonged period of debt deflation:
  1. The global jobs crisis: High structural unemployment, especially youth unemployment, and less and less good paying jobs with benefits.
  2. Demographic time bomb: A rapidly aging population means a lot more older people with little savings spending less.
  3. The global pension crisis: As more and more people retire in poverty, they will spend less to stimulate economic activity. Moreover, the shift out of defined-benefit plans to defined-contribution plans is exacerbating pension poverty and is deflationary. Read more about this in my comments on the $400 trillion pension time bomb and the pension storm cometh. Any way you slice it, the global pension crisis is deflationary and bond friendly.
  4. Excessive private and public debt: Rising government and consumer debt levels are constraining public finances and consumer spending.
  5. Rising inequality: Hedge fund gurus cannot appreciate this because they live in an alternate universe, but widespread and rising inequality is deflationary as it constrains aggregate demand. The pension crisis will exacerbate inequality and keep a lid on inflationary pressures for a very long time.
  6. Globalization: Capital is free to move around the world in search of better opportunities but labor isn't. Offshoring manufacturing and service sector jobs to countries with lower wages increases corporate profits but exacerbates inequality.
  7. Technological shifts: Think about Amazon, Uber, Priceline, AI, robotics, and other technological shifts that lower prices and destroy more jobs than they create.
These are the seven structural factors I keep referring to when I warn investors to temper their growth forecasts and to prepare for global deflation.

Hugh can cry foul all he wants about FAKE NEWS and central banks tampering with markets but the reality is he and many other hedge fund gurus have been on the wrong side of the baffling mystery of inflation deflation.

Worse still, he married into this position and failed to manage his downside risk. Period. You can be right but if you forget that markets can stay irrational longer than you can stay solvent, you're dead!

I'm going to share another story with you. Back in June 2003, Mario Therrien and I went to some hedge fund conference in Geneva. I didn't like the conference but afterward, we hooked up with two global macro managers we wanted to meet, Ravinder "Ravi" Mehra and Jesus Saa Requejo who were there for their annual medical checkup.

At the time, Ravi and Jesus were running Vega Asset Management, a large global macro fund that was growing by leaps and bounds. You can read all about them here and here.

One of my concerns was the fund was a marketing machine but I liked their risk management and thought they were worth an allocation. Right after Geneva, Mario and I flew to Madrid to visit their offices (I love that city and was saddened to learn about the terrorist attacks this summer).

But I remember at the dinner with Ravi and Jesus in Geneva, something irked me about their short US Treasuries view. Jesus was convinced rates couldn't go lower and even told me "deflation is impossible in the US where helicopter drops can occur".

At the time, we were wondering whether to allocate $50 million to them but I recommended cutting it in half. While I liked them and their fund, the marketing of the fund and their short Treasuries view bugged me. They made money the subsequent years, grew to $12+ billion in assets under management, but the fund eventually got hit and then had to close to new investors to claw its way back in 2007 after devastating losses.

I lost touch with Ravi and Jesus but the point I'm making is nobody is infallible, the market is always right until it breaks down, and if you don't have deep pockets to ride it out when it's going against you, you will die (all you young bucks should read When Genius Failed, one of my favorite books on this subject).

Below, Andrew Ross Sorkin sits down with billionaire Ray Dalio of Bridgewater Associates, the world’s largest hedge fund, to discuss tax reform, leadership and the wealth gap.

Earlier this week, I said it's time we look beyond Bridgewater's culture and principles, sharing my skepticism on "radical transparency".

But there's no denying Ray Dalio is a macro god one of the few who has been able to weather the macro storm that has hit many other macro gods. He's also built a great company and even though I have profound disagreements with some of his Principles and what I feel is radically transparent marketing nonsense, I have tremendous respect for the man and the shop he has built over decades.

I'll end by sharing one final story with you, one I've shared a few times before.

Back in late 2003 or early 2004, after I had moved over to PSP, I took a trip with Gordon Fyfe who was just getting the lay of the land as PSP's new CEO back then. We went to meet peers and funds. I had invested in Bridgewater in 2003 while at the Caisse, so we went there and got meet Ray Dalio and his senior team (only reason Ray was present was Gordon was there and PSP was a great potential client).

During the meeting, after Ray gave us his talk about how great Bridgewater's All Weather portfolio is, I started pressing him hard on the US housing market going into bubble territory, and the very real threat of deflation down the road.

We had a good exchange but I obviously got under his skin because at one point, he looked annoyed and blurted: "What's your track record?". The look on the sales guys next to him was a look of horror.

I left that meeting with my testicles stuffed in my mouth and Gordon Fyfe kept teasing all the way to the airport and for the remainder of that trip: "What's your track record?"

But the truth is I really enjoyed that and many other exchanges I had with top hedge fund managers and wasn't paid money to coddle anyone, including Ray and Gordon.

Ray is right, markets are very tough to call, taking contrarian and concentrated bets is how to make big money but when you're wrong, it can kill you, which is why All Weather takes an agnostic approach to the market environment.

Hugh Hendry discovered this the hard way. You can listen to his recent Macrovoices  podcast below but keep in mind my macro comments above.

One last thing, I highly recommend all my institutional readers subscribe to  the great market research at Cornerstone Macro. Francois Trahan and Michael Kantrowitz posted a replay of their conference call which is an absolute must watch as they explain why big downward economic revisions are coming in the US, and now is the time to be defensive.

I think they're right but I'm going back to looking at the biotech melt-up I didn't participate in (ARGH!). Hope you enjoyed reading this comment, and please remember to donate and/or subscribe to this blog via PayPal under my picture on the right-hand side (view web version on you cell).

I thank all of you who support my blog, it's greatly appreciated, but please keep me in mind for full-time employment and/ or contract work. As my health improves, I think I'm ready to get back into the daily grind but I will need your support, at least initially until I get back in the swing of things.

No comments:

Post a Comment