Monday, October 16, 2017

The Coming Renaissance of Macro Investing?

John Curran, a partner and head of commodities at Caxton Associates, and chief investment officer at Tigris Financial Group, a family office, wrote a comment for Barron's, The Coming Renaissance of Macro Investing:
In the summer of 1974, Treasury Secretary William Simon traveled to Saudi Arabia and secretly struck a momentous deal with the kingdom. The U.S. agreed to purchase oil from Saudi Arabia, provide weapons, and in essence guarantee the preservation of Saudi oil wells, the monarchy, and the sovereignty of the kingdom. In return, the kingdom agreed to invest the dollar proceeds of its oil sales in U.S. Treasuries, basically financing America’s future federal expenditures.

Soon, other members of the Organization of Petroleum Exporting Countries followed suit, and the U.S. dollar became the standard by which oil was to be traded internationally. For Saudi Arabia, the deal made perfect sense, not only by protecting the regime but also by providing a safe, liquid market in which to invest its enormous oil-sale proceeds, known as petrodollars. The U.S. benefited, as well, by neutralizing oil as an economic weapon. The agreement enabled the U.S. to print dollars with little adverse effect on interest rates, thereby facilitating consistent U.S. economic growth over the subsequent decades.

An important consequence was that oil-importing nations would be required to hold large amounts of U.S. dollars in reserve in order to purchase oil, underpinning dollar demand. This essentially guaranteed a strong dollar and low U.S. interest rates for a generation. Given this backdrop, one can better understand many subsequent U.S. foreign-policy moves involving the Middle East and other oil-producing regions.

Recent developments in technology and geopolitics, however, have already ignited a process to bring an end to the financial system predicated on petrodollars, which will have a profound impact on global financial markets. The 40-year equilibrium of this system is being dismantled by the exponential growth of technology, which will have a bearish impact on both supply and demand of petroleum. Moreover, the system no longer is in the best interest of key participants in the global oil trade. These developments have begun to exert influence on financial markets and will only grow over time. The upheaval of the petrodollar recycling system will trigger a resurgence of volatility and new price trends, which will lead to a renaissance in macro investing.

Let’s examine these developments in more detail. First, technology is affecting the energy markets dramatically, and this impact is growing exponentially. The pattern-seeking human mind is built for an observable linear universe, but has cognitive difficulty recognizing and understanding the impact of exponential growth.

Paralleling Moore’s Law, the current growth rate of new technologies roughly doubles every two years. In the transportation sector, the global penetration rate of electric vehicles, or EVs, was 1% at the end of 2016 and is now probably about 1.5%. However, a doubling every two years of this level of usage should lead to an automobile market that primarily consists of EVs in approximately 12 years, reducing gasoline demand and international oil revenue to a degree that today would seem unfathomable to the linear-thinking mind. Yes, the world is changing—rapidly.

Alternative energy sources (solar power, wind, and such) also are well into their exponential growth curves, and are even ahead of EVs in this regard. Based on growth curves of other recent technologies, and due to similar growth rates in battery technology and pricing, it is likely that solar power will supplant petroleum in a vast portion of nontransportation sectors in about a decade. Albert Einstein is rumored to have described compound interest (another form of exponential growth) as the most powerful force in the universe. This is real change.

The growth of U.S. oil production due to new technologies such as hydraulic fracturing and horizontal drilling has both reduced the U.S. need for foreign sources of oil and led to lower global oil prices. With the U.S. economy more self-reliant for its oil consumption, reduced purchases of foreign oil have led to a drop in the revenues of oil-producing nations and by extension, lower international demand for Treasuries and U.S. dollars.

