Sub­mit­ted by Brett of Con­trary Investing

Hugh Hendry Chan­nels Irony and Para­dox in His Lat­est Finan­cial Outlook

Yes­ter­day I had the great honor and oppor­tu­nity to sit court­side for a live one-hour pre­sen­ta­tion from our favorite con­trar­ian, irrev­er­ent hedge fund man­ager – Hugh Hendry him­self.  What a thrill!

Hendry, as you may know, is part­ner and Chief Invest­ment Offi­cer at Eclec­tica Asset Man­age­ment.  While his claims to fame are numer­ous, his two most notable (for those get­ting to know him for the first time) are:

1. A 31.2% *pos­i­tive* return in 2008
2. Some truly hys­ter­i­cal TV clips (See: Hugh  Hendry’s Great­est Hits for four min­utes of finan­cial bliss)

Hendry is a big favorite of ours at ContraryInvesting.com.  I also just learned that he was “The Plas­ticine Macro Chap­ter” inter­viewed (at the time) anony­mously by Steven Drobny in his excel­lent recent book Invis­i­ble Hands: Top Hedge Fund Traders on Bub­bles, Crashes, and Real Money – which pro­files a select group of hedge fund man­agers (all “off the record”) that made money in 2008.  I went back and re-read this chap­ter the night before Hendry’s pre­sen­ta­tion, to re-familiarize myself with his investing/trading philosophy.

Hendry elec­tri­fies his Sacra­mento audience.

The Power of Irony and Paradox

Rather than try­ing to com­pete pure “intellect-for-intellect” with the likes of George Soros, Julian Robert­son, and the other great minds of the hedge fund world, Henry instead relies upon what he calls “the power of irony and para­dox” to foil the log­i­cally minded and deliver his supe­rior returns.

In other words, he bets on strange events hap­pen­ing – those not antic­i­pated by the mainstream.

This strat­egy paid off in a big way in 2008, when his out-of-the-money options hit big, and his fund returned 31.2%.  It has tended to under­per­form, though, when (to para­phrase Hendry) “bad stuff doesn’t hap­pen.”  For­tu­nately for Eclec­tica investors, he sees a bad moon ris­ing once again.

Why China is Not 19th Cen­tury America

While many eco­nomic observers have drawn an anal­ogy between China's ongo­ing indus­tri­al­iza­tion and that of America’s, Hendry sees a crit­i­cal difference.

In the US, he says, cap­i­tal has always been allo­cated where it could achieve the high­est return.  In the 19th cen­tury, when Amer­ica was the eco­nomic upstart on the block, it was also on the gold stan­dard.  Which is very impor­tant, accord­ing to Hendry, because it allot­ted entre­pre­neurs one – and only one – chance to suc­ceed.  It was not a time of bailouts and mul­ti­ple bankruptcies!

China is dif­fer­ent, he believes, because it is indus­tri­al­iz­ing with a fiat cur­rency.  Thus they fall into the trap of mis­al­lo­cat­ing cap­i­tal – build­ing bridges to nowhere, tow­ers for nobody, and so on.  China’s goal is sim­i­lar to that of 1980’s Japan in his opin­ion – full employ­ment, rather than max­i­miz­ing return on cap­i­tal.  A crit­i­cal, and even fatal, dif­fer­ence, in his mind.

The New Model for the Global Economy

You know the old drill – China and Asia pro­duce, the US con­sumes.  They cycle their green­backs back over this way, finance our debt, we buy more of their stuff, and the beat goes on.

This model offi­cially stopped with the launch of QE2, Hendry says, as the US offi­cially started reject­ing the glob­al­iza­tion that had made the global econ­omy hum (per­haps largely at the expense of US employ­ment and man­u­fac­tur­ing).  With QE2, dol­lars were printed and exported – along with infla­tion – to Asia.

This led to the coun­tries in Asia – and Europe, too – rais­ing rates to com­bat infla­tion.  The result, he says, is that global eco­nomic growth has essen­tially ground to a halt.

So what’s next?

A crash, of course.

Europe’s Debt Spi­ral­ing Out of Control

Hendry then pulled up a chart of US and Europe non-financial debt to GDP, illus­trat­ing that Europe’s debt has been spi­ral­ing out of con­trol ever since the for­ma­tion of the Euro­pean Union.

