André Breedt, Capital Fund Management
The year that was
Gloating is a rare luxury in the asset management industry. However, on occasion, it is rewarding to see one’s foretelling play out. In a piece for this publication – almost exactly one year ago – I presented the many obstacles facing global financial markets, especially equity markets, going into 2022. That year, as it turned out, is one that asset managers of just about all stripes would be desperately keen to forget.
In the same piece, I also made the case for global macro strategies, arguing that not only are they a good all-weather mainstay in any portfolio, but, given the outlook at the time, that it would have been an attractive strategy to consider going into 2022 and beyond.[1]
While many hedge fund strategies laboured through a lacklustre year on aggregate, macro strategies posted commendable gains. In fact, of the main hedge fund styles, CTAs and macro strategies fared best in 2022 and far outpaced both equity and bond markets (and, for that matter, near all other major asset classes) – see figure 1.
2023 and Beyond
In the decade pre-Covid, investors operated against the backdrop of a common global factor, namely interest rates at or near the lower zero bound, often combined with vast quantitative easing (QE) programmes. This acted as a boon for nearly all asset classes, flattering most asset managers. After Covid, speedy acceleration of inflation and central banks’ ensuing response, albeit arguably delayed, removed this common factor.
This shift in the investment environment prompted an increased dispersion among asset classes, and macro funds – able to take positions in a relative value or directional construct, and also executing a vast array of trades designed to take advantage of changing economic, geoeconomic, and geopolitical circumstances – were well-positioned to successfully navigate the changing regime.
Here we highlight why we believe global macro strategies are set to remain a valuable addition to an investment portfolio, making the case vis-à-vis five themes that broad consensus expects to be the most burning issues in 2023 and beyond.
I. Inflation
Inflation was one of the most closely watched macro drivers of 2022. We are likely to see a repeat in 2023, not least because this will be dictatory to central bank policy. Whilst inflation in the US and elsewhere has receded, massive uncertainty remains as to the trajectory of prices in 2023. It would be premature to argue that cooling inflationary pressure is a settled point. Moreover, irrespective of the exact trajectory, inflation – especially in the US and Europe – remains well above central banks’ mandates, with policy makers likely to remain cautiously on the hawkish side of the spectrum.
This is not the forum to debate a long list of probable inflation or deflationary drivers. Rather, relying on historical features, we analyse how global macro strategies might perform compared to other traditional benchmark asset classes within different inflationary ‘regimes’. [3]
Our technique identifies inflationary regimes by calculating a rolling seven-year Z-score of YoY changes, as well as the difference of YoY changes in inflation. The former captures whether the inflation level over a specific window is above/below its longer-term mean, the latter whether the rate of change in inflation (or second derivative) is above/below its longer-term mean. Using this removes the need for any arbitrary inputs beyond timescales.
Figure 2 shows the average annualised returns of various traditional benchmark asset classes and alternatives within periods of accelerating and decelerating inflation. Amongst the major asset classes and hedge fund strategies, macro strategies have historically been one of the top performers when the rate of change of inflation was higher or lower than its longer-term mean.
This is consistent with an expectation that global macro strategies are among the best primed to capture dispersion across regions and especially inflation-sensitive asset classes – notably fixed income and short-term interest rates. Given the prospect of near-term central bank heterogeneity (the US Fed likely to pause, while for example, the European Central Bank (ECB) has signalled a much more hawkish posture), and the inflation-recession balancing act hardly settled, macro strategies are expected to continue successfully navigating this environment.
II. Economic Growth
Another hotly debated topic is the various probable ‘landings’ in the economic cycle. We are not about to scrutinise all the arguments for and against any recession. However, it is worth pointing to one popular indicator that is said to presage recessions – an inverted yield curve. This indicator has made headlines of late given the deep inversion of many localised spreads. The 2y-10y as well as 3m-10y spread are inverted – and have been inverted together since November 2022. We tested the historical robustness of this indicator in predicting a recession and found strong statistical evidence of its accuracy.[4]
In the same spirit as the analysis above, we investigate how macro strategies, all else being equal, typically perform during recessionary periods. We calculate the average annualised returns of the major asset classes (as used throughout above) during periods of recession as classified, post facto, by the Business Cycle Committee of the US National Bureau of Economic Research (NBER). Apart from US inflation-linked and investment-grade bonds, systematic macro strategies delivered positive returns during recessionary periods (as well as during expansionary periods) – see figure 3.
