Bond king Bill Gross is among a growing chorus of investors and economists that reckon zero-interest rates are threatening the global economy. But one of the UK’s leading hedge fund managers thinks central bankers have got it right on keeping interest rates low. Here’s why.
Historically low-interest rates, supported by quantitative easing, have dominated central bank policy of the big economies since the financial crisis of 2008. But Gross and others say these policies are distorting savings and ultimately investments.
This is what Gross told CNBC recently: “The Fed, with their focus on low-interest rates, is distorting the savings function, not only in the US but on a global basis, and savings of course is connected to investment,” he said. “Ultimately I think that’s what reduces real economic growth going forward and they don’t realize that.”
But Hugh Hendry, chief investment officer and founding member of global macro hedge fund Eclectica Asset Management, disagrees. Hendry told Family Capital: “Bill Gross is clearly something of a legend, and he has been way more right than wrong. But I disagree with him on zero-interest rates.”
In fact, Hendry’s view is that interest rates have been too high. He backs his theory up by looking at a bit of economic history. In fact, Hendry’s reference point goes back to the Great Depression of 1929/1930, where debt to GDP in America was historically very high. This led to a great swathe of bankruptcies and a backlash against financial speculation. What followed was an unprecedented period of deleveraging by the banks and the financial sector became much less willing to embrace risk. This period of financial conservatism lasted 40 years, says Hendry.
“Roughly speaking, from a debt to GDP perspective, you saw debt decline from say 340% to 140% by the 1970s. Then slowly but surely society embraced the notion of the financial sector taking on more risks. And once again debt began to pile up until the debt to GDP ratio surpassed the levels that we saw in 1930.” US debt as a percentage of GDP more than doubled between 1981 and 1993.
Hendry points out that the S&P500 has lost upwards of 85% of its value on a risk-adjusted basis, versus the trend in 10 year US treasury bonds. “That struck me as being remarkable given all the amazing and good things that have happened: the rise and rise of China; the rise of tech with the creation of Microsoft, Apple, Facebook, and the internet. We’ve also had amazing world trade – in fact, there’s been an incredible rostrum of achievements.
“It’s been 40 years of resounding successes with three black stains: stock market reversals in 1987, 2000 and 2008. And yet the stock market has lost 85% of its value, compared with bonds.
“With the benefit of hindsight, it would seem that interest rates were too high. The reason for that was nothing malicious. It was simply the behaviour, the frailties of the human mind. Of course, the first ten years of that period were marked by a terrifyingly high degree of inflation, and that heralded a new type of central banker, most obviously in the guise of Paul Volcker.” The former head of the Federal Reserve was a new type of central banker because he is credited with ending the US stagflation crisis, with inflation falling below 3% by 1983. He did this by raising interest rates.
Hendry explains bond versus equity performance by dividing real economy participants into two parts: creditors, which have a surplus of money, but a deficit of ideas; and entrepreneurs, with a surplus of ideas but typically a deficit of finance.
“Entrepreneurs were paying too much to access capital and so from an economic perspective you could say that the creditor or the banking class imposed a rent or a transfer levy on the rest of the economy.
“What that also does, which is rather repugnant, is create immense inequality because creditors by definition are rich and we over-reward rich people at the expense of everyone else, and so de facto you get inequality.”
Hendry believes a rebalancing is now taking place, evidenced by a stronger performance of US and UK equities – two countries that have stuck firmly to QE. By saying interest rates were too high during some of these boom years is controversial because many people believe that the bubbles in housing and the stock markets at the end of the 1990s were a function of low-interest rates.
Hendry points out that this contrarian view isn’t something he volunteered for. “I find it rather dubious. I guess it’s explained by the fact that the principal challenge I set myself is to construct a contentious view of the immediate future, which is not necessarily accepted by the general body of investors.
“And it opens up the rather oxymoronic notion of there being a trend for being contrarian, which at first blush doesn’t make that much sense.”
He adds that he only ever commits money when there is evidence that an idea is taking root in public markets and there is the start of corroboration in price movements. “I and my team have an intellectual curiosity for the notion of change. We are very determined that as we embrace change, it has to be already in motion, rather than just a projection or a supposition.”
Most managers express the discipline governing their ideas in terms of a portfolio stop loss, which is to say if they lose a certain amount of money they would then reduce back positions.
“I certainly do not disagree with that,” says Hendry. “But what I find to be a very effective portfolio stop is the passage of time. So when I set myself a vision of how the world might change, I have to be able to monetise the profits for my clients within a time period no greater than two years.
“If I find myself still pursuing the same argument after two years but with no profits, with no performance in the preceding two years, then I more than start questioning my wisdom. I have to go back to base camp to review all of the assumptions and more often than not, reject the original hypothesis.”
It was in this way that Hendry came to embrace the loose monetary policy of central banks since 2008. Initially, he was angry that policy makers had failed to purge the rottenness that led to the financial crisis.
At first, Hendry was unwilling to take on risk, fearing another bubble and a corresponding crash. However, the evidence with regard to market prices didn’t follow the course he feared, and eventually he reached the conclusion that the central banks got it right.
“I felt it was actually better to bail out some unappealing financial groups for the greater good of taking away the very distinct probability that we would have suffered an economic reversal on a par with the 1930s.
“That did not happen because I believe the Federal Reserve, and indeed the Bank of England, took some rather intellectually courageous decisions to pursue a very unorthodox and very controversial monetary policy, which I would say has pretty much been a success.”