I loved a Zero Hedge excerpt of Hugh Hendry’s letter to investors. Brilliant. Risk-on vs Risk-off, as the crucial choice in finance right now. I have carefully selected a few paragraphs.
“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 (Eclectica), 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 (for him), is that mankind clearly has the ability to suspend rational judgment long and often. …
What is one to do with such a situation? In my view there are really only two responses.”
The bearish response.-
“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… (Some) 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.”
The bullish proposition.-
“I (Hugh Hendry) have long thought of myself as one of the enlightened… 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 (so he says he has taken the blue pill). Look back on the last five years and I think that it is indisputable that mass injections of loose monetary policy have both fuelled 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.”
I am impressed with the clarity of thought underpinning the argument. As I would most likely do, after a representation of “La sonnambula” by María Callas, I can hardly temper the impulse to shout ¡¡¡¡ BRAVO !!!!!! And yet, I fully disagree with his judgment.
First. I have always said that mathematics has been rightly quoted as introducing not only “rigor”, but also “mortis”, in economics. I do not agree that we have to optimize the expected return on our portfolio, regardless of the shape of the bell curve representing the “normal distribution” of possible returns. Fat tails have to be considered when deciding. And tails denote morbid obesity right now. When I have to jeopardize the return of my capital (to a substantial degree), in order to enhance the return on my capital, I always leave the game. Invariably. Above a certain level, expected losses or gains, outweigh each other naturally in a normal distribution, but they don’t in my book of vital choices.
Second. The “blue pill” might be the right option, but I will never, ever, go for it. As Emiliano Zapata once said, “It is better to die on your feet than to live on your knees.” There is more to life than optimizing your well-being or survival options. Call me a Jesuit if you want, but I will always go for the red one. Serfdom to principles comes before serfdom to debt or performance. I respect other points of view.
Third. I loved his reasoning, but there is a clear inconsistency in it. If he asserts that it is not possible to say when the asset price bubbles will end in tears, how come he can be certain about the outlook for the year ahead. If you don’t know when, it could be a decade down the road, but it could also be tomorrow.
Fourth. I think he is not picking the best option for his clients (because his brainless clients are mostly unaware of this subtlety), but for himself. He needs performance to subsist in the industry, so he puts performance first, and all the other considerations behind. He is honest about it, a lot more than others who try to sell biased analysis of the underlying reality in order to sustain their businesses. Admittedly, he gives his customers what they want: performance at all costs.
So despite the harmony in our diagnosis, I think the only consistent policy available is to stand aside, because -agreed- you do not know when the meltdown is going to happen. And use patience (the new cool word in fedspeak). If you are a man, in the meantime you can enjoy playing with your nothing box. If you are female, do as James Montier suggests, listen to Winnie the Pooh, and do nothing!
My financial survival is highly more unlikely than his. In essence, our divergence is all about a well known aphorism: “the end (performance) justifies the means (the blue pill)”. To me, increasingly, it is the other way around, and “the means (the red pill) justify the end (a period of underperformance)”. As a rule, I am sure no end justifies the means. All my sympathy for Hendry nevertheless. He may be right, and he sure does not deceive his customers. You have to credit him with clear risk disclosure in this scripts.
In any case, unfortunately, the consequences of the previously described global financial situation are ample, and affect us in many ambits. The intrinsic value of our portfolio is one of them.
We live a financial world of junk, because most assets have no qualitative support at current prices. That specifically includes cash, because cash is inevitably held in a currency of choice, and fiat currencies are easily going to fluctuate 20-30% in the next couple of years. The Rouble is a case in point. Gold is also volatile, and not a stable source of value any more. ¿How junk are the currencies in your portfolio?
Back in May, I suggested the yen was junk (see my post “junk yen“). I also insisted that the euro was a failure:
“We will comment on the EURUSD in future posts. But let me say for now, that political commitment (and the political capital already invested) can delay the result for the euro, but sound economics always generates the road map. A currency is really a claim on an economy, “vía” the balance sheet of a central bank. As a medium of value and exchange it cannot be delinked from the underlying economy. There cannot be one claim on multiple economies, unless the currency is used in a way that some of them subordinate to others. Can subordination to German policy be sustained in the long run? Without major adjustments, the Euro is not a viable currency. For Europe it’s either full integration, or disintegration, or splitting the currency in at least two.”
Two junk currencies to begin with. ¿Any more junk currencies to be considered at this time? Any changes?
JPY. As I said at the time, the yen was, at those prices (101-102 vs the USD), the junkiest of the lot. Things have changed in the meantime, but not that much. Despite trading twenty percent lower today (120 vs the USD), their economic situation has not only not improved, but become increasingly more unstable.
The issue is: are all the negative factors weighing in the yen valuation, already incorporated to the price? It depends. In absolute terms, categorically not. The country is bankrupt, their accumulated debt being unsustainable. Interest rates are a farce (32bps yield for the 10 year bond). Trade is no longer a strength (see Wolfstreet chart), and their energy dependence is desperate (actual crude oil price developments will help them materially). Their enmity with the Chinese will not help their future either, nor will their population pyramid perspectives.
In relative terms, the same overview can yield different conclusions. The US may be the cleanest dirty shirt, but it is still filthy. PPP is a valuation tool after all, however long term it works about to be. The financial reality of the remainder of the fiat currencies is far from optimal, with few and rare exceptions (well protected against undesired appreciation by their respective central banks). So it is not about the JPY not being junk, but about the value of the other currency in the cross. I find it unrewarding to hold on to yen shorts at today’s market prices. The yen will be very volatile and can collapse much further, but the situation of the counterparties is far from optimal.
