After Louis Bacon closed Moore Capital this past week, both the FT and the Economist had interesting articles on the future of global macro investing. They struck almost opposite tones, each making good points about the current and future reality. Global macro will return, but likely in an unexpected form.
Stability killed the macro star
The glory days of global macro as we know it started when the Bretton Woods system collapsed in 1971, ending fixed exchange rates. Broadly speaking, there were two different groups of investors who entered this environment and profited immensely. The first was people with long/short equity experience in global markets and included George Soros, Jim Rogers, and Michael Steinhardt. The second group included people with a physical commodities and futures background. The Commodities Corporation trading firm trained and/or funded many macro investors including Bruce Kovner, Paul Tudo Jones, Louis Bacon, Michael Marcus, etc.
The dramatic changes in the institutional architecture of international trade and finance created a volatile playground for these investors. Exchanges developed new derivatives instruments for trading newly volatile currencies and increasingly global commodities markets in a high inflation environment. Global trade started to open up dramatically, and global supply chains spidered out in response to changes in policy and technology. Many investors made or lost fortunes betting on big equity moves like the 1987 stock market crash(shortly after Greenspan became head of the Fed), or the breaking of fixed currency regimes such as the sterling crisis of 1992, the Asia crisis of 1997, Russia in 1998, etc. There was also the emerging market debt crisis in the 1980s and the surprise interest rate hike in 1994.
After the 2009 global financial crisis, interest rates and inflation have been abnormally low. The euro crisis notwithstanding, markets have lacked volatility. With no volatility its hard for the traditional global macro style to work. Moore and his proteges have all closed down recently. The decline of the legacy macro investors is just one part of the broader decline of active management. Its been a long torturous capitulation.
Yet stability leads to instability. Long periods of calm tend to be followed by extreme volatility.
The future is global micro
Is there any future for global macro? That depends on what your definition of “global macro is” Making bold systemic predictions about surface level data is unlikely to lead to profits. Yet global macro’s main benefit is its flexibility to take long or short positions in any asset class anywhere in the world. Although trades in large liquid markets get the most attention, the analytical techniques of global macro can also uncover insights leading to lucrative opportunities less liquid frontier, emerging, and alternative markets.
The future of global macro will involving finding bottom up industry and company specific insights that fit with top down shifts: global micro. Steven Drobny mentioned this evolution in Inside the House of Money . Indeed most quantitative techniques of the original macro greats are commoditized. Analysts need to look beyond headline numbers numbers for less obvious global micro trends and second order impacts on tradeable assets.
Capital flows and valuations have a funny historical tendency to overshoot in both directions. Many investors build up leveraged positions based on stale fundamental inputs, and when they wake up to a new narrative taking over the market, they must rush to a crowded exit. What will be the next gestalt shift in which a new narrative takes over markets?
The next gestalt shifts
Don’t try to play the game better, try to figure out when the game has changed
Over coached football players do not respond well when a game takes an unexpected turn. Investors schooled in calmer markets may similarly struggle with renewed volatility.
Many of the classic macro bets(and blowups) involved major breaks in fixed currency regimes. Sometimes the big trade(or blowup) involved direct currency exposure. Other times it involved investments impacted by second order effects. Its possible that the big macro trades of the future will be more subtle, and play out over many years away from headlines before becoming obvious.
For the past few decades, global trade was getting generally more open. That is starting to reverse. The WTO dispute settlement mechanism will completely shut down next month because the Trump administration is blocking new appointments to the appellate body. Trump’s attitude is just an extreme manifestation of a global trend towards populism and trade conflict. At best, there will be a spaghetti bowl of bilateral agreements, instead of a large open multilateral trading system. Companies will need to dedicate more resources to supply chain strategy.
At the same time, emerging markets are starting to trade more with each other than with the developed world. Africa might become the world’s largest free trade area. China is attempting to facilitate more commodities trading without using the dollar. As China develops its own bond markets, it will invest less in US dollar based debt markets. As the world shifts to cleaner energy, oil producers will have fewer dollars to recycle into US capital markets. The relative importance of the US dollar and of major US companies is likely to decline.
Often policy changes have second order impacts on individual businesses because they alter competitive forces in their industries. Indeed its difficult to find an example of businesses that are completely immune to change in international trade policy.
Reality and narratives change at different paces. Narrative changes alter capital flows ultimately impacting valuations.
