Macro Strategy Is Dead. Long Live Global Macro

Rumours of its demise are exaggerated

PHILIPPE BONNEFOY, CEDAR PARTNERS INVESTMENT MANAGEMENT

Macro investing is perhaps the most publicised of hedge fund strategies, due in no small part to the substantial headlines generated by managers such as George Soros and Julian Robertson. Not surprisingly, macro investing is perceived by many to be a risky, volatile investment strategy, a perception often fuelled by a media inclined to revel in ‘hedge fund meltdown’ stories.

It was only recently that industry pundits were conducting the post-mortem of the macro strategy, which never quite recovered from its association with the high-profile debacles of the 1990s. Persistent lacklustre performance in this sector has not provided an incentive to lure participants back. Then the last two days of February shook up the status quo. The subsequent global rout has finally forced the market to accept what a handful of market specialists have stressed for some time now, that the opportunities for macro strategies have been increasing as a result of the inherent disequilibrium of markets. The warning signs have been evident for some time as market complacency in some asset classes reached a peak as implied volatility fell to ridiculous levels. We witnessed 20 year lows in foreign exchange volatility, while hovering above 10 year lows in equity volatility. In fixed income markets, the 100-day volatility of ten year treasuries reached 4.5%. The Volatility Index reached such low levels, it was indisputable that risk was poised to make a flamboyant ‘comeback’ (Fig.1).


Macro events often occur as fundamental changes in global economies, typically brought about by shifts in government economic policies, political climates or interest rates which impact all financial markets. Often, prices adjust abruptly causing severe market dislocation. There are probably as many approaches to identifying and capitalising on macro trends as there are macro hedge fund managers, but all the players and their approaches have several things in common.

First, macro players are willing to invest across multiple sectors and trading instruments. They are able to monetise every attractive opportunity, trend and strategy. Moreover, they see the entire globe as their playing field and are well aware that events in countriesor regions can have a domino effect across global markets.

Because macro managers have many ways to structure a trade, they will often express a market view differently from their peers using almost any investment technique to trade foreign exchange, fixed income, equities and commodities. Leverage and derivatives are often used to accentuate the impact of market moves. It is this use of leverage, on unhedged directional bets, that has the greatest impact on the performance of macro funds and results in the high volatility that they may experience. The interesting evolution, over the last decade, has been the enhanced risk management practices adopted by many macro managers. Institutional investors, who are fast replacing entrepreneurial High-Net-Worth-Individuals as the main group of hedge fund investors, prefer a lower volatility of returns. As such, the new breed of macro manager is generally operating with much tighter risk constraints, thus improving the quality of their investment returns. As an illustration, over the most recent 5 year period, the annualised returns of the macro strategy within the HFRI index are around 10%, while risk registers at just under 5% (See Fig.2).


Until recently, macro hedge funds represented approximately 11% of the overall hedge fund universe compared with around 40% in equity-focused hedge funds1. In fact, most hedge fund investors have been under-exposed to global macro funds while over-exposed to equity-focused hedge funds, with equity long/short representing the largest percentage of European hedge fund strategies and invested assets. After years of short exposure having caused a drag on their investment returns, most long/short managers gradually decreased their short positions to the extent that they began to resemble leveraged, long-only funds. It could be understandable to see the increase in equity beta as the path of least resistance for them. However, it has been worrying, over the past year, to observe the surprising number of managers who were lured into increasing their directional exposure, all of whom have undoubtedly felt the sting of the downturn in global equity markets. During the same period, we also witnessed an increased correlation of a number of hedge fund strategies to traditional asset classes. On the contrary, global macro has historically demonstrated a low correlation to traditional asset classes2.

The global macroeconomic stage is now set for a resurgence of the macro strategy. There are several ‘macro themes’ which represents a major opportunity for investors in energy, commodity and infrastructure plays. Most economic surveys have been forecasting a slowing of global growth in 20073 just when global markets will be challenged by higher interest rates. In developed economies, corporate profit margins will begin to face a more challenging environment due to higher structural costs and potentially slowing revenue growth.

