Humayun Shahryar is something of a contrarian. As investors clamor for liquidity, he sticks to running his Auvest Capital Management hedge fund like a private equity vehicle, with a five-year lockup. An 18-year veteran of the financial world, he wants to see the sector—Shahryar objects to the term "industry"—decline, rather than increase, in importance and prominence. And the Indian native throws cold water on the West's hopes that emerging markets will save them from themselves.
The Auvest founder spoke recently with FINalternatives Senior Reporter Mary Campbell about his Cyprus-based firm's outlook for investing and the global economy and the need for an emphasis on the "real economy," in contrast to the "financial vandalism" of the past decade.
In the wake of the financial crisis, liquidity has become the watchword of cautious investors, and yet your fund has a five-year lockup. Why?
The logic is very simple: Even the funds that offered monthly and quarterly liquidity during the crisis were forced to set up gates. They just couldn’t liquidate fast enough and if you are an investor who’s able to actually increase exposure at times of stress like this, you can benefit at the expense of other funds who will be forced to liquidate assets. Things like gold sold off very sharply in 2008, even though the fundamental case for gold was very strong. Now, if instead of selling gold you had actually been able to buy, you would probably have doubled your money.
Everyone has become very, very short-term focused. It’s like everyone has become a trader, and I think that it’s very difficult to generate returns with that mindset. I think that hedge funds should be treated more like private equity funds, in the sense that when you give your money to a private equity fund you are not expecting to suddenly go to the fund and say, "Hey, give me my money back." If an investor needs liquidity, they should stay in cash or directly invest themselves.
And, by the way, the funds that did put up the gates did pretty well coming back. A lot of hedge funds that set up gates managed to come back very strongly while a lot of people who were forced to liquidate essentially had to shut down. A lot of our investments and trades that have done exceptionally well are the ones where we just did not do anything—we bought them and we just sat on them.
You say it’s important to have an accurate macro picture when investing and your firm has done significant research into the current macro situation. What is your current view?
We are in a stage of deleveraging of the global economy which is highly deflationary, and everything that you see as a policy in response to that is essentially an attempt to try and slow down and make sure that the pace of deleveraging does not get out of hand.
There were five key drivers of global growth from 1982 all the way to 2007, when we had this massive bull market in literally every asset. One of the key drivers was financial innovation, essentially, the creation of leverage in the economy. Between 2000 and 2008, global debt more than doubled, especially in the developed world, and so from $80 trillion we went to $180 trillion of total debt in the world, which obviously is fantastic for risk asset prices because if someone gave you a blank credit card, you would create a lot of GDP growth, you would go and buy everything in sight.
The way our monetary system works is that money today in the world is not backed by anything except for the faith and credit of various governments; there’s no gold backing, so there’s no limit to the amount of money you can create. Now, in our system there are two types of money: the monetary base which primarily consists of all the money created by the central bank, including our printed banknotes. But most of the money in the world today is actually money created by commercial banks through the creation of debt. Contrary to popular belief that basically what banks do is lend out the deposits of the savings they get from depositors, the system creates money through the creation of debt and most of the debt in the world is denominated in dollars.
As more and more dollars are created, the value of the dollar falls—and you saw that in the last decade, particularly between 2003 and mid-2008, the dollar just kept falling. Now when that happens, obviously it essentially reflates all kinds of risk assets, so gold went up, stocks went up, commodities went up. And now that process of creation of credit is in reverse gear, because there is essentially no borrower of last resort left in the world. We see everywhere in the world that the borrowing cycle has kind of reversed; we have the crash in U.S. housing, which used to serve as a huge source of creation of credit. Corporations in the U.S. are flush with cash; they’re not borrowing anymore. So the U.S. government had to step in and borrow to create those dollars to get them out there.
Where do we go from here?
This deleveraging will continue for a few more years and, depending on the pace of it, it could either get really bad or, if we are lucky, it could be managed—every year, the Federal Reserve, for example, does maybe $500 billion or $600 billion of quantitative easing. That’s probably matching the deleveraging that’s happening in the system—people just paying back their loans—and when they pay back their loans, the electronic money goes back into the bank and the bank will cancel that money and the number of dollars is reduced.
We will have these periodic bouts of quantitative easing which will set off some kind of a rally in risk assets, but eventually asset prices will be a lot lower than they are today. If central banks lose control and the markets lose faith in the central banks, we will have a collapse. If they somehow can maintain a semblance of power and control over the system, then maybe we will see a small trend down in asset prices, maybe a more controlled reduction. That's basically the broad trend, at least for the next two years.
One of our central themes is that the U.S. will see a recession very soon. Nobody’s prepared for that, nobody’s pricing that in, everyone’s accepting that the Eurozone is in recession and that emerging markets will slow down and the consensus view is that China will have a soft landing, whatever that means. But I think a lot of the stronger growth coming out of the U.S. was because of transitory factors, like lower oil prices and rebuilding after the Japanese earthquakes. Saving rates have dropped in the U.S. in the last two quarters, people are basically drawing down savings because wages are not going up and, if I were to be positive, I want to see wages go up.
What is happening is there is a policy attempt to try and borrow and spend our way out of this, and I don’t think that works—if that works, you’d have never had the Great Depression or any of the other major economic downturns we’ve seen throughout history. It’s always the same story, excess borrowing, mal-investment, overcapacity and then a collapse.
What do you invest in then, given that macro thesis?