Here are some other speculations on what shocks or regime shifts might occur:
- I don’t have a strong view on inflation, but do find it concerning how few S&P 500 companies will do well if we encounter high inflation. Its commonly accepted wisdom that low inflation will continue. Yet most analysts are only considered demand driven inflation, and ignoring possible supply side shocks. There has been little investment in new production capacity for many key over the past decade. Note the conspicuous absence of resource companies in the top holdings of any indices. More insidiously, if certain prominent venture funded startups shifted from growth mode to harvest mode, and suddenly needed to make money, they would be forced to raise prices, impacting consumers directly (See: Cheap Stuff and Cheap Capital) . Alternatively, if we face deflation, then debt burdens on over leveraged companies and consumers will be a much greater drag on growth.
- If negative interest rates continue, they’ll force banks and insurance companies to find new business models, or slowly perish. If negative interest rates reverse, it will be a shock to a lot of overleveraged companies
- Pension funds are a looming disaster in many western countries. The government will overreact somehow when it becomes a social issue.
- Many investors, including pension funds, have rushed into illiquid alternatives such as private equity in search of higher returns. It is likely that those investments will fail to deliver the expected returns, and worse yet, they might be illiquid for longer than expected.
- ETFs have grown from obscure backwater to the default investment option for both institutional and retail. Many ETFS are invested in illiquid assets- creating the potential for a unique type of death spiral. The SEC recently made some changes to its filing requirements which might make it easier to preemptively find which ETFs are most vulnerable.
Investing goes through fads. Investing strategies and fund structures(1) go in and out of style. Nowadays long/short hedge funds are out and infrastructure funds are in. Within the public equity markets, value is out, growth/momentum is in. Each time this happens, people forget how the cycle repeats.
In fact, one CIO contended that if he brought a hedge fund that paid him to invest to his board, the board would dismiss it without consideration — simply because it’s called a hedge fund, and hedge funds are bad.Institutional Investor
Hedge funds may have to do a name change if they want to raise capital.
Remember last time?
And yet people forget:
Allocators woke up craving the next rising hedge fund star and couldn’t invest enough at high and increasing management fees after the widespread success of long-short funds in the weak equity markets of 2000-2002. Board rooms back then castigated CIOs for not having long-short equity hedge funds in their portfolios.
This isn’t the first time:
People forget that 40 years ago, officials such as Paul Volcker of the Federal reserve wanted an active hedge fund industry to absorb the risk that was not well managed by state-insured banks.Financial Times
Each investment strategy picks up a certain type of risk(and potentially earns a profit in doing so)- if a strategy disappears that particular risk can become a systemic issue. Fortunately, around this time it also becomes more lucrative to bear the risk others are unwilling to bear. Eventually the risk reward tradeoff starts to make sense again.
Different, different, yet same
In the 1960’s Warren Buffett put up ridiculous returns, and Alfred Winslow Jones proteges profitably exploited anomalies in markets. By the mid 1970’s of there were many articles about hedge funds shutting down though. Industry AUM declined ~70% peak to trough. Nifty fifty boom and bust followed by the long nasty bear market. But as the institutional architecture of international trade and currency shifted we entered glory years of global macro/commodities traders. Then the 80’s were great for Graham deep value and Icahn style activist investing after the 70’s bear market left a huge portion of the market selling below liquidation value.
Likewise late 90’s again saw the death of hedge funds as day traders in pajamas earned easy returns from the latest dot-com- until the crash. Yet out of the rubble of the tech bubble rose a new generation of great hedge fund managers. There was rich pickings for surviving value hunters- and those with the guts and skills to execute became household names a few years later. Many value managers that nearly went out of business during the tech bubble put up ridiculous numbers 2000-2002 and through the next financial crisis. (See: The arb remains the same)
The greatly exaggerated death of a style gives rise to an environment where there is a plethora of opportunities for something similar to that style to work. Each time the narrative in the greater investment community favors some type of uniform strategy, and LPs give less capital to other strategies- causing them to nearly die off. But then the lack of people pursuing the out of fashion strategy makes its return potential more lucrative. Eventually someone finds a new method to pick up those dollar bills on the ground that shouldn’t exist.
Economics emphasizes rational actors and equilibrium. Yet the messy reality is far more complicated. Ecology is a far more useful mental model.
