After more than 15 successful years as a central banker, strategist and real money manager, I launched a new macro fund in May. It has been a chastening experience so far. I have to put my hand up to what now appear to be some fundamental errors. The first; that I assumed for inflation to abate, we needed a period of sub-trend growth. With the Institute of Supply Management index heading south and the housing market looking vulnerable, I believed that a period of sub-trend growth was the most likely path for the US economy, especially as the Fed appeared unable to proactively forestall a slowdown because their hands were tied by inflation. The risk to this negative view was that real income growth was strong and could hold the economy up. If we followed this path then surely inflation would remain elevated and this would force the Fed’s hand. You couldn’t have your cake and eat it!
As it turned out however, you could have your cake and eat it, at least for a time. Manufacturing was weak, but this was largely offset by strength in services. The housing market also remained vulnerable and this depressed mortgage equity release, but was offset by the strong real income growth that fuelled consumption. The happy picture was then completed for risk assets as inflation waned without a significant rise in the output gap. This happened partly because commodity prices dramatically reversed some of their recent year’s gains while other components of core inflation reflected the weakness in the manufacturing sector.
The second fundamental error was to underestimate how difficult it was to construct a portfolio that was not dominated by the theme of liquidity. Some things did work out as we’d expected. As growth eased back, we made profits from playing the bond bull market and we made some money being short of the Canadian dollar as commodity prices fell. We also profited from being long non-Japan Asian currencies as they benefited from falling commodity prices and valuation. But even in Non-Japan Asia, yield seemed to matter more than anything. The phenomena of yield and equity beta dominating can be seen across markets.
So where do we stand now? Well, two rules that have served me well as an investor and strategist through the years are firstly to learn from your mistakes and secondly to keep an open mind. Experience has also taught me that things change, but sometimes it takes longer than expected.
With respect to liquidity, we believe that it remains plentiful by most measures. The manner of the price action in the market in 2006 is testament to this. Monsieur Trichet likes to make that point about the Euro area, but we believe it to be more widely true (see chart 1 which shows two G10 measures of liquidity that we have constructed using core inflation, GDP and alternatively policy rates and term rates). That leads us to the conclusion that, in the absence of a negative growth surprise (we still do not rule out the possibility of this being afforded by the US housing market see chart 2) it will not only be the ECB who are withdrawing liquidity from the system in 2007. We believe that central banks will tighten faster thanis discounted because they generally believe that they still have accommodative monetary stances and because we believe that global labour markets are showing signs of tightness. The strong real income growth in the US is evidence of this. The implication of the plentiful but draining liquidity is that carry and beta are likely to remain important in 2007, but with waning influence.
With respect to the bond market we have shifted from being bulls (with the risk to the view being higher inflation) to being bears with the risk to the view being lower inflation because of lower commodity prices. Look at a chart of 10 year US swap rates minus core CPI to underline that if growth risks are abating then the US bond market looks expensive. With respect to equity markets, as growth accelerates again due to the still plentiful liquidity, the more cyclical markets should do well. As bonds back-up however, we look for support to switch to the more defensive markets.
In currencies, we will not again underestimate the power of carry. But I still believe that it should not be the be all and end all as it was for much of 2006. As a result, we will look for carry opportunities but also those where other factors such as correlation with commodities, FDI and valuation are compelling.