I think the major policy reaction to this will always be monetary, which is basically trying to print more money, so gold is an obvious candidate that will do well. Central bank balance sheets are getting bigger and bigger, so higher quality government bonds will probably still do well because I don’t see a lot of inflation happening. The U.S. dollar could be a beneficiary of problems in Europe.
A recent Auvest report, “The End of Financial Vandalism,” is critical of what you call the “supremacy” of the financial sector in recent years.
The financial sector—finance itself is not an industry—is in the business of facilitating an efficient allocation of capital to the real economy. Banks are supposed to lend to the real economy and investment firms are meant to advise players in the real economy. You can’t let finance become a disproportionately big part of the economy.
In the last 10 years, the brightest students from all kinds of schools want to go into banking and finance—real engineers and people who should be doing something more valuable in life—because of the crazy money. You have banks where 50% of earnings actually goes to bonuses. Even hedge funds only take 20% of the profit. And if you see the profits of the financial sector as a percentage of overall profits, they were completely out of whack in the last 10 years.
People are getting disillusioned because you have a segment of this industry that went and completely gambled away, literally, the whole economy. The whole craziness of derivatives and structured products that nobody understands and trading against their own customers—I read that this is the only industry in the world that can actually get away with abusing its customers as much as it does. The level of regulation you need to protect the customers from this industry—what we call “financial vandalism"`—is crazy.
Your view is that this “supremacy” of the finance sector will end and the focus will return to the “real economy." How will that play out?
This is for me the positive aspect of this crisis—people are slowly going to realize the problems, there will be cleaner and better regulation, although more regulation is not necessarily the answer. The whole incentive structure has to change; this is not just about regulating people, it’s also about changing psychology and better educating people in the sense that it’s just insane for someone who is just out of college to expect half-a-million dollar or million dollar bonuses.
A lot of these things will revert back to the mean. The U.K. is, in my opinion, doing it without the hysteria that everybody else seems to be showing in Europe. And they’re basically saying that you’ve got to separate out the whole investment banking kind of gambling in a way that it should not be paid for with public money. Take them back to private partnerships so if they gamble, they gamble with their own money, and if they lose, they’re going to lose their shirt. Because now you basically socialize the loss and it’s only capitalism when it comes to profits. At the end of the day, if we are not realistic, it’s going to kill the industry and the idea, I think, is to realize that what is happening is madness and to tell people to step out into the real world and see what a million dollars or a million pounds is.
I think what will happen is a lot of the profit that the financial industry is squeezing from the rest of the economy will actually come back to the real economy, and that will be good.
You don’t subscribe to the belief that emerging markets—particularly China and India— will “save” us. Why is that?
There’s a lot of marketing involved in emerging markets. The banks had to create these fancy concepts that investors would like, the BRICs and other acronyms created to sell the emerging markets. But those markets are extremely dependent on the developed world and the whole concept of decoupling the systems, in my opinion, doesn’t fly. What has happened is the U.S. was running these constant current account deficits and was flooding the world with dollars, so countries like China and India got the opportunity to get their hands on a lot of these dollars and use them to set up capacity to supply all kinds of stuff to the developed world. That’s how the whole story started.
I remember when I was in college, and even when I was an investment banker in India in the mid 1990s, a dollar was a big thing. When I traveled overseas—in 1996 I went to Seoul and to Hong Kong on business—you could only buy $200 a day for business expenses. But in last 10 years everybody could get their hands on dollars and that’s how you saw this massive, massive investment boom—especially in China.
China is a really peculiar case. It, in my opinion, is heading for not a hard landing but a crash landing. China has had a massive expansion of credit since the 2008 collapse. A lot of it has gone into real estate, and the story is becoming mainstream that real estate in China is collapsing. China today is what Japan was in the 1980s, when Japan was going to take over the world. The Japanese were doing exactly what the Chinese are doing now—they were taking over companies, they were fighting over resources, they were investing all over the world and "made in Japan" was the big thing. And then Japan collapsed and one of the biggest reasons why was a massive investment boom. Investment in fixed assets—including roads and buildings and highways and all kinds of bullet trains—in Japan, at its peak in the late ‘80s, was close to 32% or 33% of GDP. In China, it’s been running at an average of close to 40% for the last eight years. And that has never been sustained in history.
In Japan, the stock markets collapsed first, followed by the real estate market. The stock market in China has collapsed, exactly like in Japan, and despite the massive expansion in credit in the last three years, the market is far from its previous peak. The other interesting fact that is mentioned in the report is that China had close to 206 million people of working age joining the labor force between 1991 and 2010. From 2011 to 2030, over the next 20 years, China will only add 3 million people to its workforce. And the labor force will actually start shrinking from around 2017.
The same thing happened in Japan in 1996, six or seven years after the collapse happened. So if you were to try and draw any kind of parallels between Japan and China, the collapse has started.
You already see what has happened to India in the last year. India is the country most susceptible to an Asian Tiger-style crisis, because India is one of the two prominent emerging markets in the world that actually has twin deficits—running a deficit on the current account along with a fiscal deficit makes India and Turkey prone to some kind of crisis over the coming days and months.
It’s very difficult; these really are poor countries and I think people need to go and travel and see for themselves that it will take generations, especially in a place like India. I’m very bullish on India because it will have a very large expansion of its labor force over the next two decades and they have a lot of strength in that, but just to build Indian infrastructure you need massive amounts of money and this is the kind of the return to the real economy that I’m talking about. These are the investment opportunities for the future, but we need to take our minds away from speculation and gambling, and people need to start thinking in the slightly longer term. Today everyone just wants to make money on a monthly or quarterly basis, and I just don’t know how that’s possible.