An Inflation Blow-Up?

SIMON KERR

The first time I met Crispin Odey, CIO of Odey Asset Management, it was in somewhat surprising circumstances considering he ran a European equity long/short fund. We were at a lunch meeting in 1997 with an economist, Nancy Lazar from ISI, who spends her days analysing and describing the state of the US economy. Yes the US was the dominant economy in the world to much greater extent than today, but Odey was the only guest not running American assets or who was not a strategist or economist themselves.

You see, Crispin Odey spends a lot of time considering the macro environment. He is unusual within equity long/short management in doing so. But he is so adept at interpreting the big picture that he commands investor intention when he reflects back his views, which he recently did at the Morningstar European Investment Conference.

Sometimes the considerations with the Odey Strategy Team turn into explicit forecasts for specific macro variables. Out of the big picture thinking comes a strategic asset allocation – say, a bias for growth and so towards equities, which in turn can drive the net market exposure at the fund level as well as stock selection based on themes arising out of macro research.

At the moment the analysis suggests to Odey, one of Europe’s hedge fund pioneers, that there are further negative consequences ahead from the second order effects of the credit crunch. So his key question of the moment is: “Will problem solving by governments result in another crisis sooner or later, and what kind of crisis will it be?”

The historical context
Crispin Odey says that it is useful to start with a little bit of history to give some context to today’s world. In his view, a good point to begin is the extended period of disinflation from the early 1980s onward. The disinflationary trend in the OCED was given a kicker by the consequences of the fall of the Berlin Wall in 1989, and increasing globalisation of supply. These trends made the decades of the 1990s and the Noughties very good for bond markets, but as we know, not great for equities overall.

Yes the ‘90s were good for equity returns; but this was partly because of corporate leverage. A build up in borrowing by companies was one of the consequences of Greenspan setting rates too low for the state of the US economy at the time. This eventually led to the misallocation of capital in the technology bubble (1998-2000), and then to problems in profitability in the corporate sector in 2002-3, according to Europe’s longest established equity hedge manager.

It is Odey’s view that in an unequal society like the United States the authorities have to ensure that GNP grows at a rate to give consumption growth of 6-7% to keep everybody feeling better off. In the Great Moderation (See Fig.1) inflation fell due to low cost production. Whether unintended or not, Greenspan allowed the stimulation of the housing market to provide the confidence to consumers to keep on spending. He says we all know that theresult was that by 2004-5 housing started to move from being an asset to being a speculation. Property was yielding about 4% at the time – and the funding rate was 200 basis points over LIBOR (5-6% then). So the only way to fill that gap of the net cost of funding was to sell on the property to someone else at a higher price.

The US housing market sucked in a lot of capital at this time – at a rate that was three times that of the previous five years. “It was always obvious that this was going to blow up,” says Odey.

So the housing crisis was the catalyst, and the financial world changed in 2007. When the bubble of housing speculation did blow up, the only solution was to drop interest rates to zero. With a zero interest rate policy property becomes an asset again (it has a positive cost of carry), but interest rates at zero also makes other speculations like gold become assets at the same time.

Odey postulates: “We have a world at the moment where nearly everything is an asset because nearly everything has a positive carry. This is not a world in which any financial asset is normalised in any way. So where do we go from here? How do we get out of this mess?” According to Odey the key is wages.

No assets to lend against
After 2007 the credit creation mechanism of the West practically disappeared. Given the level of indebtedness in the developed world, and there were no assets against which bankers could lend, Odey says that the only solution is to ask wages to grow, and this is difficult given how uncompetitive wages have been in the West compared to emerging market wages. Though, as Fig.2 shows, the starting point now is after a 10-year period in which wages have been eroded as a proportion of output in the West, the trend given here for the US being typical.

Currency pegs and relative wages
Most emerging economies have currencies pegged to the dollar – this has given stability to the terms of trade in the era of the Great Moderation (See Fig.1). However in an era of rising inflation, and in particular rising food prices, given that up to 50% of personal income can go on food spending in a developing nation, the cost advantage of producing in emerging countries can be eroded. Emerging economies are now experiencing 20% per annum wage growth, which Odey suggests will continue into 2012 though with some strain on the currency pegs.

odey1
On the other side of the trade competitiveness argument some Western economies have been putting themselves into better relative positions through the austerity measures. “If you were employed in Eire last year your wages fell by 10%,” states the hedge fund maven. “So Ireland is getting cheaper just as the emerging markets are getting more expensive (as suppliers of internationally traded goods and services).” The question Odey then asks is: “How long do these processes of wage pressure have to go on for to get to the point of being competitive with emerging markets?”

Odey turns specifically to the UK economy and suggests that the UK has to have a sustained fall in real wages to the point that it is more competitive internationally. The fall in real wages may have to be for a year or two more yet. When UK exports rise more substantially the economy will be better balanced, and the population will feel better. But the risk at that time will be of a demand for wage rises. In Odey’s view we will only see an interest rate rise in the UK when higher inflation can be caused by domestic factors, that is when wage inflation is evident to central bankers.

