Hugh Hendry: "The Storm That Caused Chaos In Markets Will Not Dissipate Anytime Soon"

From Hugh Hendry’s Eclectica Fund’s June Letter,

Fears of monetary tightening by the US Federal Reserve continued to push rates higher. The yield on the US 10-year Treasury bond rose from a low of 1.62% at the beginning of May to 2.61% at the end of June, its highest level since August 2011. The jump in the reference yield, which was paralleled by higher mortgage rates and soaring gasoline prices, triggered a broad based equity sell-off. The S&P500 closed in negative territory (-1.5%) for the first time in eight months. This had a detrimental impact on foreign equities. Global stock markets dropped by 3.1% in June, underperforming US equities for a fifth month in 2013. Low variance equities cost the Fund 39bps last month.

The higher yields in the US caused a subsequent rise in global market debt yields. Emerging markets were badly hit, revealing cracks in local fundamentals. Countries from Brazil to China are now dealing with a combination of money outflows, worsening current and fiscal accounts, depleting reserves and social unrest. The days of easy money are coming to an end. In Brazil for instance, the biggest emerging debt market, no company has been able to raise debt abroad since mid-May as borrowing costs soared to a four-year high in June, at 7.1%. Confronted with the biggest street protests since 1992, Brazilian authorities are now forced to engage with ramping inflation. The Bank of Brazil recently raised the benchmark SELIC rate to 8.5%, giving continuity to the world’s biggest tightening cycle and adding pressure on local businesses.

Moreover with the on-going economic slowdown in China, companies and currencies of commodity producers that rely heavily on sales to China continued to weaken in June. This was particularly the case in Australia and Brazil where exports to China account for 29% and 16% of total shipments respectively. This structural weakness benefited our EM currency basket, which made a modest gain for the month but was outweighed by losses elsewhere in FX.

While EM economies came under attack, China experienced one of its worst credit squeezes in modern history. The overnight Shanghai interbank rate (SHIBOR) surged from 4.8% on 17th June to 13.4% three days later, the highest in at least six years. The negative liquidity trend in China was bad news for Chinese equities, especially banks. The Shanghai Composite Index declined by 14.0% in June, its worst monthly performance since August 2009.

We retain our bullish curve steepeners in Australia and South Korea. These two nations are highly geared toward exports and China’s economic growth, while having a developed world FX profile and relatively high overnight rates. In South Korea for instance, exports accounted for 57% of the country’s GDP in 2012, compared with 28% in 1995 and a mere 14% in 1970. Faced with rapidly deteriorating domestic consumption and international trade activity, we believe that the respective central banks are likely to use their flexibility to cut short-term rates aggressively, which would be beneficial to our curve steepeners.

In Japan, stable bond yields and encouraging fundamentals supported local markets. The TOPIX closed nearly flat in June (-0.2%). Inflation, retail sales and wage growth continue to rise. In Tokyo for instance, the consumer price index in May was flat from the same month a year ago. It was the first time since November 2010 the index was not in negative territory. As our position management system gave us a positive signal at a time of receding volatility, we re-opened a long exposure towards Japanese equities. QE-fuelled ‘Abenomics’ combined with rising inflation expectation may insulate Japan from external shocks.

The storm that caused chaos across financial markets since May should not dissipate any time soon. As such, we retain a short bias towards China and an outright short in EM currencies. If world trade remains weak and local inflation keeps on gaining momentum, the currencies of several EM countries (ex-China) may remain under pressure. Such weakness may be exacerbated by tightening liquidity.


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