The environment of 2018 has seen most global macro investors caught between conflicting tensions. On the one hand there has been an observed slowdown in the rate of global economic expansion, and on the other pressure from rising US interest rates. The former arguably represents more of the same; markets are constantly buffeted by reasons to be fearful of unpleasant fundamental developments, whether they originate in ‘trade wars’, sovereign crises, natural disasters, or straightforward cyclical dynamics.
The latter however may represent a more profound structural shift. Not since 2004 (with the possible exception of the ‘tapering’ phase in 2013) have we seen a situation in which upward pressure on the global discount rate, rather than fear of growth weakness, dictates broad asset class performance.
This type of dynamic represents a very different type of risk to that which many of today’s macro investors will have experienced in their careers: the risk that arises when old ideas of how to value assets are challenged, resulting in new types of volatility and correlation patterns.
If we were to go by market coverage provided by the popular press, it may seem unusual to point to the interest rate dynamic as the key variable behind market moves in 2018. By weight of coverage (beyond the usual ‘Fed watching’) trade wars, slowdown in Asia and Europe, and now commodity price declines might seem the more likely suspects for the largely disappointing returns (particularly relative to the previous year) delivered in many areas in 2018.
However, it is notable that the key phases of correlated weakness in global equity and credit markets this year came first in February, and then again in October. As can be seen in Fig.1, which shows the relationship between US 30-year linkers and the Vix index, these were both phases in which US longer-term real rate expectations began to shift higher.
In this publication earlier in the year I wrote about how the increase in US short rates, which had been treated as a benign trend in 2017, would ultimately have to cause these types of distortion across assets should it persist.
Most importantly, I suggested that such a change in behaviour would not resemble the patterns of much of the recent past and could play a large role in dictating which investment strategies were successful or otherwise.
The popular conception of investment (and the model still followed by large parts of the industry) is that the best route to success lies in being able to forecast future news about fundamental variables like growth, profits, inflation, and so on. By getting these right, you have a clear ‘map’ to where prices will end up.
This is the type of thinking that dominates most of the headlines (the ‘trade war-type‘ fears listed above) and such themes certainly can play an important role in investment returns. For example, the outperformance of the US stock market versus the rest of the world in between February and October can at least partly be explained by the evolution of earnings, growth, and currency trends.
However, the major dislocations and investment opportunities in markets – particularly at a macro level – are often about something else. Even before the notion of efficient markets was being challenged in academia, the best active investors were observing that there is far more going on in markets than a straightforward news/price relationship. In most public markets, if there was any investment ‘edge’ to be found, it was likely to be elsewhere.
This is because, even with the same news, individual investors will form different sets of beliefs about the future, and the distribution and correlation of these beliefs play a major role in driving asset prices. The importance of diverse beliefs was described by economist Mordecai Kurz as ‘endogenous uncertainy.’  ‘Endogenous’ in that the uncertainty was derived from the divergent beliefs of market participants and not simply related to new information (which is ‘exogenous’ to the market).
Importantly, this type of uncertainty can have its most profound effects when it is harder to value an asset.  This is part of the reason why you typically see more volatility and extreme dislocations in currencies as opposed to government bonds for example.
I believe that this framework for understanding markets is crucial for making sense of the investment environment today. As I wrote in April: ‘US rates represent our best measure of the ‘risk free rate’ that underpins the valuation for all assets’. Consider the traditional ‘building block’ approach to valuation; investors need a sense of risk-free returns before we can begin to assess whether risk premia on offer are attractive or otherwise.
If investors can be less sure about the ‘correct level’ of all valuations, then the propensity for a different sort of volatility, and changing correlation properties across assets is increased. The ‘valuation anchor’ that tells us whether we view assets as cheap or expensive is loosened, and with it the sense of gravity that it can exert on prices. Without this gravity, markets can become more prone to wild swings and overshoots.
The reality is that the long-term risk-free rate (whether or not we choose to refer to this as an ‘equilibrium’) is constantly on a journey. The structural decline in this rate which began in the 1980s accounts in no small part for the strong real returns enjoyed by both equity and bond holders over that period.
In figure 2, we can see this structural shift as US 10 and 30 Year Yields have followed the average of the prior ten-year average policy rate. We can also see how the middle of 2016 may have represented a break in that trend.
At that time (in “A Pivotal Moment?” The Hedge Fund Journal, June 2016) I noted the extreme nature of asset valuations, and the nature of investor psychology that went with them. Since then we have seen a move upward in rates, initially unwinding the final ‘blow-off phase’ of yield declines that took place amidst 2016’s deep pessimism, then largely limited to short end of the curve (the much-discussed curve flattening of the last two years) until very recently.
This leaves investors with a challenge: are we facing a structural shift upwards in yields from here, back to what used to be considered ‘normal levels,’ or will the path be more consistent with cyclical moves around a permanently lower equilibrium?
