In 1992, George Soros famously shorted the pound in one of the best known and most highly publicised trades using a global macro approach to trading currencies at the time of the European Rate Mechanism debacle. In 1997, global macro traders were again able to capitalise on market volatility by shorting many of the Asian currencies in the lead up to and aftermath of the Asian Monetary Crisis and subsequent de-valuing of currencies such as the Thai Baht and Indonesian Rupiah. In 1998, after the Russian default, the average hedge fund fell and Long-Term Capital went under. However, Caxton and Moore, a couple of the largest and best-known global macro funds returned +17% and +23% respectively. The divergence in the performance of large global macro managers seemed to begin in 2002 when global stock markets plunged and hedge funds declined -1.45% (their only losing year since Hedge Fund Research started collecting data). Whilst some large global macro funds did well, others who maintained a high correlation to equities faltered. With such a large mandate, many investors began to shy away from the sector in favour of more specialised strategies. Until, that is, this past summer, when global market volatility kicked-in and the fear of a US lead global recession became a real threat.

Global Macro 2008 – discretionary and systematic

2008 has proved to be interesting for the global macro sector. Year-to-date the financial markets have experienced tremendous volatility as a result of the sub-prime melt-down, emergence of a US recession, global stock market declines, ever-weakening US dollar, and rising commodity prices resulting in extreme price movements in a multitude of markets. The S&P 500 has moved by 1% or more on about half of all trading days in the first quarter according to S&P – a level of volatility not witnessed in seventy years. Crude oil has continued to be remarkably volatile, trading as high as $119 a barrel and as low as $90 a barrel year-to-date. Not to be out-done, the US dollar has lost over -4% against a trade weighted basket of currencies and the S&P 500 has fallen approximately -6% in the first quarter of 2008.

Amidst this gloom, the Global Macro Index was a shining star at the end of the first quarter as short US dollar and long commodity trades produced profits for many of the funds. However, it is important to differentiate between the systematic and the discretionary global macro managers. Systematic managers/CTAs had the best quarterly start to a year since 2001 as deep trends that began in 2007 continued to play out in 2008. HFRI Macro Systematic Diversified Index returned +9.16% and HFRI Macro Total Index +4.71% versus the HFRI Fund weighted Composite Index which lost -3.06% for Q1 2008 according to Hedge Fund Research. London-based CTA Winton futures with $13.6 billion under management was one of the leaders of the pack with a +11% Q1 return.

Discretionary global macro managers in the Q1 2008 had a wider dispersal of returns than the systematic trend-following CTAs. March, in particular, saw a large correction in trends from the beginning of the year as interest rate curves flattened, equities rallied before posting a flat month and the US dollar strengthened in response to the Fed’s bail out of BearStearns before resuming its downward slide. Commodity markets too saw widespread profit-taking, largely in response to losses elsewhere in their portfolios. This highlights two key strengths that global macro managers need to posses to generate alpha. Firstly, they need to identify and catch the trends as they develop and secondly that they need an iron will to reduce risk when market conditions turn against them.

2008 The return of Global Macro

Global macro managers, not being confined to specific markets and themes, have the greatest flexibility to apply their trading skills to any scenario that may develop within the financial markets. This manifests itself in the constant search for the clearest and deepest trends. However, where global macro investing differs from niche players is that often due to the sheer size of their hedge funds, global macro managers need to capture these trends in the most liquid markets.

From 2004 until August of last year the major global trend had been continuous low inflationary growth, resulting in strong returns in global equities. This was coupled with declining volatility across all the major asset classes. There is little doubt that global macro managers caught the equity trend, however, against this, the nimbleness of the smaller niche players in the equity markets resulted in a stronger performance, whilst the lack of opportunities for global macro managers to add alpha through in other asset classes was a detractor to their returns.This appears to have been confirmed in the flow of funds and management style of hedge fund of funds over this period. In a recent report by Fitch Ratings, the aggregate correlation between funds of hedge funds and global equities had been continuously rising over the last few years and by December last year was 0.8.