A giant self over-correcting ecosystem
There is in ecological function to speculative capital and over time there should be some excess returns to those willing to take mark-to-market lossesFinancial Times
Like biological species, financial strategies can have competitive, symbiotic, or predator-prey relationships. The tendency of a market to become more efficient can be understood in terms of an evolutionary progression toward a richer and more complex set of financial strategies.Market force, ecology and evolution
Ecology emphasizes interrrelationships between different individuals and groups within a changing environment, and indentifies second order impacts.
Thinking like a biologist
One can develop a useful framework by replacing species with strategy, population with capital, etc
Flows and valuation interact, self correct, and overshoot.
….capital varies as profits are reinvested, strategies change in popularity,and new strategies are discovered. Adjustments in capital alter the financial ecology and change its dynamics, causing the market to evolve. At any point in time there is a finite set of strategies that have positive capital; innovation occurs when new strategies acquire positive capital and enter this set. Market evolution is driven by capital allocation.
Market evolution occurs on a longer timescale than day-to-day price changes. There is feedback between the two timescales: The day-to-day dynamics determine profits, which affect capital allocations, which in turn alter the day-to-day dynamics. As the market evolves under static conditions it becomes more efficient. Strategies exploit profit-making opportunities and accumulate capital, which increases market impact and diminishes returns. The market learns to be more efficient.
When an ecoystem is overpopulated with a certain species, it eventually overshoots and results in mass starvation. Populations fluctuate wildly across decades, and sometimes species go extinct or evolve into something that seems new.
New conditions give rise to new dominant species.
(1) Although I am frequently pedantic about the differences between structure, strategy, and sector, many in the media seem to use these interchangeably when discussing reversion to mean situations. Fortunately they all exhibit the same boom/bust phenomenon, so I am using them interchangeably here.
Hyman Minsky developed a framework for understanding how debt impacts the behavior of the financial system, causing periods of stability to alternate with periods of instability. Stability inevitably leads to instability. Minsky identified three types of financing: Hedge financing, speculative financing, and ponzi financing. It seems some people only remember Minsky every so often when there is a financial crisis, but the framework is useful in all seasons.
An asset generates enough cash flow to fulfill all contractual payment obligations. For example, a conservatively leveraged rental property that generates enough rent to pay down the entire mortgage over time, regardless of the change in quoted property prices. Or a company that issues some bonds, then pays them back using cash flow from the business Generally hedge financing units have a lot of equity down. Even a market crash, will not cause an investor to suffer permanent capital impairment if they only use hedge financing. The equity holder who uses hedge financing will never depend on the capital markets.
An asset generates enough cash flow to fulfill all debt payments, but not the full principal amount. In this case debt must be rolled over, or the asset must be sold, in order to pay back the full amount. For example, a rental property financed with some sort of balloon payment structure that generates enough cash flow to pay off mortgage payments up until the balloon payment at the end. When the balloon payment comes due, the investor must roll over the debt or sell the asset. An investor ttat uses speculative financing is dependent on capital markets. If there is a delay or a problem in refinancing, they could lose their investment.
This is basically “greater fool” investing. Ponzi financing means there is so much leverage n an asset, that the investment must be refinanced, or sold at a higher price quickly, otherwise the entire investment is lost. Sometimes property purchases will be financed with shorter term bridge loan. If the bridge loan can’t be refinanced with longer term mortgage, the investor is out of luck. Towards the end of the market cycle, many companies will be issuing bank loans or bonds that can only be repaid by refinancing. If their unable to refinance, they go bankrupt.
Use of ponzi financing means the investor is highly dependent on capital markets. The slightest disruption in capital markets or change in interest rates/inflation results in a large capital loss.
Junk bonds are not inherently bad. A higher interest rate can in many cases compensate for greater risk, especially across a portfolio of non correlated investments. Howeve, duringthe junk bond era, many companies
Similarly securitization is not inherently bad. It can allow capital to flow more effeiciently. But often banks would end up aggressively securitizing, with the need to sell the loans they made quickly. But if they weren’t able to resell they couldn’t hold the loans. This happened to Nomura during the Asian financial crisis, as vividly told in this Ethan Penner interview.
Ponzi in this case is not illegal activity, just extremely risky. Of course those investors who finance their activities ponzi style often end up feeling the need to commit illegal acts. The Minsky Kindleberger model is useful here.
The cycle repeats
During a recession is very difficult to get any debt financing that is not “hedge financing”. Lenders are scarred from the last cycle, and there is a paucity of available risk capital. But a price rise, and investors get more comfortable, more and more financing becomes ponzi units In fact. Lenders may lower their standards and become more accepting of ponzi units.