My conclusion for the yen is to “stand aside with a clearly short bias”. But no yen in my portfolio, until I see a bunch of macro numbers out of Japan that sound consistent and make some sense. And one day, in the not so distant future, the yen ten year future will be the mother of all shorts in history. Bide your time, yields are already below the 30 bps level. Amazing.
USD. The greenback is the actual market darling. Herding is as bad as ever, and now the word is out that the US will lead us all out of the GFC. Hope is great, but not a viable investment strategy. Hope in a strong revival of the US has gone “religious”. I am strongly supportive of the belief that the US is simply one year further down the road of the GFC, and its consequences. Their actual growth is the result of a competitive exchange rate due to QE (an advantage that dwindles every day), the energy sector (See chart by zero hedge. Shale states generated all the extra jobs for the last couple of years), and some animal spirits induced by krugmanite infected politics. Capex will be seriously impacted by crude oil price developments.
Stagnation will also reach the US, only later. Nobody will avoid stagnation as a final outcome, unless or until, debt overhang is taken care of.
Having said that, it is clear that I do not think the USD is a strong buy, or something to go for, “all in”. In fact, there is few ideas in finance I would go for “all in” right now. You do want to be on the long side of the USD crosses though, because there is very few other feasible options left. Together with the fact that herd behavior will probably intensify the reasonable comparative strength of the currency. In particular, the EUR mess might take the pair all the way to par. Yes, I said par. Bear in mind it will be a risky ride, as it always is in the final and highly volatile stages of a major market pricing upheaval. For the final tranche of the EURUSD re-pricing, I would only hold non-leveraged shorts.
EUR. There is just the one concept I would go for, “all in”, at this time. In fact I have been “all in” for what seems an eternity; “euro shorts”. Outright shorts. No volatility or similar plays. My picks have been:
- EURSEK. I sold a small to medium position at about 9.24 on average (so I am in the red). I plan to hold on to it. I see substantial value in this position with a medium term perspective
- EURUSD. I went full short, in size, years ago, made some big money, and then gave some back. I increased and leveraged further in June last year (see the post “reading this and long time short in EURUSD?”). I booked some profits, and brought the trade down to two thirds of my portfolio from 1.26 onwards (downwards). I’m still there. I will reduce further depending on developments, but will remain short the pair. Let us be mindful of the fact that the price has already factored in all the QE printing implicit in the target specified by Dragui.
- EURCHF (huge size short for a long time, and still there as I write). I wonder how long they can keep this up. Nothing to add to my June 2013 comments:
“At levels a touch below 1.22, I also think the EURCHF offers a good short entry point. Very little upside, and substantial downside potential. You just have to be patient. Some day, some time, the SNB will allow the swissie to slide gradually past the 1.20 floor. In the meantime I see a low risk entry. You can gear up on this one.”
The euro is an ugly experiment were everybody lost money, except Germany. But life is fair, and the money Germans made on the euro, will be lost in their loans to weak euro countries.
Talking about sloppy lending. Einstein was totally right when he underlined that the difference between genius and stupidity, was that the former had its limits. Just see the chart for the Spanish debt taken up by foreigners over the last two years. Spanish NFCs placed another 32 billion net issuance with foreigners. Insane financial behavior. The Spanish 10 year bond yields less than treasuries. Truly an accident waiting to happen.
We all lost with this crazy experiment. The euro is doomed. Your euros are also junk. I do not hold any euros in my portfolio. Play it light if holding euros.
THE REST OF THE FIAT CURRENCIES. I stand by my description of their flaw, as described back in May:
“The end of Bretton Woods, was “the end” of solid currencies, and the beginning of a truly fiat currency regime. The minute that central banks were independent, and could dimension their balance sheet at will, the value of the currency in their books became, to say the least, unclear. With the gold standard gone, the value of the currency became correlated only with the quantity and quality of the assets in the books of the central bank, and more indirectly, but finally, with the value of the underlying economy. …
… When currencies are left without a standard of value, the experience tends to end badly. Gold is gone, and we have not yet found a substitute. History says, sooner or later the doves take control of the central bank´s balance sheet, or engage in currency (beggar thy neighbor) wars. The reasoning is ever so simple: being a dove you exchange good short term macro policies, for unintended perverse long term consequences. A dovish policy sticker is a win-win proposition when trying to be nominated.”
Gold is not a reasonable alternative to me. For reasons I have described in past posts I coincide with Warren Buffet in considering it an inadequate store of value. So here we are, in a world of fiat currencies, with some junk currencies being the elephant in the room, but with the valuation of the rest not really substantially above the investment grade mark.
The perfect, no nonsense, portfolio, is 100% long in CHF, and holds only “triple A” non government bonds. An obvious practical impossibility. You can try to adapt it to generate some income (no income in CHF) and reduce SNB intervention risk, but that is your starting point before a debt meltdown. And even then, you always have to consider the risk that the SNB ends up inflating its balance sheet with junk fiat currencies in order to defend the peg. Maybe the Swiss economy is not junk, but their oversized central bank assets (in relative terms to their GDP) will have to be significantly marked down if they are not very careful. Oh yes, there is risk everywhere at this time. Nowhere to hide.
The red pill is an awful “trip”, but I want to be conscious, and with my eyes wide open, if the GFC is going to deprive me of most of my wealth. No blue pills. I will not be blindfolded, and want to see this massive debt cleanup -whether it knocks me out or not.
A positive note? We survived the end of the Babylonian empire, the Roman Empire, the Spanish (Castilian) dominance, the UK Commonwealth previous sovereignty, the Gorbachev USSR. Etc etc. We will survive this. But debt overhang will be cleaned up, one way or another.
Debt will be cleaned up. You can take my word for it. Gravity always beats levitation. How and when, I just don’t know, but it could be any day.