From this point, however, we anticipate that the outlook for equity specialised hedge funds will be particularly challenging. Conversely, the increasing opportunities in other asset classes have substantially increased. Given the market themes to date for 2008: rising commodity prices, potential destabilisation of emerging economies as a result of rising food prices, continuing currency and global stock indices volatility, global macro managers are poised to take centre stage

Commodities

As a result of falling global supplies and increased demand, commodity markets, from fuel and energy to agricultural commodities and precious metals have witnessed an incredible rally. Irrespective of the present state of the equity markets, the rally in commodities is likely to continue as demand drivers from emerging economies such as China and India seek to 1) improve their diets and standard of living (agricultural commodities: meats, coffee, sugar, cocoa and energy: crude oil, natural gas, etc), and 2) improve their infrastructure by building new homes, railroads, airports and even cities (base and precious metals). The above are likely to replace any fall off in demand from developed nations. In fact, in 2008, China, India, Russia and the Middle East consumed more crude oil than the US for the first time, burning 20.67 million barrels a day this year, an increase of 4.4% according to Bloomberg and the International Energy Agency in Paris.

It is interesting to note that many of the world’s best known global macro managers began their careers in commodities and futures: Bruce Kovner of Caxton Associates began his trading career in the mid-1970s trading, copper, soybeans and interest rate futures. In 1980, Paul Tudor-Jones was an independent floor trader on the New York Cotton exchange and Louis Bacon of Moore Capital began his career as a trader and broker of financial futures for Shearson Lehman Brothers before founding Moore Capital in 1986. Going forward, an investor would do well to look to invest in a global macro fund manager that has significant experience in trading commodities as well as financial futures as the commodity super-cycle continues to play itself out.

Foreign Exchange

Short US dollar positions has been a core theme in many global macro funds for a number of years, but recent developments have proved to be most beneficial to this trade. The Fed’s reaction in response to the fall out of the sub-prime debacle and ensuing banking crisis has been to deeply cut rates resulting in pronounced US dollar weakness. The US dollar has fallen nearly 20% since the summer of 2007 and 10% in 2008.

Secondly as the interest rate differential between the US and in particular Japan has substantially narrowed, another key theme has been the unwind of long carry positions financed through short yen positions, and the resulting surge in the value of yen.

Finally, the US dollar has been in a unique position as a global benchmark currency against which many emerging and commodity producing countries peg their own currencies. The pronounced weakness in the US dollar has exerted strong upward pressure on these currencies as central banks and monetary authorities struggle to contain inflation, the aftereffect of a disproportionately weak currency coupled with strong domestic demand.

Fixed Income

The outlook for fixed income is perhaps at its most uncertain for a number of years. The paradox facing the fixed income markets is whether to follow the Fed’s lead and assume that interest rate cuts herald an impending recession and therefore a steeper yield curve. Or on the other hand, that growth outside the US will continue and this coupled with surging commodity prices will lead to inflation that will inevitably be imported into the old world economies given their dependence on imported goods. In which case, central banks will be forced to keep monetary policy tight to contain the inflation; this is best seen to effect in the ECB’s current adopted policy stance.

It would appear that for the moment the fixed income markets are most focused on inflation as a driver for policy. As a result, the initial steepening of the US curve during the first two months of 2008 has been followed by aggressive flattening whilst in Japan, where 10yr bonds have recently held as low as 1.4%, the markets have begun to actively re-price the risk that the BoJ will hike rates later this year.

Conclusion

The Chinese proverb, “May you live in interesting times” should be the byword for global macro funds. Clearly the lack of volatility in global markets until last year was a major detractor for the opportunity set of these funds. But with a number of key themes beginning to be played out across all major asset classes, global macro managers are well-placed to capitalise on the resulting volatility and developing trends in commodities, currencies and global financial markets.

Biography

MADILEAN COEN

Madilean Coen co-founded Blacksquare Capital. She began her financial markets career at Prudential Securities in New York where she worked in the futures and commodity brokerage division. In 2000 she joined Scudder Investments in London as Regional Sales Director for Europe and the Middle East. Following the merger between Scudder Investments and Deutsche Bank, she became a Director and Head of European Retail Distribution for Deutsche Asset Management. She left the firm in 2002 and worked as an independent funds raiser for hedge funds.

RICHARD SHERWIN

Richard Sherwin joined Blacksquare Capital as a director in 2008. Previously he worked at JP Morgan Private Bank as the Head of Fixed Income, Commodities and Foreign Exchange for Europe, Middle East and Africa as head of strategy, product origination, fund management and trading for those asset classes.

About Blacksquare Capital

Blacksquare Capital LLP is a London-based alternative asset management firm. It builds sector specific funds of funds in the global macro and commodities arena accessing top-tier asset managers who have demonstrated superior risk adjusted returns throughout a variety of market conditions. The firm’s clients are mainly institutional: private banks, wealth management firms and family offices. The firm is authorised and regulated by the FSA.