A major theme we are currently developing is the effect of globalisation on worldwide economies. UN data suggests that the wealth gap between rich and poor has roughly doubled in the last 40 years. As an illustration, the income of the richest 20% of the world’s population in 1960 was 30 times that of the poorest. In 2006 it stands at 80 times greater4. These prosperity divergences are becoming evident to the less advantaged through the proliferation of internet, satellite television and other communications. Social unrest is already manifesting itself as populism, antiglobalisation, religious extremism, anti-Americanism, surging nationalism.

Governments wanting to hold on to power (viz. Latin American nations, India, China) will have to provide fast economic growth. The World Bank estimates that developing countries need annual growth rates of 5% to 6% for at least 10 years in order to raise people out of poverty5. This can potentially be a bullish development for global economic growth, albeit creating enormous structural supply/demand imbalances which can exacerbate inflation in many commodity markets. Alternatively, emerging market leaders can adopt more radical populist policies such as nationalisation of industry, as Chavez is attempting in Venezuela, which will have wide-reaching ramifications.

There will be an incalculable impact on world markets over the next decade of Chinese infrastructure development projects and the urbanization of its 70% rural population. Development projects are already creating shortages in global supplies of copper, cement and zinc. China should be able to quadruple its GDP in 20 years. In the meantime, it is progressing toward a consumer-led, rather than an export-led, economic model which is expected to create demand in the luxury goods sector. The implications for such significant growth and consumption will affect world energy and commodities markets, as well as the trading and political arenas. Similarly, in India, which currently lacks a viable highway system connecting major cities, the Prime Minister recently declared the need for a $320 billion infrastructure investment over the next 5 years to generate 10% annual growth6.

One of the emerging structural dislocation themes we monitor is the disequilibrium in the energy supply-demand dynamic. Namely, the global challenges related to the depletion of world oil reserves and the increasing use of energy supply as a political weapon. Of great interest is the generation of sustainable energy alternatives with the concomitant long-term investment implications of producing and distributing biomass (biodiesel, bioethanol and biogas); hydro, wind and solar power; as well as the development of biodegradable waste and recycling industries.

Another global investment theme is the financial viability of industrialised societies. The most important demographic trend of the past 50 years is the declining birth rate in the developed world. The U.N. reports that in 65 countries representing 48% of the global population, the fertility rate is less than replacement levels. This includes all European countries, Japan, South Korea, China, Singapore, Thailand and certain Caribbean countries including Cuba7. The potential economic implications include mass immigration, labour mobility, pension crises, extending the retirement age, huge social welfare liabilities, lower economic growth and higher taxes.

Climate change may impact global economies as a greater risk of natural disasters and flooding, of the scale of New Orleans, may impact agriculture as well as industrial productivity. We are already seeing the worst drought in the wheat growing areas of Australia, where grain inventories are at 25 year lows. In the same vein, the acquisition and safeguarding of potable water supplies around the world may also present great conflict and opportunity. Across the globe, disruptive climatic phenomena may also increase the political will to restore the damage inflicted by industrial development and urbanisation. Enormous resources may be dedicated to eco-system remediation and infrastructure restoration such as: wetland, mangrove and fishery rehabilitation; reforestation; sea-dike and levee reinforcement; as well as electrical grid development and up-modelling of water supply, waste facilities, transport networks etc. This emerging industry is at least $1.5-$2 trillion a year and growing fast8. One-off systemic shocks may also create big picture macro plays: a further significant fall in US housing prices; the collapse of a major money centre bank or a significant credit event (such as we are seeing with sub-prime lenders) or an M&A-instigated one. In Europe, in a report on the LBO market, Dresdner Kleinwort warned, “the question of whether or not the leveraged market turns into a bloodbath may depend on the severity of any downturn in the cycle.”

Sir Isaac Newton probably best described the macro approach “I do not know what I may appear to the world, but to myself I seem to have been only like a boy playing on the seashore, and diverting myself in now and then finding a smoother pebble or a prettier shell than ordinary, whilst the great ocean of truth lay all undiscovered before me”. This could be the mission statement of global macro managers everywhere as they traverse the world stage looking for endless possibilities and combinations of themes that pique their interest. However, it is also worth noting the cautionary words of Vernon Walters, ex-US Ambassador to the UN, who stated that “the expected rarely occurs and never in the expected manner”9.