Doing The Hugh Hendry (#debt, #diversification)

Below is some commentary from Hugh Hendry I found in an FT.com editorial I since can not access as I don’t have a login. But I thought it was interesting when I first read it awhile back and I still think it’s interesting now. I meant to post it earlier. Rectifying my mistake:

For the moment, let us forget the chances of a hard landing in China. Forget the drama of Europe’s circus of politically inspired economic incompetency. Forget that the good news of the US economy’s succession of positive economic surprises is really bad news as fixed income managers have sold copious amounts of too cheap volatility and because it has made equity investors turn bullish, sending stock market volatility back to 2007 levels. This is dangerous. Improved US data may represent a classic short-term cyclical upturn amid a profound global deleveraging cycle.

Such moves have been commonplace for the past three years and have yet to prove a harbinger of any structural upswing. I worry that the pathological course of the last several years will see volatility rise sharply once again. Even so, there exists, in terms of my parochial world of hedge fund investing, a bigger issue.

I fear that my no longer small community has been compromised. Last year was generally very tough for long/short strategies and I commiserate with all concerned. But last year world class funds lost more than 15 per cent in just two months. Today they are celebrated again for making double digit returns in the last quarter even though they still languish below high water marks and their reputation for risk management, at least to those clients who have poured over their copious due diligence statements, has been sorely compromised.

You can probably live with that if you are a pension scheme or a large, sophisticated fund-of-fund because you have a global macro sub-sector that can benefit from short-term shifts in volatility. But the unfortunate thing is that this group exercised its stop losses somewhere between the great stock market rallies of 2009 and 2010. That is to say, they honoured the pact they had with clients. They adhered to the terms of their risk budget: they lost money and they reduced their positions. I fear that owing to this nasty experience the financial world is in danger of harvesting a monoculture of fund returns that could prove less than robust should the global economy suffer another deflationary reversal.

To my mind the situation has parallels with the plight of the banana. Today the world eats predominately just one type of banana, the Cavendish, but it is being wiped out by a blight known as Tropical Race 4, which encourages the plant to kill itself. Scientists refer to it as programmed death cell destruction. In stressful situations bananas fortify themselves by dropping leaves, killing off weaker cells so that stronger ones may live to fight anew. They operate a stop-loss system.

But modern mass production of single type bananas has replaced jungle diversity with commercial monocultural fields that provide more hosts to harbour the blight. The economy keeps producing stressful volatility events. Good managers keep shedding risk and monetising losses and are duly fired, leaving us with a monoculture of brazen managers who will never stop loss because they are convinced central banks will print more money.

Diversification has proven the most robust survival mechanism against failures of judgment by any one society, hedge fund manager or style. But what if we are now a single global hedge fund community afraid to take stop losses and convinced of an inflationary outcome to be all short US Treasuries and long real assets?

This is pertinent as I have always been fascinated by that second rout in US Treasuries in 1984, long after the inflation of the 1970s was met head on by Paul Volcker’s monetary vice and a deep recession. How could 10-year Treasury yields have soared back to 14 per cent and how could so many investment veterans have been convinced that a second even more virulent inflation wave was to hit the global economy?

Psychologists tell us the explanation is embedded deep in the mind. They refer to the “availability heuristic”. Goaded by the proximity to the last dramatic event, investors overreacted to the news that the US economy was pulling out of recession in 1984. They saw high inflation where there was none.

With this in mind, I would contend that it may take several more years before the threat of debt and deflation can be successfully exorcised from investors’ minds, even if the global economy were not set on such a perilous course. Such is the potency and memory of 2008’s crash that anything remotely challenging to the economic consensus could be met by a sudden and severe reappraisal to the downside.

Should such an event send 30-year Treasury yields back to their 2008 low of 2.5 per cent, we believe enlightened investors might better be served by thinking the opposite. Only then might it prove rewarding to short the government bond market and embrace what may turn out to be a much promised once in a lifetime buying opportunity for risk assets.