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Unhedged US exposure among corporates and pensions offers cheap options play for macro funds

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Last year provided some optimism for global macro hedge funds, ending the year up 6.50 per cent according to eVestment’s aggregated hedge fund performance data. And there are signs that 2020 could offer good opportunities to make upside, as macro traders position themselves for higher inflation in Europe and investor rotation out of US equities.

“We’re not constructive equities. We want to be on the front foot when bad things happen like the Iran incident. We had a good couple of weeks being short equities, long oil but for the last two weeks we’ve given back some of those gains as the markets have moved back up. If it stays on this trajectory, although the sources of returns might differ I think most macro strategies will probably meet in the middle by year-end,” says one US-based global macro manager, who asks not to be named.

A lot of money that has been hiding in the US over the last few years was based on volatility falling, and that a 60/40 balance of equities and fixed income would do okay. And it’s done more than okay. Rates have rallied, equities have rallied and volatility has fallen. Combine that with negative interest rates in Europe (principally Germany) and Japan and being long US has been a no brainer of a trade.

But it’s been such an easy trade, hedging has been made to look like a mug’s game.

“A lot of SWFs, Japanese corporates and pension funds have stopped hedging their dollar and US treasury positions, which is a big deal because it means they aren’t just overweight the US, they are further underweight by being un-hedged. Rating agencies have started to notice that,” remarks the US macro manager.

Two reasons could lead to a reversal in this stockpile of assets sitting in the US.

First, in a benign way, where the rest of world starts to outperform and pulls assets out of the US, perhaps because the Japanese start to do fiscal easing – and in Europe under the guise of green energy investing – and Germany moves rates back to zero.

Second, in a malign way. For example, the US elects a left wing president. When Elizabeth Warren peaked in the polls last Fall, healthcare stocks got crushed, as they did when Bernie Sanders peaked earlier in January.

“We see the opportunity for an FX play in this situation,” says the macro trader. “People pull money out because they are worried about Sanders and Warren, and the dollar underperforms, or because other markets like Europe or Emerging Markets start to look more attractive. Either way, we are looking for ways to structure the portfolio for dollar downside and the pick up in volatility.”

For macro to perform, traders need volatility – and continued volatility – but it continues to be extremely depressed. There also need asset class return dispersion to return.

One driver that could lead to a higher volatility regime is fiscal expansion in the UK and on the Continent, in a bid to drive GDP growth.

George Papamarkakis (pictured), co-founder, Managing Partner & CIO, North Asset Management, a London-based global macro manager, remarks that re-loosening of monetary policy has been the main cause of market performance as opposed to the underlying fundamentals.

“You need to have an explicit and overt fiscal policy to support growth and central bankers are now endorsing this,” says Papamarkakis. “It’s the first time in quite a while that they are now talking about fiscal policy and recognising that there is a limit to the efficacy of further monetary easing. So that is an important juncture.

“Does it mean we are going to see things change in 2020? Probably not but I wouldn’t be surprised if they do in 2021 and we start to see inflation picking up. This could be driven by a new US administration, resulting in an increase in fiscal policy and other wage or social redistributive income policies, and also by increased fiscal policy in Europe as we get closer to the German elections…but we need this year to play out first.”

Some hedge fund investors, such as SkyBridge Capital, are beginning to look at macro funds for their portfolio, in anticipation of regime change, with co-CIO Raymond Nolte stating that macro could have a good run as volatility levels pick up. “If, in Europe, the signs of economic recovery unfold, you could see policy shifts (and inflationary expansion), which could allow the macro guys to make money on those shifts,” he says.

Wilrik Sinia is Founding Partner and Director of Mint Tower Capital Management, a Dutch volatility arbitrage strategy. “Any return to classical normality will, I think, prove positive for the macro players, volatility players and market neutral players, who can handle stress and volatility much better,” he comments.

Papamarkakis believes expansionary fiscal policy in the UK will probably have to “pick up the slack of Brexit”. “In the UK right now, you can borrow 30-year money at 1 per cent and inflation is at 2 per cent; any orthodox analysis would tell you that you should be investing when you can borrow with negative real rates,” he says.

Consequently, North Asset Management is positioned for higher inflation, holding long positions in inflation-linked bonds. In his view, inflation is mis-priced on the downside based on a purely cyclical perspective and is cheap already, based on fair value, let alone if there was a change in the policy rate, “which would make it extremely cheap”.

“The UK is one of our bigger exposures in the Fund,” he says. “We expect the long end of the rate curve to steepen as a result of fiscal easing, which has already been announced so we expect to see more issuance. The Bank of England could potentially cut rates, which would bring the front end of the curve lower. The long end is where we think things are most mis-priced.”

He considers US inflation to be more of a 2021 story compared to the UK. Some smaller countries in Europe, such as the Czech Republic are currently interesting and a microcosm of the inflation story. “It has had extremely loose monetary policy and led to substantial consumer credit growth. Nominal wages have been growing at 7 per cent. So there are pockets of inflation in the world. It is all dependent on the policy mix, and also on how the labour market is structured. A lot of factors are involved in whether inflation comes back to the fore,” cautions Papamarkakis.

Long volatility still a cheap trade

For most investors – pensions, corporates, SWFs – it’s not their job to try to bet on future regime change, but to react to it. Hedge funds have the luxury to anticipate how that money may flow. By looking at the direction of options pricing macro traders can anticipate where that price action will change.

“Eventually you’re going to get to a point where rates are in the lower bound and fiscal expansion reaches its peak…and then we’ll see what happens.

“Either the Fed is going to hold fire because they don’t want to react too soon and inflation spirals out of control, causing the rate curve to steepen. Or, the Fed decides it can’t stomach doing nothing, raises rates and equities and credit markets end up getting smashed.

“This is the paradigm shift you pray for as a macro fund. Because we haven’t seen volatility in 10 years, corporate and pension funds have been unlimited sellers. The ability for us to buy volatility at a cheap price and stockpile it away for a rainy day is huge. When there is an extended period of volatility, we think it will be gold dust,” says the US macro trader.

North Asset Management is also long volatility as a tail risk hedge in the portfolio. Papamarkakis thinks that option buying around March post the Iowa primary might give traders a better understanding of how the Democratic process is going. “We might see things moving later in 2020, ahead of 2021.

“Overall, I think economic growth will muddle through while markets are priced so rich. Based on that conclusion, we think there is more risk to the downside than the upside,” he concludes.

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