Par­tic­i­pant nations, he puts it, received ini­tial “ALT-A” rates – nice low Ger­man inter­est rates – for sign­ing on.  But the fixed exchange rate that the euro imposes on the periph­eral nations started the time bomb ticking.

Hendry, in fact, is very down on fixed exchange rates, and believes the euro and the dollar/renminbi peg are at the heart of global eco­nomic inse­cu­rity today.

He believes the recent ref­er­en­dum in Greece could be a very sig­nif­i­cant event, liken­ing it to a 1931 mutiny in Eng­land that forced the Brits off the gold stan­dard.  He things the Greek ref­er­en­dum could be the trig­ger to dis­en­gage from their fixed exchanged rate (and cited everyone’s lack of antic­i­pa­tion for the ref­er­en­dum as a clas­sic exam­ple of irony in finance).

Stage Not Yet Set for Hyper­in­fla­tion and Gold $3000

The high CPI num­bers being reported in the UK and other West­ern nations are “mean­ing­less”, Hendry says, because in today’s eco­nomic envi­ron­ment, it does not trans­late into wage growth.  (In the 1970’s, it did).

Because wage labor is approx­i­mately 70% of total busi­ness costs, he does not see mean­ing­ful infla­tion with­out wage inflation.

He’s also down on gold because it is not a con­trar­ian invest­ment today as it was 10 years ago (he had a nice year in 2003 buy­ing gold and gold stocks when nobody wanted them).

The wide­spread belief among the great­est finan­cial minds today that hyper­in­fla­tion is inevitable greatly dis­turbs him.

In the West­ern world, he sees hyper­in­fla­tion as a polit­i­cal choice – one that requires the will of the pop­u­lous.  (For­get Zim­babwe, he says – that might as well be Tim­buktu.  It’s not our culture.)

He sees society’s cur­rent mood as “dark” (Tea Party, Occupy Wall Street, and social unrest in Europe to name a few), and believes this makes bailouts and money print­ing very hard.  The only envi­ron­ment that makes hyper­in­fla­tion pos­si­ble is “the mother of all depres­sions” he says.

In keep­ing with his antic­i­pa­tion of para­dox, he quipped that if you believe in hyper­in­fla­tion, then you should be lev­ered up long on 10 and 30-year Treasuries…because in order for hyper­in­fla­tion to become a polit­i­cal real­ity, defla­tion must arrive first.

2012 Eco­nomic Out­look and Invest­ment Positions

Of the many places Hendry doesn’t want to be long, China is near or at the top of the list.  He thinks China could be sub­ject to a 25% (!) decline in GDP over the next five years.

How is that possible?

He draws an inter­est­ing anal­ogy: “UK GDP fell 8% in the Great Depres­sion, while US GDP fell 25%.”  Infer­ring, of course, that today’s China is the upstart US to our cur­rent “UK peak empire” role.

In what he calls “the great unwind­ing”, the strongest economies in the world are also – iron­i­cally – the most vulnerable.

But that doesn’t mean he’s bull­ish on the devel­oped world, either.  He has an aver­sion to just about everything.

“It’s check­mate.  Every­where it’s checkmate.”

He believes Italy is insol­vent, cit­ing their huge bor­row­ing binge over the last ten years that has only achieved 0% growth.

He loves Japan – as a cul­ture and place to visit – but is espe­cially bear­ish on sev­eral Japan­ese sec­tors.  He’s long credit default swaps with respect to cycli­cal, lever­aged Japan­ese busi­nesses.  He’s also bear­ish on Japan­ese util­i­ties, which have issued tremen­dous amounts of debt since the Fukushima disaster.

Hendry’s favorite sacred belief – which he’s bet­ting against, of course – is the fact that no one believes the ECB will ever cut rates below 1%.

He’s made bets that he says will deliver a 40-to-1 return if the ECB cuts rates below 1% next year.

Big thanks to the CFA Soci­ety of Sacra­mento for host­ing the event, and to my pal Jonathan Led­erer for land­ing Hugh and let­ting me crash the event as his guest!

Read more from the author/contributor here.

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