ANOTHER MAJOR SECULAR CHANGE that is under way in the oil market comes from the geopolitical arena. China, now the world’s largest importer of oil, is no longer comfortable purchasing oil in a currency over which it has no control, and has taken the following steps that allow it to circumvent the use of the U.S. dollar:
  • China has agreed with Russia to purchase Russian oil and natural gas in yuan.
  • As an example of China’s newfound power to influence oil exporters, China has persuaded Angola (the world’s second-largest oil exporter to China) to accept the yuan as legal tender, evidence of efforts made by Beijing to speed up internationalization of the yuan. The incredible growth rates of the Chinese economy and its thirst for oil have endowed it with tremendous negotiating strength that has led, and will lead, other countries to cater to China’s needs at the expense of their historical client, the U.S.
  • China is set to launch an oil exchange by the end of the year that is to be settled in yuan. Note that in conjunction with the existing Shanghai Gold Exchange, also denominated in yuan, any country will now be able to trade and hedge oil, circumventing U.S. dollar transactions, with the flexibility to take payment in yuan or gold, or exchange gold into any global currency.
  • As China further forges relationships through its One Belt, One Road initiative, it will surely pull other exporters into its orbit to secure a reliable flow of supplies from multiple sources, while pressuring the terms of the trade to exclude the U.S. dollar.
The world’s second-largest oil exporter, Russia, is currently under sanctions imposed by the U.S. and European Union, and has made clear moves toward circumventing the dollar in oil and international trade. In addition to agreeing to sell oil and natural gas to China in exchange for yuan, Russia recently announced that all financial transactions conducted in Russian seaports will now be made in rubles, replacing dollars, according to Russian state news outlet RT. Clearly, there is a concerted effort from the East to reset the economic world order.

ALL OF THESE DEVELOPMENTS leave global financial markets vulnerable to a paradigm shift that has recently begun. In meetings with fund managers, asset allocators, and analysts, I have found a virtually universal view that macro investing—investing based on global macroeconomic and political, not security-specific trends—is dead, fueled by investor money exiting the space due to poor returns and historically high fees in relation to performance. This is what traders refer to as capitulation. It occurs when most market participants can’t take advantage of a promising opportunity due to losses, lack of dry powder, or a psychological inability to proceed because of recency bias.

A current generational low in volatility across a wide spectrum of asset classes is another indicator that the market doesn’t see a paradigm shift coming. This suggests that current volatility is expressing a full discounting of stale fundamental inputs and not adequately pricing in the potential of likely disruptive events.

THE FEDERAL RESERVE is now in the beginning stages of a shift toward “normalization,” which will lead to diminished support for the U.S. Treasury market. The Fed’s total assets stand at approximately $4.5 trillion, or five times what they were prior to the financial crisis of 2008-09. The goal of the Fed is to “unwind” this enormous balance sheet with minimal market disruption. This is a high-wire act a thousand feet in the air without a safety net or prior practice. Additionally, at some not-so-distant future date, the U.S. will need to finance enormous and growing entitlement programs, and our historical international sources for that financing will no longer be willing to support us in that endeavor.

The market participants with whom I met theoretically could have the ability to accept cognitively the points made in this article. But the accumulation of many small losses in a low-volatility and generally trendless market has robbed them of confidence and the psychological balance to embrace any new paradigm proactively. They are frozen with fear that the lower- return profile of recent years is permanent—ironic in an industry that is paid to capture price changes in a cyclical world.

One market legend with whom I spoke suggested he wouldn’t have had the success he enjoyed in his career had he begun in the past decade. Whether or not this might be true, it doesn’t mean that recent lower returns are to be extrapolated into the future, especially when these subpar returns occurred during the quantitative-easing era, a period that is an anomaly.

I have been fortunate to ride substantial bets on big trends, earning high risk-adjusted returns using time-tested techniques for exploiting these trends. Additionally, I have had the luxury of not participating actively full-time in macro investing during this difficult period. Both factors might give me perspective. I regard this as an extraordinarily opportune moment for those able to shed timeworn, archaic assumptions of market behavior and boldly return to the roots of macro investing.

The opportunity is reminiscent of the story told by Stanley Druckenmiller, who was promoted early in his investment career to head equity research at a time when his co-workers had vastly more experience than he did. His director of investments informed him that his promotion owed to the same reason they send 18-year-olds to war; they are too dumb to know not to charge. The “winners” under the paradigm now unfolding will be market participants able to disregard stale, anomalous concepts, and charge.

