the Merryn Somerset Webb interview se China and prepare for hyperinflation Hugh Hendry, co-founder of Eclectica Asset Management and hedge-fund manager ofthe Eclectica Fund, taks to our editor in chief about why the consensus view on China is wrong and what this means for investors. Going to see most fund ‘managers is a straightforward alfa You elas building and announce yourself ro a receptionist who signs you inand sts you down. ‘You flick through the FT until the fund manager appears and ushers you into his smart meeting room (oval rable, ten chairs, mid-grade art on the walls). You admire the view. You get a coffee. You chuck out a question or two and the fund ‘manager tells you all about how the West has had its day; how emerging markets are where the action is; and how he uses a mixture of special valuation methods to pick his stocks. Making sure, of course, that wherever they are listed they have ‘good exposure to China, You nod a lot. ‘Then you get shown out. You go back to your own office (no meeting room, no coffee, no view) and that is that ‘Not so with Hugh Hendry. For starters, Ihe doesn’t have the right kind of office. Ie just off Queensway in Bayswater (kind of “Think of China as you would fashion chain Next in the 1980s” behind Ann Summers) and while chere is receptionist she just waves you vaguely towards a grubby seties of staircases that lead you to Hugh's very white very open-plan office. When I arrived there last week, Hugh wasn't in. So Thad a coke and read the Evening Standard. It wasn’t quite the same. China and nuterackers Buc with Hugh the differences really show when he starts talking, He arrived in a rush, sat down and said that che big debates in the markers are really just like the “nurcrackers”. The nnutcrackers? Ie turns out he is talking about an incident 40 years ago when just 30 MoxtyWeex 28 May 2010 before a performance at Amsterdam's Concertgebouw, a group of radical young ‘musicians interrupted proceedings by taking nies with nucractern bicycle horns. The idea being to denounce the orchestra as a status symbol oF the ruling elite. When he talks about China, High feels like he is banging nuterackers atthe financial elite (of which he absolutely denies being a member ~ he sees himself as more ofa “pirate”) and their cosy consensus of 10% growth extrapolated forever He doesn’t se China as the saviour of, slobal growth. Far from it. Think of ‘China as you would have fashion chain "Next back in ghe 1980s, he says. Next was seeing “parabolic growth”. By the ‘end of the decade there were “two or three Next stores on every high street, you were falling over them”. Revenue growth was growing. Bur the marginal return on investment “was collapsing” Now look at China — it’s gor the parabolic growth and rising GDP, but no one seems ‘concerned about the marginal return on investment. They should be. Look at che high-speed ral inks. They sound good ~ who woulda’t wane to link the prosperous coastal areas of China to the miserably poor? Bat can it really be a good use of capital? No, says Hugh. You may be “shuffling people backwards and forwards at over 200km an hour”, but the people in question are peasants on $1,000 a year, So the productivity expahsion from that investment I suspect is zero.” How to profit from the impossible Ona recent tip to Japan, every investor Rogh mer told hit that a major fallin Chinese growth was very unlikely; falling GDP was “impossible”. He liked that a lot. Before the subprime esis, Hugh spent lots of time tling people (inluding other members ofthe MoneyWeek roundtable, and hence our readers) chat the US housing market was going to crash ~ big time, Everyone said it was “impossible”. Hugh went on to make “a great sum of money” from its impossibility. He thinks hell do the same from the impossibility of collapse in China. Where others see endless growth, he sees “dramatic hubris” and over-expansion. Where others see ‘government firmly in control, he ees a disastrous mixture of operational leverage and financial leverage. China should be pulling back from everything, as consumers in its major markets do the same, But it s gearing up instead They could get away with it, say, if we are ina classic V-shaped recovery from recession, and demand from the US returns t0 pre-2007 levels reasonably fast. ‘You have to be careful suggesting that ‘you might disagree with Hugh ~ this is the man who told Liam Halligan on CNBC that he clearly had his head “lodged somewhere” and who told a presenter on the same programme that he was a “silly rman” who should “wash his mouth out with soap” for suggesting thac anything in ‘modern markets isa “screaming buy”. Luckily, Hugh is prety confident that Pmas pessimistic on markets as he is. So he just points out that if it were a Veshaped recovery, they would. Buti isn’t = something chat ha implications for China”, already one of the world’s worst-performing markets this yeat. No governments are currently able ‘profoundly serious to boost spending, so the “only means for GDP to be sustained” at even current ‘ww moneyweek.com The dragon cant dance fo+e heading bak to his ir levels of growth is forthe private sector ro ccome back and take on more leverage. But “there is ust no evidence of that” Instead unemployment is