Throughout the market cycle, more and more financing is ponzi units. Eventually there is no greater fool to sell to. When many ponzi units are forced to sell at once, it eventually leads to a collapse in values. This is how stability inevitably leads to stability. The cycle repeats.
How to apply this?
To protect my capital, I look try to mainly expose myself to hedge financing, with a small amount of speculative financing. I position my portfolio so that I don’t need to refinance anything or sell anything in a rush. When I invest in leveraged companies with speculative or ponzi financing, I make it small position(always in some sort of limited liability structure), and generally won’t average down much if at all. Additionally, when I notice an increase in ponzi financing in the markets, I become more cautious.
Leverage, like liquor , must be consumed carefully if at all.
Everybody has access to Bloomberg and Google. Every global macro investor closely follows macro data out of every country. To gain an an edge, one must look beyond headline numbers, and find underutilized datasets.
This applies when finding countries, industries, and individual companies in which to invest. Any time you want to combine top down and bottom up insights, you need to get creative with finding the right data.
Schumpeter and Perez
Joseph Schumpeter pointed out that aggregate figures “conceal more than they reveal”.
Relations between aggregates are
“entirely inadequate to teach us anything about the nature of the processes which shape their variations, aggregative theories of the business cycle must be inadequate too…”
In Technological Revolutions and Financial Capital, ( Carlota Perez emphasizes that new technological paradigms can only be analyzed by looking closely at inner workings of an economy. Within the same country, or industry some subsectors will grow at astonishingly high rates, while others decline. Perez’s framework is valuable to analyzing times of great technological change, which is basically anytime. Examples she uses include the first British Industrial Revolution( the age of Steam and Railways, the Age of steel, electricity, and heavy engineering, age of oil, automobile and mass production.
Top line numbers such as GDP or earnings could deceive an analyst, especially when looking at a new market.
Valuation and pricing
“People living through the period of paradigm transition experience real uncertainty as to the ‘right’ price of things(including that of stocks, of course).”
Extreme jumps in productivity change relative price structures in the economy. “The change in relative price structure is radical and centrifugal. Money buying electronics and telecommunications today does not have the same value as money buying furniture or automobiles.” Therefore, looking at inflation or deflation in aggregate is deceptive. Many years after Perez’ book, this now exacerbated by the Amazon effect. To some effect this may impact valuation in some industries.
Long term aggregate data, spanning multiple periods of technological change are senseless. This goes for GDP, corporate earnings etc. Yet disaggregated stats are rarely available(except during more stable phases), as Perez points out.
The internet has provided more opportunities to find disaggregated, unique, underutilized datasets. Often this means poking around on weird regulatory websites, and following up on footnotes to academic papers.
This process might be about to get a lot easier.
Google launched a new dataset search engine. I’m excited to see how its impact snowballs as more datasets are added. Although intended for journalists, it is likely to be a valuable tool for investors seeking differentiated alpha.
Of course that means today’s edge, will be tomorrow’s table stakes.
See also: The hard thing about finding easy things
While packing for my redeye flight to Istanbul tonight, I remembered the last time I had travelled to Turkey around 6 years ago. After getting sort of stranded in Kazakhstan for a day, I ended up wandering back alleys of Istanbul talking to questionable people in the non-bank financial service sector.
A planning error left me with no choice but to run an experiment on the fringes of the global forex market.
At the time, I was working at an investment bank in China, but I got a week off for a some sort of Communist Party workers holiday in October. My then girlfriend now wife was a grad student in the US. We decided to meet in Turkey for a little getaway.
As I prepared for the trip I was flush with RMB(Chinese yuan), but short on dollars and Euros(1). None of the banks in Beijing I went to would directly change RMB to Turkish Lira. Plus all them had silly wide bid-ask spreads on RMB/USD or RMB/EUR transactions. No point in changing here I thought, I’ll just change once when I get to Turkey. Turns out that was a rookie mistake.
I was on the Air Astana flight from Beijing to Istanbul with a layover in Almaty, Kazakhstan. Checking in was a bit of a debacle. I had to wait in a long line behind migrant laborers who had absurdly large quantities of luggage to check, much of it in non-traditional suitcases (ie barely sealed cardboard boxes).
The guy in front of me in the line to check in was about 6 foot 4, bald, big boned, with the look of a football referee who let himself go. After some sort of commotion at the front of the line , he turned around, smiled and said in a baritone, probably Russian Accent: “Almaty airlines ,this always happens. “
The flight was delayed a few hours but it ultimately did take off. However we were late enough that I missed my connecting flight. I had a day to wait for the next flight to Istanbul.
