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| SATURDAY, FEBRUARY 18, 2012
Keeping an Eye on Wealth Creation
By LESLIE P. NORTON
Hugh Hendry of Eclectica talks about hyperdeflation, why China might have a hard landing, and his off-the-beaten tracks Japan plays.
Eclectica's acquired a nice reputation among contrarian investors, thanks to some enviable results. The London-based Eclectica Asset Management saw a 12% return last year in its flagship Eclectica hedge fund, and an eye-popping 46% gain in a new fund that buys credit-default protection on Japanese corporations. Much owes to the relentless logic and cheeky inventiveness of Hugh Hendry, chief investment officer. The Glasgow-born Hendry tells Barron's why he expects a hard landing in China, and why hyperdeflation will precede hyperinflation. Barron's: What makes a great macro fund manager? Hendry: First and foremost, an ability to establish a contentious premise outside the existing belief system, and have it go on and be adopted by the rest of the financial community. My great hero is [Caxton Associates' founder] Bruce Kovner, who was able to imagine the dollar falling to 100 yen—when the rate was 200. I am an existentialist. To my mind, the three most important principles when it comes to investing are Albert Camus' principles of ethics: God is dead, life is absurd and there are no rules. Of course, that's a doctrine of promoting the individual. You own your own decisions. As CIO of Eclectica, with $700 million [under management], I have no engagement with the sell side. Where do you find yourself outside the existing belief system today? In 2009, I made a YouTube video of the empty skyscrapers in Wuhan, China. Goldman Sachs and others articulate a very reasonable and compelling argument of being invested in China. With the evidence of my own eyes, I concluded that China had a very robust system of creating grossdomestic-product growth, but forsaking the creation of wealth. When America was having its China moment in the 19th century, it occurred against the backdrop of a gold standard, a hard-money regime, with a public sector that was minuscule versus the overall size of the economy. As an entrepreneur, if your project failed to generate a sustainable level of cash flow, you failed. China's great opportunity is taking place within the U.S. fiat system, and so the consequences are perhaps less stark than in 19th-century America, which had stops and starts and many depressions, though with an overarching prosperity. China has
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You can have a modest amount of gold. China's swollen public sector is directing asset Enlarge Image Chris Gloag for Barron's allocation. it could have enormous repercussions for the global economy.. To lay the seeds of hyperinflation. you need really. our fund made 12%. If you talk about a hard landing in China. which can prove quite damaging. it could have enormous repercussions for the global economy.Barrons. but chose to bet on the euro being weak. quantitative easing [that eventually sent more money flowing to China]. and created a global recovery.5%. A year or two down the line.2. I thought the U.000. because the rest of the economy can subsidize it. and if you asked an 2 of 4 22. because there's no risk premium or carry in foreign exchange. which has just come to an end. The road to hyperinflation is via hyperdeflation. Most people understood Europe. China's stock and property markets are weak. but the performance of global macro last year was quite disappointing.S. Pension schemes have a preponderance of real assets. This time last year. But it creates a bubble. What's the worst that could happen? But the sum of all my fears would be China having a real hard landing of minus 5% or minus 10% GDP growth. How does one play it? The world is very fearful of hyperinflation.Keeping an Eye on Wealth-Creation .com/article/SB500014240527487037860045772. British interest rates were at a 300-year-low at 0. China now has inflation. They see [their system] as a success. bad things happen. That is why it's proving so difficult for hedge funds to make money. We may now have the pricking of the Chinese bubble. But then my Chinese friends pumped $1 trillion of credit into their $5 trillion economy. promoted because America had two sharp recessions and pursued orthodox policies. A year or two down the line. and I would have gold at $5. mostly from investing in the short end of interest-rate curves. That's why people are struggling. If we had that—and Europe—the Fed would be printing $20 trillion.S. not minus 5% or minus 15%. The policy was very successful. a side-effect of quantitative easing. on the presumption that rates will remain low forever. because they are very fearful. from forestry to gold to TIPS [Treasury inflation-protected securities].2012 5:47 . Last year. Minimum wages have grown 20% annually for the past three years. I'm speculating that hyperdeflation happens before hyperinflation. really bad things to happen. When you have bubbles and you tighten. housing market having a massive crash would be hyperdeflationary. It can build superfast railways and overbuild airports.barrons. I should add something else that is contentious—U. not had that volatility. rather than pursuing profit maximization. How does the rational mind that anticipates hyperinflation own 10-year government Treasuries yielding less than 2%? It can't. in case we get that hyperdeflation event. and had very little to show in the creation of jobs. The Chinese government prints money. You've already had a hard landing—in the Chinese "We may now have the pricking of the Chinese bubble..com http://online. The risk premium in fixed income was huge. but you can't have all your assets in real assets. This has encouraged the Chinese to tighten monetary policy. which is a hard trade." -Hugh Hendry stock market. That view would be consistent with interest rates staying low forever. you talk about GDP growth of 5%.
and the other part is having a party.Barrons.2." The first thing he said was. Korea] are building huge." Then I thought. I'm buying the CDS on investment-grade Japanese corporations because of the overpricing anomaly. Any other potential disaster catalysts? Continuing yen appreciation. yielding 30 basis points. exports half its output. investment bank to guess where rates would be in three years. you pay 130 basis points. My broker said. Initially. "I've been in a 20-year bear market. Compare that to five-year Japanese government bonds. yet it's the largest exporter of steel in the world. It is credit-default swaps on individual Japanese corporations. my boss will kill me. I wanted to buy a three-year. out-of-the-money put on Nippon Steel. You no longer pay 50 basis points. being long credit protection is being long volatility. But if Asia hiccups or reverses. If I'm a Japanese bank and I lend money to a new business. Steel credit protection is more like 650 basis points. and I'm willing to pay 50 basis points for five-year protection on this same company.2012 5:47 . I bought reams of the stuff. a sharp Asian recession. relative to [Japanese bourse] Topix. people are cautious on selling protection on such volatile businesses.S. they are fine. Then the bank gets a call from me. I redialed his credit counterpart. The bank thinks: This is a great trade! Japanese steel companies are investment-grade and won't go bankrupt. are making fresh lows. Japan is confronted by a European sovereign-type loss of confidence in the JGB market.S. To put that in context. because the yen is so strong. we set up a stand-alone fund to buy this credit protection. So suddenly. an exogenous shock—like a run on the Italian bond market. very vulnerable. I think the yen could soar from these levels [about 79 to the 3 of 4 22. they can and do go bust. So how do you make money? Would you believe that the AIG strategy of selling too much credit protection in risky assets like mortgage-backed securities is alive and booming today in Japan? It doesn't concern mortgages.com http://online. U. "Would you consider 10 billion?" So one part of the bank is banned from selling volatility. because in America.barrons. and thinks it is not taking any risk. So. but Posco and Hyundai [5380. As long as Asia is strong.3%. no iron ore or coal. Japan had a bust 20 years ago. One of my partners told me about Japanese steel: Here is a country with no energy. The figure today is more like 1. They don't share that worry in Japan. In August 2010. plant-utilization rates go from very high to very. Korea]. the bank gets this huge yen yield.S. China manufactures 700 million tons of steel and exports perhaps 30 million. and that Korea was the biggest importer of Japanese steel. I said: "I'm thinking of purchasing up to a billion yen of five-year credit-default swaps in Nippon Steel. a slowdown in China.. Do you seriously believe Japanese corporations are going to fail? Clearly. It could make them very.. it was betting above 4%. We bought protection on steel names. and yet today the banking stocks. Then we discovered that Warren Buffett owned shares of South Korea's Posco [5490.com/article/SB500014240527487037860045772. the yield has gone from 1% to 1½%. very low very quickly. They have a surplus of steel capacity and—guess what?—they're exporting to Japan. and also on businesses with a huge sensitivity to the yen. integrated steel plants. You'd better believe it will sell way too much of that good thing. Japan produces 110 million tons and exports 40 million. I get 1% on 10-year paper.Keeping an Eye on Wealth-Creation .
What other names have you bought protection on? Shipping companies. please contact Dow Jones Reprints at 1-800-843-0008 or visit www. So the steel CDS is 130 basis points. Despite my reservations. it always invoiced in dollars. We are partly playing it through Japan. So Japan is short its own currency. dollar] into the 60s. Japan began recording current-account surpluses. the end game will be the Greeks rejecting austerity.com http://online. pension funds in Tokyo will have fewer yen assets. and I'll get us out of this system.com/article/SB500014240527487037860045772.2. We have protection in trading companies like Sumitomo[8053. For non-personal use or to order multiple copies. If events kick off again in Europe.djreprints. a Greek politician will say. All Rights Reserved This copy is for your personal. while to insure against default by the French government.com Copyright 2011 Dow Jones & Company. We have protection in Nippon Sheet Glass [5202. Which is riskier? A very leveraged steel company that can't tax you? Or a government that can? Our bearish bets are largely outside Europe. So they'd have to sell some overseas dollar assets and retrade them back to yen.Japan]—companies leveraged. Eventually. 'Vote for me. if not the 50s. and some bullish fixed-income positions. and there was overbuilding. These are very leveraged businesses. E-mail: editors@barrons. the correlation across all [global] asset classes will go to one. and your hedge and private-equity funds fall. some nonindustrial commodities. and has an enormous private-sector hoard of foreign assets. If the Nikkei falls. with further dislocation in European sovereigns or a China hard landing. and all the onus is on private citizens to take the pain. but their liabilities will be the same. If we have a series of bad events from China to Europe. The euro is nothing but a gold standard lacking flexibility.Keeping an Eye on Wealth-Creation .. Thanks. We've barely discussed Europe. Distribution and use of this material are governed by our Subscriber Agreement and by copyright law.Japan]. I'm modestly long equity-market futures. I'd be paying the same amount.com 4 of 4 22. The only place in the world one can buy credit protection on the shipping industry is Japan. Unlike Germany.' What else do you own? In the next 12 months. we'll see further pathological swings in investor sentiment. non-commercial use only.barrons.. Inc. From the early 1960s almost.Barrons. that will express itself in a very strong yen rally. opaque and very geared to the global economy. such as Mitsui OSK [9104.Japan]. and hold a global basket of businesses—with interests ranging from fertilizer to farm equipment.2012 5:47 . We are very bullish agricultural commodities and agricultural equities.Japan] and Marubeni [8002. As for Greece. which bought Pilkington.
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