III. Volatility
There was no shortage of market-moving macro events in 2022, and 2023 is gearing up to follow suit. This given the uncertainty around the key drivers of macro performance, including inflation and economic growth as discussed above. ‘Macro volatility’, as measured by say the standard deviation of macroeconomic variables, has also increased. The ‘great moderation’ that originated in the mid-1980s, and which featured benign fluctuations in the US business cycle, was upended during Covid with ripple effects still present. The complexity of the current market backdrop is also resulting in a lot of guesswork, and projection misses – reflected in the elevated spread between, for example, expected and actual economic data prints. This all results in higher levels of volatility across assets classes.
Again, in the context of historical evidence, one would expect global macro strategies to have outperformed during periods of elevated volatility and the data bears out this expectation – macro strategies outperform equities and global fixed income when the implied volatility of these asset classes is respectively higher – see figure 4. The expectation of higher volatility in the coming years should continue to provide attractive trading opportunities for macro managers.
IV. Correlations
In figure 2 and 3, we observe how equities feature negative, and similar, performance across regions during periods of recession and decelerating inflation, while fixed income – on aggregate over the full sample – typically provided protection. Equities feature comparable performance on account of a high level of correlation between them, while the negative correlation between equities and fixed income has made bonds hitherto a mainstay ballast in portfolios.
There are, however, two worrying developments that should provide pause. Not only has the mean cross correlation between equity markets been steadily increasing (inter-market correlation) – which reduces the diversification potential across regions, but, as written previously, the negative correlation between bonds and equities has reduced and even turned positive of late.[5]
There are several ways to illustrate the effect of increased correlation between equities and fixed income – the two major asset classes in many institutional portfolios – as well as how systematic macro strategies, which continue to show low correlation with traditional benchmark asset classes, act as a stable diversifier. In figure 5 we plot the 50% worst monthly returns of the S&P 500 since 2020, along with the concomitant returns of both the Bloomberg Global Aggregate and Systematic Macro Hedge Fund index. For most of this period, fixed income failed to protect – especially during those months where the S&P 500 registered its worst performance. Macro systematic hedge funds, however, delivered – bar a few exceptions – positive returns when equity and fixed income markets both sold off.
There has been much debate about the longevity of the traditional 60/40 portfolio, more so after the near-record negative returns such a portfolio registered in 2022. The environment that bolstered the efficacy and popularity of such an allocation, primarily low volatility, low inflation, low real yields, and central banks stepping in whenever trouble was brewing, are not evidently set to endure.
An allocation to global macro strategies, however – with the ability to be long or short in each market; generating a high level of diversification by trading across many asset classes; and the ability to focus risk on the markets where opportunities are greatest, contributing to its uncorrelated characteristic – can act as a diversifying pillar.
V. Political and Geopolitical Risks
Two themes need stressing.
First is increased political partisanship which, in and of itself, is a very noticeable manifestation of growing populism (and nationalism). Concluding that politics have become more polarised is a merited inference based on data from, for example, polling campaigns; the prevalence of tight election races; as well as sentiment in mainstream and social media. However, with the advent and development of various alternative data sets, one can now, more than ever, quantify developments in this field. This allows for a more systematic monitoring as well as, ultimately, the incorporation within the investment process.
In the context of the US political landscape, for example, we measured – using Congressional voting records – the evolution of political fragmentation since the founding of the Republic. We found, irrespective of proxy, that US politics are at-or-near record levels of political fragmentation in both the House and the Senate. [6] See figure 6 left. This is significant, because higher levels of political partisanship, inter-and intra-party, are understood – with a healthy amount of academic literature confirming – to propagate various negative drags, not only on economic growth, but on policy making in general. At a juncture where more, not less, political cohesion is required, this is a worrying development. Consider for example the looming debt-ceiling discussion in the US.
The second theme is a much more polarised geopolitical landscape.
There is scope for many ‘Black Swan’ events, not least an escalation of hostilities in Ukraine, a US-China strategic showdown, and an Iranian regime collapse. There are also a bevy of possibly more worrying ‘Grey Rhinos’ – highly probable, high impact events, yet being underestimated – among which an escalation of aggressive posturing by China towards Taiwan, and a nuclear break-out by Iran. Again, here an increasing number of data sources and techniques to quantify and track geopolitical dynamics are becoming available. Taking the example of just one such bespoke geopolitical risk data source, we observe that geopolitical risk is hovering near record highs. See figure 6 right.