RELATEDLY, THERE IS a running debate as to whether trend-following is a dying strategy. There is plenty of anecdotal evidence that short-term and mean-reversion trading is more in vogue in today’s markets (think quant funds and “prop” shops). Additionally, the popularity of passive investing signals an unwillingness to invest in “idea generation,” or alpha. These developments represent a full capitulation of trend following and macro trading.

Ironically, many market players who wrongly anticipated a turn in recent years to a more positive environment for macro and trend-following are throwing in the towel. The key difference is that now there is a clear catalyst to trigger the start of the pendulum swinging back to a fertile macro/trend-following trading environment.

As my mentor, Bruce Kovner [the founder of Caxton Associates] used to say, “Nobody rings a bell at key turning points.” The ability to properly anticipate change is predicated upon detached analysis of fundamental information, applying that information to imagine a plausible world different from today’s, understanding how new data points fit (or don’t fit) into that world, and adjusting accordingly. Ideally, this process leads to an “aha!” moment, and the idea crystallizes into a clear vision. The thesis proposed here is one such vision.
John Curran has written a lot of food for thought in this comment which admittedly is also a bit self-serving, but let me quickly go over some of my thoughts.

First, I don't buy the nonsense of the "end of the petrodollars". This is pure nonsense and all this talk of alternative exchanges that will threaten the preeminence of the US dollar or US exchanges is beyond ridiculous.

 I suggest Mr. Curran and all of you who buy into this nonsense read Yannis Varoufakis's first book, The Global Minotaur. Let me be clear, I'm no fan of Varoufakis and his pompous leftist nonsense but this book is a must-read to understand why the US is gaining global strength as its national debt mushrooms.

In short, the US runs a current account deficit for years but it benefits from a capital account surplus as all those countries running current account surpluses (China, Germany, Japan, etc) recycle their profits back into the US financial system, buying up stocks, bonds, real estate and other investments as well as subsidizing the US military industrial complex.

The second book I want you all to read is John Perkins's The New Confessions of an Economic Hitman, an expanded edition of his classic bestseller. You will learn the world doesn't work according to some nice, tidy economic model full of complicated equations. Behind the scenes, there are a lot of dirty things going on.

Importantly, and this is my point, the US dominates global finance and the global economy, which is why I scoff at the idea of China, Russia or any other country is gaining on it and threatens to displace it or displace the greenback as the world's reserve currency.

Is China important? Absolutely. But make no mistake, the US exerts immense power over China and other countries and it leads the world, not the other way around.

And China has its own internal problems right now. Over the weekend, I read about how China’s mortgage debt bubble raises spectre of 2007 US crisis and why Jim Rickards thinks we need to prepare for a Chinese Maxi-devaluation.

Remember, it was a little over two years ago that China's Big Bang rocked markets, clobbering risk assets across the spectrum.

Is it possible that another Chinese devaluation is coming? It's unlikely now but if the US dollar continues to appreciate from these levels, which is one of my macro calls, I certainly think it's a definite risk.

Why should we care if China devalues again in a significant way? Because it will heighten global deflation at a time when deflation already threatens the US and a time when global inflation is in freefall.

Importantly, the last thing the world needs right now is for China to devalue its currency, it will wreak havoc in emerging markets and heighten global deflationary headwinds at a time when the world is at risk of entering a long period of debt deflation.

[Note: China devaluing puts pressure on Asian emerging markets to devalue their currencies and on Japan to devalue its yen, flooding the world with cheap goods, effectively exporting more goods deflation to developed nations which are already highly indebted and unlikely to keep buying cheaper goods indefinitely.]

This brings me back to John Curran's comment above. I agree, there is a technological revolution going on in energy which is deflationary and will cap and lower the price of oil over the long run. The Saudis aren't stupid, they see the writing on the wall which is why they're planning to sell part of Saudi Aramco.

And where do you think Saudi Arabia will invest its proceeds to diversify its economy away from oil revenues? You guessed it, global stocks, bonds, real estate, private equity, and infrastructure and it will invest primarily in the US using US banks and funds.