Almaty airport wasn’t fancy, but it was no worse than many of the small airports I’ve been to around the globe. I went to a cafe to get some food.
Turns out they wouldn’t accept RMB. No problem I thought, and I walked over to the one moneychanger accessible from the terminal I was at.
Turns out they wouldn’t change RMB at all.
I went to the ATM, and it wouldn’t accept my card for some reason.
For amusement I tested if any of the shops there would take RMB. None would.
At least I got a lot of reading done passing the time with no money to entertain myself in the airport for a day. I don’t remember what the meal was on the next leg of the flight, but I remember it was quite delicious.
When I got to Istanbul, and ran into identical forex issues with shops, moneychangers, and ATMs.(2)
So I wandered the streets going into moneychangers asking to change money. Even banks with China origins wouldn’t do it. Finally one money changer looked surprised, and asked “how much,” as he motioned me over towards the other end of the counter.
I answered him, then he took out a pen and a piece of scrap paper, and started to draw a map.
It was a long journey. As I recall, I had to go to the far end of one of the subway lines, then walk for about 15 minutes. Finally I found a shop that would change RMB. But their rate was horrible so I said I’d be right back.
I finally found another one a block over with a much better rate. I was relieved to at last clutch a fistful of Lira.
The rest of the trip went smoothly. Of course those days were before Erdogan, um “changed” (3).
This time I’m going back to Istanbul, with a mix of USD and Euro I’m excited to enjoy deeply discounted falafel, and drink coffee while working from a deck on the Asia side of the bosphorus, with a perfect view of the river, and Europe on the other side. I won’t have time to explore the far ends of the subway lines since I’ll only be in Istanbul for a day. After that I’ll be going to Sofia Bulgaria and working there for a week.
(1)When if ever will the RMB be a global currency? I don’t know. My general view on currencies is I never make pure directional bets. I just try to avoid getting killed by sudden changes. This basically means cautious sizing of any position that is exposed to fringe markets. Smart operational decisions have real alpha implications in these areas as well I guess you can say I learned this on the streets, the hard way.
Anyways, while there is now a surplus of superficial media coverage of China’s One Belt One Road policy,few people are talking about the capital markets implications. China is basically throwing money at every country to its west all the way to Europe, with a potentially huge impact of the smaller countries. What I find interesting is that most of it is going to be financed with yuan denominated debt, not dollar denominated debt. Combined with a yuan denominated oil futures contract hitting the market, One Belt One Road will result in a lot more financial market activity in yuan rather than dollars. I would still consider yuan internationalization(and a decline in the dollars status) a bit of a long shot near term, but these recent changes make it a lot more plausible over the next decade. At the very least there will soon be a lot more funky securities denominated in yuan(many probably, ahem, distressed and deeply discounted), so it makes sense to get comfortable with custody and banking issues involving the currency.
(2) My ATM card ended up getting flagged with a security alert for suspected fraud, which I was later able to resolve.
(3) Much as been said about his more populist tendencies. I also find it amusing how non-populist policies have had unintended consequences contributing to the current crisis. For example, the government incentivized small and medium sized companies to borrow in non-Lira currencies, by loosening restrictions on loans over a threshold(IIRC, $5 million). This part of the economy is seriously hurting now. Alas there will be some fun picking in the distressed debt space before too long.
Credit markets are crazy, from US buyouts, to frontier market bond offerings.
Buffett released the annual Berkshire letter this past weekend, and it contained a number of gems as usual, although it was shorter than the typical letter.
Petition’s excellent distressed credit focused newsletter last week pointed out that Buffett’s concerns about high M&A prices were:
affirmation of a number of macro themes that ought to portend well for distressed players in a few years: (i) excess capital supply, (ii) resultant inflated asset values, (iii) lack of discipline, and (iv) over-leverage.
The big dam indicator
The loose credit has spread to frontier market bond offerings as well. Tajikistan, a country with $7 billion in annual GDP in September raised $500 million of debt at 7.125% for 10 years. Tajikistan had no problem raising this capital. In fact funds put in $4 billion in bids for the $500 million in paper. Tajikistan will use this capital used for the Rogun barrage project, which involves building the world’s largest hydroelectic dams. Building large buildings tends to correlate with hubris, and bubbles(although the empirical evidence around causality is loose), as many have noted: