Global Macro: Farewell 2006, Hello 2007!

Yet another year of generally disappointing macro returns

Originally published in the December 2006/January 2007 issue

Well it hasn’t exactly been a ‘shoot the lights out’ year for Global Macro hedge funds but then again, most things haven’t moved a great deal. Sure there has been a lot of noise, but ultimately there hasn’t been much to grab hold of to generate macro-based returns. At the time of writing, the Dollar has fallen 6.5% as measured by the DXY; 10-yr bond yields are up a whole 15bps; oil is down 3.8%; whilst the S&P500 is up 12%. Unless you were long soft commodities, Russian stocks, Cypriot stocks or similar, the chances are that you found it tough to make anything more than single digits at best in macro investments.

What has made it even more difficult for investors is that many forward-looking economic indicators for the global economy – and in particular the US economy – deteriorated dramatically in 2006. Thus it took a certain leap of faith for funds that employ macro-based analysis to take significant positions in risk assets such as emerging market equities, or even equities in general. Consequently, the result is nothing to write home about (excluding the fact that December has a habit of bailing out Global Macro hedge fund returns).

2007 – A vintage year for Global Macro?

However, looking ahead to 2007 we have pretty much a perfect set-up for a high-returns year.

Everything points to a recession dead ahead…

As noted earlier, one of the complications in 2006 was that most of the forward-looking economic indicators such as the yield curve, US Leading Indicators, NAHB Homebuilders Index and US Car Sales, showed marked deterioration, while some asset markets such as base metals and equities showed economic strength.

Unfortunately, market participants are often a little too quick to dismiss these signals as false, forgetting that they are not called “Leading Indicators” for nothing, and as such foretell of activity often six- to 18 months ahead, as opposed to when the signals are first generated. This is almost always the case in every cycle. Remember 2000? In Q4 2000, not a single economist in the Bloomberg Survey predicted that we were going into recession in 2001 or that rate cuts lay ahead in the following four months. The fact remains that at that point the economy was already in recession!

The future is now…

We’re now in the situation whereby predictions made by tried and tested, forward-looking indicators some 12 months ago, are starting to take place. Already GDP growth has fallen significantly and early signs do not point to any particular improvement in Q4.

… and it’s not so bright

My analysis suggests that things will get worse in 2007 for the global economy and that we will see a mild recession in the US, followed probably by a flirt with recession in Europe in 2008. What magic hocus-pocus is this based on? Each of the forward- looking indicators above has a near 100% ability to predict recessions, and taken in combination they have never failed. Every single one suggests a recession is just round the corner…

A bad economy is great for Global Macro hedge funds

Why does this miserable prediction mean it’s going to be a great year for Global Macro? Well typically, macro funds (along with CTA’s) make more money on the downside of the economic cycle. If for example, we get interest rate cuts in 2007 (a near certainty in a recession), then in risk-adjusted terms, bonds and FX produce far higher quality returns than equities.

Falling rates and a falling Dollar do wonders for your P&L

It is highly likely that we will get both interest rate cuts and a falling Dollar next year, providing a spectacular opportunity for Global Macro players.

2001 – Short equities versus long fixed Income

To demonstrate, in 2001 the equity market realised a 100-day historic volatility of 28% and produced a return of -13%. Ignoring the negative sign (thus assuming that hedge funds are happy to be short), the returns available were half that of the volatility. Let’s call it a simple Sharpe ratio of 0.5. Compare that to December 2001 Eurodollar futures, which produced a 100-day volatility of 1.7% vs. a return of 3.5% (in futures terms). That gave us a simple Sharpe ratio of 2.

What does this mean to the bottom line? Well if you had a $10mm position in SPX futures, you would have made $1.3mm. If you had taken the same risk (as accounted for by volatility) in Eurodollar futures you would have a $165mm position in them, making your daily P&L swings roughly comparable to the equity trade, but you would have made returns of $5.77mm – or 344% more. Hmmm…

This is a perfect example of why Macro tends to do very well in rate-cut years. Risk-adjusted, Macro is by far and away the best strategy in these types of markets.

2002 – Short equities versus short the US Dollar

Let’s also see what happens when both the Dollar and equities fall in a weak economic year. We will use 2002 with the DXY US Dollar Index as our proxy for the US Dollar. In that year, equities had a big move lower with the S&P500 producing a negative return of 23.4% versus an average 100-day volatility of 26%. The simple Sharpe ratio was thus 0.9.

For equity shorts it was a better year risk-adjusted than 2001. Your $10mm would have produced a return of $2.3mm. In 2002 the Dollar, as measured by the DXY Index, fell 13%. Over that period it produced an average 100-day volatility of 6.5%, thus a simple Sharpe of 2. Therefore in order to take the same amount of risk as in the equity trade, you would have sold $40mm of the DXY Index. This $40mm position would have produced a return of $5.2mm – double that of the equity trade.

In the downcycle, own Global Macro…

Quite simply, Macro investors will always do better reflecting economic weakness than straight equity investors.

Generally speaking, if you know a Macro fund that produced okay results (7% +) in strong equity bull markets and did well in the last recession (producing much higher returns, 20%+), then there is a chance they will repeat the same performance if 2007 is a weak year forthe economy. That means their pay-off profile is akin to a self-funding put option for your portfolio. If you match that with some equity-biased funds which produce 20%+ in strong equity bull markets and decent single digits in equity bear markets, then you have a portfolio made in heaven…

Now is the time to start upping your investments in Global Macro hedge funds. If the age-old economic indicators are right, it should be an excellent year.

Now for another small prediction…

While you are tweaking your portfolio for 2007, make sure you have some soft commodity exposure. It is too big a topic to discuss now, but all the evidence suggests that we are in the early acceleration phase of a secular bull market, and it’s likely that soft commodities will produce the best returns of any asset class in the coming year or two.

This is no cyclical bull market starting, but a major secular one that should run for at least 10 years. That is an enticing prospect, especially when you realise that soft commodities are at their all-time cheapest valuations versus every other asset class in the world (using 100+ years of data).

Good luck for ’07, it should be an exciting year.

Raoul Pal publishes The Global Macro Investor which is an exclusive investment strategy and economic research service with a tightly restricted circulation (