‘It’s Macro Time’

Views from a major manager in the Permal Portfolio

Originally published in the September 2007 issue

Preface from Permal

Global macro has been a core strategy since we started investing in hedge funds more than 30 years ago. Since 2000, we have witnessed a very favourable environment for macro strategies (2000-2003) and, in recent years, a more challenging period relative to other investments, as shown in Fig 1. Looking at the state of affairs as of mid-2007, we may be entering a new phase where macro will generate attractive performance in absolute terms as well as relative to other hedge fund strategies and to traditional investments. The commentary below highlights many of these conditions, some of which have already begun to develop since its writing. It is excerpted from a second quarter 2007 investor report written in early July by Dr. Menachem Sternberg, Chairman and CEO of Eagle Trading Systems, an independent Systematic Macro specialist manager with whom Permal has had a long investment relationship. Whilst our macro view may differ from those presented below in some areas, we agree wholeheartedly that we are moving to an environment characterised by declining liquidity, rising volatility and growing divergence among asset classes. This creates attractive trading opportunities for skilled macro managers.

Attractive Trading Opportunities

The global economy is in transition. Markets have until recently been dominated by liquidity and harmonised global growth, resulting in declines in volatility and risk premiums, and narrowing of credit spreads. Liquidity and solid growth previously provided shock absorption to the global economy, making markets more forgiving of structural imbalances, dislocations and global uncertainties. There are now signs that the period of complacency is over and one needs to pay more attention to fundamental factors. The gradual withdrawal of liquidity and the moderating of global growth are making the global economy increasingly vulnerable to adverse developments, especially given the high level of leverage currently employed in the markets. While liquidity previously contributed to many markets moving in tandem, with moderate price changes and declining volatility, its gradual withdrawal is now likely to give rise to divergences in market behavior, amplifying price responses to global economic and political developments. The current environment, with its higher sensitivity to risk is likely to continue to justify price adjustments across many markets. This is furthered by existing structural issues such as unsustained manipulative currency regimes, currency reserve issues, carry trades and a high degree of financial leverage, as well as the rise of protectionism in trade issues and persistent inflation risks. In such an environment, markets can rapidly shift their focus between various factors as well as new developments, triggering rapid liquidation flows but also giving rise to extended trading opportunities.

In particular, one should pay closer attention to, and closely monitor, the following issues:

  1. Inflation does not seem to get the full attention it deserves. Markets are quick to excuse higher numbers by distinguishing between headline and core inflation. Yet, faced with consistent trends of higher energy and food prices one would expect markets to stop looking at these prices as a one time aberration. Underlying factors including higher resource utilisation, rising prices of raw materials, steady rises in wages and with China becoming an exporter of inflation rather than deflation are all pushing prices higher and likely to challenge complacent and slow central banks, triggering further price adjustments.
  2. The task of central banks in conducting monetary policy has become more challenging, given the levels of growth and liquidity, and amplified by rising global wealth, access to financing tools and ability to transfer risk and leverage. Positive effects of liquidity on growth and its adverse effect in fuelling inflationary pressures should have encouraged central banks to be more vigilant. Yet most central banks have been somewhat tentative and slow in raising rates, thus fuelling the accommodative global monetary conditions.
  3. The transition of global growth from developed to emerging economies and the importance of policy decisions in these countries on global developments turns attention to the lack of historical precedence in judging such decisions. Markets are quick to respond to each policy change or comment, especially in China, but the lasting effect on price behavior has so far been limited. Markets seem to distinguish between financial adjustments, which do not necessarily affect the real economy, and other adjustments, which can cool off Chinese and global growth. One should expect, however, that any adverse change in China's growth prospects will have an adverse effect on global growth prospects and price levels in many markets.
  4. Global fixed income markets are facing challenges from the changes in the financial landscape. Rises in volatility and risk premiums are likely to slow lending as lenders re-evaluate the risks associated with their loans. The picture is clouded by the huge borrowing needs which are about to hit the market to finance the latest LBOs and other private equity deals.
  5. The crisis in the US sub-prime sector and its continuing effect on the whole housing market need to be watched further. So far, its effect has been limited to financial markets without apparent effect on consumer behavior or the economy.
  6. The currency environment is likely to present difficulties for the US dollar and, thus, continue to provide opportunities. Several factors are working against the confidence in the US dollar and can contribute to its decline: the deceleration in US growth relative to global trends, divergence in monetary policy with the US on hold while other central banks are still raising rates; the need to continue to adjust reserves away from the US currency, increased discussions by several countries to de-peg their currency from the US dollar, the decline in US economic and political dominance and domestic US issues are the main such factors.
  7. Countries that have been at the centre of carry trades, such as New Zealand on the long side and Switzerland and Japan on the short side, are showing increased concerns with the disruption that the liquidation of such trades can cause, and are warning against the continued use of them.
  8. The energy and commodity sectors are likely to continue to witness high volatility. Speculative flows, strikes, production and weather developments, along with Chinese and global growth concerns are triggering frequent changes in market sentiment. Various opposing factors often shift and result in periods of strength, quickly followed by weakness, and vice versa.

In sum, given the breadth and flexibility of their investment strategy, global macro managers are best positioned to profit from the structural opportunities present in the markets.