Inflation in the UK is set to go higher, despite a weak domestic economy, because the inflation is all imported. So interest rates are correct for the American and UK domestic situations, and wrong in emerging economies, but the emerging economies are stuck with those interest rates because of the currency pegs. Odey points out that those countries that have chosento address their inflation problems, namely Brazil and Australia, have seen massive capital inflows, and have become very uncompetitive very quickly. This discourages others from following the same path.

Crispin Odey’s son is doing economics at A Level, and through it came a reminder on elasticities. There is a big difference between the elasticity of demand to price changes and the elasticity of demand with respect to income (wages). What is important here is the relative – the difference between the two – and the fact that the sensitivity to price changes is higher than the elasticity of demand with respect to income means that the UK can experience inflation next year at a much higher level than that seen to date. At the same time Odey is looking for much higher (and better balanced UK economic growth) next year.

The rise in UK wage claims will bring a policy response in terms of interest rates that may surprise some. But higher inflation is certainly on the way, according to Odey. Whether it is 11% by the end of 2012 (See Table 1) or into 2013 is not so important to Odey in terms of portfolio positioning, but its inevitability is a certainty in his mind. In fact the longer it takes the better as it gives the UK a chance to become more competitive. The corollary of higher wages claims (on the back of a higher cost of living) is much higher interest rates in the UK (7% in 2012/13).

odeytable1
“The difference between now and 2007 is that we (in the UK) are not in charge of the process – the creditor nations are in charge of the process,” says Odey with conviction. “Ultimately UK prices have to reflect that the UK is a debtor nation – I don’t know whether that will happen in 2012 or 2013, but it has to happen.”

Emerging markets have been very mercantilist in that what they wanted was an undervalued exchange rate. This gave the opportunity to generate super-normal profits, and to invest in growth.

This goes back to the foreign policy doctrines of President Kennedy’s Secretary of State Robert McNamara. McNamara’s idea to counter the political uncertainty in South East Asia was for the US to become the export market for these economies to grow, and reinvest without pain. In a world in which a producing country can export the production not required to meet domestic demand that surplus production becomes the country’s free cashflow. In Odey’s mind this raises the question of whether the goods are of a quality for which the producing country can charge enough to create a surplus. That is, can they generate economic profits? But the key historical point was that the US encouraged the least developed countries to produce export quality goods.

Further he argues that once a developed nation like the US faces direct competition from an emerging nation with a cost advantage through the wage structure then the US has only one solution to apply. The doyen of European hedge fund managers sees that solution as the US engineering circumstances in which emerging nation wages have to rise. According to Odey this was done through the US commitment that 20% of US crops should go to bio-fuel. “What they ensured in one fell swoop,” affirms Odey, “was that food was going to become expensive in the world. The combination of food and oil was the secret – food and oil cost four times as much in emerging markets as they do to us. That is why if we (in the UK) have 5% inflation, they will have 20% wage inflation (See Table1).

Does the macro pondering matter?
Does the fact that Crispin Odey spends a lot of time pondering on the macro environment matter to investors? Isn’t it just a distraction from the time that could be spent on the major alpha source of stock selection?

Absolutely not. The result of the process is what matters to investors, and hedge fund managers that spend a lot of time considering themacro environment and build that top-down input into the portfolios produce a return series that is different in a good way from the run-of-the-mill long/short equity managers.

Investors in hedge funds overwhelmingly build portfolios of hedge funds, so that individual hedge funds have roles within that portfolio structure. Relative value strategies should produce steady returns; credit cycle returns should be different from risk arbitrage cycle returns; and away from the core strategies and managers there should be diversifying strategies and managers. CTA and global macro funds produce positive return series at times when other investment strategies don’t. And managers with big macro factor bets in their equity long/short portfolios produce big return phases when bottom-up managers don’t. The reverse is often also true: when managers who mostly add value by stock selection and net market exposure do well, the macro-driven equity managers are often still waiting for the pay-off from their implicit macro calls.

odeytable2

Crispin Odey’s flagship fund, the Odey European Fund, has a compound return of over 15% going back to 1992 – a quite exceptional record. Table 2 shows over a short run history that Odey’s fund has a return series that has much better years when other equity hedge funds suffer, though when Odey’s fund does not do well it does not plunge. The last two years are typical that in that at the time of writing the Odey European Fund is up about 8% year-to-date and a typical equity hedge fund is up about 1-2%. Last year, Odey’s flagship fund had a flat year and a typical European equity fund was up in the high single digits.

odey2
This characteristic of producing good returns when other equity hedge funds don’t is highly desirable for those building funds of funds, and particularly for an end investor that gives a high priority to absolute return from their alternative investments. Given this attractive attribute it is surprising that institutional investors haven’t forced a hard close on the Odey European Fund yet. Maybe because his process and return series are different, some investors have difficulties fitting Crispin Odey into a style box. I’m sure he considers that their problem and not his.