The above, considered in combination with sticky inflation and moderating growth, can act in unison to reinforce these risks. With such a macro tinderbox, any small spark is likely to generate and exacerbate already higher levels of volatility. It is therefore unsurprising, and arguably necessary, that political (and geopolitical) risk become an ever more important metric that demands investor attention.
Global macro strategies can not only exploit this information but stand to benefit from increased volatility and dispersion in a market driven by political and geopolitical uncertainty and manifestation of any such risk-driven events.
Conclusion
Investors are having to grapple with a disparate set of indicators that, following the Covid pandemic, continue to muddy the outlook for the global economy. There is, however, amongst this uncertainty, some consensus as to the investment environment for the near future. For one, inflation remains too high in most countries, but central bank rate changes and any consequent market volatility don’t happen in lockstep across countries, nor regions. Any policy surprises – not unlikely given the uncertainty of inflation direction, along with central bank divergence, will generate volatility and interest-rate differential opportunities.
Associated is economic growth that has been moderating but, again, there is disparity among nations, which will trigger dissimilar fiscal and monetary responses across geographies resulting in higher levels of volatility across assets classes.
A lack of political cohesion, along with geopolitical tension, can generate wild swings in the market, create uncertainty and, moreover, increase the dispersion of potential outcomes.
All and any of the above discussed themes could yet deliver surprises, creating more uncertainty and volatility.
In this environment, macro strategies – which have a flexible mandate in going long or short and, typically, hold a highly diversified portfolio of all asset classes – have more opportunities to generate uncorrelated returns with minimal dependency on the direction of risk assets.
Yet another, non-negligible consideration, is that global macro strategies (and for example, CTA programmes) maintain excess levels of collateral. Global macro strategies take positions in all asset classes through derivatives, typically the futures market. This inherent leveraged structure means only a fraction of capital is deployed, with the balance held in collateral. This balance, in a rising (and higher) short-term rate environment, has a mechanically positive impact for these funds.
The outlook for the global macro industry remains favourable, given the uncertainty around some of the key drivers of macro performance, including inflation, economic growth, and geopolitics. Historically, macro funds have delivered attractive risk-adjusted returns with low correlation to traditional stocks and bonds, particularly during periods of market dislocation. Copyright. HedgeNews Africa – February 2022.
André is a member of the research team at Capital Fund Management (CFM), a quantitative systematic hedge fund founded in 1991, headquartered in Paris, with offices in London, New York and Sydney. CFM manages a large set of quantitative strategies, trading a priori liquid instruments including futures, equities, bonds, options, and spot and forward FX. CFM manages approximately $9.5 billion as of 31 December 2022, with 120 institutional investors across the globe. André holds a BCom Law from the University of Pretoria as well as an MSc (Economics) and MPhil (Economics), both from the Sorbonne in Paris. Prior to joining CFM, he worked for the United Nations and Deutsche Bank in New York, as well as Société Générale in Paris. André holds dual South African and French citizenship. www.cfm.com
Disclaimer: Any description or information involving investment process or allocations is provided for illustration purposes only. There can be no assurance that these statements are or will prove to be accurate or complete in any way. All figures are unaudited. This article does not constitute an offer or solicitation to subscribe for any security or interest.
[1] https://hedgenewsafrica.com/the-reading-room/2022/02/02/what-are-systematic-global-macro-strategies-and-why-they-should-be-considered/
[2] All HFRI hedge fund index returns are reported net of fees.
[3] We direct interested readers to our paper Inflationary Regimes and Asset Class Performance in which our technique of identifying inflationary ‘regimes’ can be leveraged to inspect the average performance of benchmark asset classes during high, low, accelerating, and decelerating periods of inflation. The paper is available here.
[4] Interested readers are encouraged to review our paper, Using the Yield Curve to Forecast Recessions … do you feel lucky? available on our website.
[5] Please refer to our paper Bond-Equity Correlations. Are the times a-changin’? available here.
[6] Interested readers are encouraged to read our paper Partisanship in the US Congress. Has the US reached peak political fragmentation? in which we propose various alternatives of calculating political partisanship in the US along with exploring the effect of increased partisanship on financial markets. The paper will be published in February and made available on our website.
[7] There is a burgeoning ‘alternative data’ industry that makes available data sources in addition to traditional fundamental and price data, geopolitical risk being just one of these. The GPRI is one such source and in addition to a headline global geopolitical risk index, their database includes country-level as well as theme-specific indices. Further details can be found on the Federal Reserve’s website here.