high, pay is static, at best, and thete's every sign that the ‘recovery’ in GDP is nothing’more than a rebuilding of run-down inventories. Sure, fund managers are talking to lots of fiems claiming that everything is “going sgangbusters”. But that tells you nothing. Imagine, says Hugh, that you'd gone to the same firms in early 2009. Then they would have told you their businesses were “falling off a cliff. Instead, they had a ‘great year. The upshot? “I don’t really see that asa source of wisdom for directing my portfolio.” Meaningless valuation measures The reality is that wih public and private debe levels having peaked, the “deflation genie is out ofthe bot... and bad things happen to equities when deflation is out there So no new bull market then? Hugh doesn’ quite tell me to wash my mouth out But he does make it clear that the general public need to think dhrough its expectations of investment returns. Back in 1974, the Dow Jones had halved in two years to 475 In 2008 i peaked at 14,700. That's a 30-fold increase. “That's the South Sea bubble,” says Hugh [But the days when it was perfectly reasonable to expect 10% a year forever are long gone. So much so that if anyone offered you 5% of 6% a year guaranteed wow moneyweek com the Merryn Somerset Webb interview you'd wane to jump on it. And as for valuations? Meaningless. Fund managers ‘go on about stocks being cheap based on book value. But “just before a business goes bust, do you know what... it's a5 cheap as it has ever been”, And valuing, things with ple ratios is a nonsense too, ‘Why? Because the price of a market isn’t about value and it isn’t about growth, “The eal “calibrator of turning points” is social mood. “Stocks trade at incredibly low valuations when the social mood is unforgiving and at very high valuations ‘vengeance. Anyone feeling forgiving about finance at the moment? Quite. (Odds are that from here on, equities just ‘get “cheap, cheap, cheaper”. ‘The story ends with hyperinflation T want to know what che end game i. T keep asking people this, but it isn't easy to get clear answers, Except, of course from Hiugh. From day one, he says his story has Been thatthe final outcome will be hyperinflation, He ses the cursent deflationary shock deepening and then creating “the politcal legitimacy wo go nuclear with hyperiflason” via the Printing presses T agree. But what's the timescale? “The past is certainly no longer now and the present is simply the now that flows from the past tothe future,” says Hugh. That doesn’t realy help, I say. Ir turns out that what Hugh means is that hyperinflation {is some time off. The US President doesn’t press the nuclear burton as soon as the ‘missle leaves Tehran. He waits until its i US airspace and al interventions from space stations have failed. Then having sven up hope, he presses the button. Central banks are much the same~ they'll (Who is Hugh Hendry? led 100 fell by 31%. “Buy the largest and safest stocks. Think when he social mood Nestlé and Unilever” investment manager B first non-Oxbridge recruits. He went on to jin Credit Suisse before making his name st leading hedge-fund group Odey ‘Asset Management. In 2005 he lett to form Eclectica Asset Management wit former Odey partners. His hedge fund, the Eclectica Fund, returned more then 30% in 2008, while the FTSE have to have given up hope (as Chi blows up, for example) before they get their printing presses into real overtime, That said there is a possible way out ~ ‘one I have to say [had never thought of. China could simply write off che Western debe represented by their “huge pools of foreign exchange reserves” (China has S3tmn). Why would they do that? Several reasons, says Hugh, but mainly because US debt is a “subprime asset” that the Chinese can't do such with as i stands, But write it off is forgiving.” Bull and at a stroke markets are about they will have forgiveness and bear markets are about secured the “health and vitality” of, their biggest customer. The enhanced its credit rating, made it less indebted and allowed it to be a bit more self-financing, to the extent that it ‘might even be able to improve its own, infrastructure. I'm not going to hold my breath for that one. I don't think Hugh is cither.So hyperinflation itis. So far so scary. Bur then comes something ‘unexpectedly conventional. When we get to the end of our chat, [ask Hugh what ‘on earth isthe ordinary investor to do? iis answer? Buy the largest and safest stocks: businesses with very little debt and “balance sheets which are far more secure than sovereigns”. Think Nest, Unilever and Procter & Gamble. Otherwise, given that hyperinflation is still some way off, you buy 30-year US Treasury bonds or gilts. Iris, says Hugh, the one thing most of us can't bring ourselves to do. But it is also the one thing that, pre-hyperinlation, “makes a lot of money”. [At this point Hugh starts talking about interactions between Jesus and Peter in the Garden of Gethsemane, I look confused and we call ita day. Then he gives me a lift to the station in his G-Wiz, Glasgow-born Hendry graduated from Strathclyde University in 1990, after studying accountancy. An interest in investing toturn down ajob at KPMG to work for Edinburgh ie Gifford, Becoming one of their 28 May 2010 MosexWik 31