A background of a more interconnected global economy through free trade, more flexible economies, and technological advance would point to the latter. But the scope to make meaningful returns out of this observation, at least from large parts of the fixed income universe, looks to be played out at prevailing levels of yield. At an intuitive level, the ‘lower for longer’ thesis is certainly not a contrarian stance anymore and for many of us it is difficult to envisage a return to the type of rate levels seen even as recently as ten years ago.
On the other hand, current geopolitical challenges add to doubts over whether this environment will persist, while debates about the legacy of quantitative easing reveal nearer term sources of confusion.
There have been a number of periods in history in which macro investors have been confronted with such uncertainty about the real rates underpinning the valuation of their assets. Most recently phases like 1994 and 2004 rate moves caused similar confusion for investors (and conundrums for policy makers).
In each of these cases, the de-rating associated with these periods, ultimately meant a ‘re-setting’ of valuations to a path of higher returns over the next few years, rather than a destruction of value. However, for this to be true in the case of long exposure to equities and other ‘risk assets,’ it was necessary that rising policy rates be associated with strong earnings growth. The scope for assets to withstand a de-rating without this is clearly limited.
The awareness of this fact would appear to explain the nature of market psychology in 2018. Outside of the February and October phases, markets have been hyper-sensitive to signs of slowing growth.
Almost all investor debates are couched in terms of dealing with a global economy and markets that are late-cycle, signs of slowing growth in Asia and Europe have been extrapolated, and there has been a skittishness around corporate earnings announcements such that strong earnings releases were frequently given less credence in markets than signs of weaker guidance.
Macro investors clearly need to keep an eye on these variables, but also need to accept that the changes we are seeing today may be more profound than that.
A different type of environment may be emerging, one in which the confusion caused by investors’ attempts to grapple with a sense of value, rather than simply assessing the path of fundamental developments, creates significant opportunities in the form of higher short-term volatility and more profound dislocations at an asset class level.
Strategies that are to succeed against this backdrop will need a framework for assessing which variables – fundamentals or investor beliefs – are driving markets in each major move. In a world where endogenous uncertainty is high, investment success is likely to require different tools than those that have been successful for much of the last decade. In 2017 (“The Wrong Type of Macro?” The Hedge Fund Journal, July 2017) I argued that a key part of this would involve a change in attitude: an obsession with low volatility, which largely reflected a fear that returns could not be generated rather than anything else, should not be as widespread in the hedge fund industry as it has been.
Heightened volatility in markets should be treated as a source of opportunity as opposed to something that needs to be hidden from. The risk with the latter mindset is that those strategies which have promised strong returns with lower volatility based on the regime of the last decade could at best be set up to disappoint, as has been the case for the last couple of years, and at worst be driven into ‘reaching for stability’ and simply replacing volatility with a whole host of other risks that are hidden from plain view (illiquidity, credit risk and so on).
Past phases have shown that a de-rating of asset valuations need not always be feared, while the associated volatility can often be a source of opportunity.
The correlated nature of volatility across growth-sensitive assets in 2018’s major phases of endogenous uncertainty has made it possible to buy diversified assets on far more attractive valuations. It should be remembered that, in the absence of significant inflation, real rate pressures should be a function of improving growth and profits dynamics.
The reverse is also true. The success of long only mixes of bond and equity, and ‘risk parity’ strategies in particular, over the past decade was built largely on the negative short-term correlation between growth and rates. Even government bonds which appeared to offer low absolute yields were able to offer protection via capital gains in periods of growth fear.
This is clearly a finite game, even if we allow for the possibility of negative yields, but with US Treasury yields now at materially higher levels, they arguably offer greater scope currently to provide some protection in the face of major growth disappointment.
This is not the case for the government bonds of Germany, the UK, or Japan (see Fig.3). Pressure from changing US rate expectations in these regions has manifested itself in currency moves rather than yields, and they remain vulnerable in the same way as the US was in 2016.
Domestic investor psychology in these regions continues to resemble that which I identified globally in 2016: a fear of short-term volatility and a willingness to pay a high opportunity cost in order to avoid it. While my recent trips to the US have revealed a shift in the attitudes of American investors (due in no small part to recent performance of the domestic equity market), the ‘pivotal moment’ I identified in 2016 away from pessimism and volatility aversion still has some way to go. A failure to change one’s thinking in line with the environment could prove costly.
 See for example: Kurz, Mordecai, “Rational beliefs and endogenous uncertainty,” Economic Theory, Vol. 8, No.3 (Oct, 1996) pp. 383-397. We thank Horace (Woody) Brock for his work in outlining the importance of Kurz’s work over the years.
 This is what Horace (Woody) Brock has described as ‘Pricing Model Uncertainty’).