Now, let me tackle this part of John Curran's article:
The Federal Reserve is now in the beginning stages of a shift toward “normalization,” which will lead to diminished support for the U.S. Treasury market. The Fed’s total assets stand at approximately $4.5 trillion, or five times what they were prior to the financial crisis of 2008-09. The goal of the Fed is to “unwind” this enormous balance sheet with minimal market disruption. This is a high-wire act a thousand feet in the air without a safety net or prior practice. Additionally, at some not-so-distant future date, the U.S. will need to finance enormous and growing entitlement programs, and our historical international sources for that financing will no longer be willing to support us in that endeavor.

The market participants with whom I met theoretically could have the ability to accept cognitively the points made in this article. But the accumulation of many small losses in a low-volatility and generally trendless market has robbed them of confidence and the psychological balance to embrace any new paradigm proactively. They are frozen with fear that the lower- return profile of recent years is permanent—ironic in an industry that is paid to capture price changes in a cyclical world.

One market legend with whom I spoke suggested he wouldn’t have had the success he enjoyed in his career had he begun in the past decade. Whether or not this might be true, it doesn’t mean that recent lower returns are to be extrapolated into the future, especially when these subpar returns occurred during the quantitative-easing era, a period that is an anomaly.
I used to invest in top macro funds all over the world and one of my biggest pet peeves was lame excuses for underperformance. "The Fed and other central banks are distorting financial markets and this will come to an abrupt end."

Really? Why? Because you say so as you collect a big, fat 2% management fee on billions as you severely underperform these markets? I've been waiting for years for your theory on central banks "blowing up" to come to fruition and so far, you've been wrong and it cost me potential returns elsewhere as you collect a management fee on billions.

I read Charles Hugh Smith's comment on the endgame of financialization being stealth nationalization where he posted this chart (click on image):


So what? We all know Janet in Wonderland and her global colleagues are buying up assets like crazy, enriching bankers and their elite hedge fund and private equity clients.

What I want to know is whether there are limits to central bankers' prowess? I asked one astute hedge fund manager this very question and he replied:
"The limits to CB prowess are now in full manifestation via political+social volatility.  It is this apparent and rising political and social volatility which is forcing central banks to shift from expansion to contraction of their aggregate balance sheets."
I'm hardly convinced this is why central banks are shifting gears. In fact, I firmly believe the Fed knows deflation is headed for the US and it's trying to store up ammunition as fast as possible to help shore up big banks and prepare for the next financial crisis.

It's a big gamble. Why? Because the Fed only controls the short end of the curve, not the long end which is primarily influenced by inflation expectations which keep dropping. And the irony is that as the Fed tightens and raises rates, it's accelerating this drop in inflation expectations, further stoking deflationary headwinds here and around the world.

This is why BlackRock's Larry Fink is warning of the risk of an inverted bond yield curve:
The head of the world’s largest asset management company said investors’ appetite for those assets could move long-dated yields below those of shorter-term debt.

That condition, known as an inverted yield curve, is often considered a precursor to recession and could presage a decline for stocks.

“If there is a risk, it’s that,” Fink said in an interview. “I hope the Federal Reserve pays attention.”

However, he said he did not see an inverted yield curve materializing within the next year as global economic growth accelerates.
Larry is dreaming if he thinks global economic growth is set to accelerate. I know that's what BlackRock is hoping for but the opposite will happen.

This brings me to my final point on the coming renaissance of macro investing. As bond traders face an inflation gamble that will last a generation, they better get it right, because if they don't, it will cost them dearly.

The link between asset inflation/ bubbles and the real economy is what worries me as this crazy stock market keeps punishing sellers. Now more than ever, you need to be very careful navigating though these prickly markets.

As I stated in my last comment on why the bubble economy is set to burst, downside risks are mounting:
Nothing can stop these central bank-controlled markets. Janet in Wonderland and her global colleagues are in control (or so they want you to think), which is why Jim Chanos and other short-sellers are losing money this year as markets melt up.

Is it time to party like it's 1999? Are we on the cusp of a major parabolic market breakout that will last a couple of more years?

Before you get all excited, let me share with you what one astute hedge fund manager I know, Dimitri Chalvasiotis, sent me last Friday after the close:

Volatility Adjusted SP500, as of Friday’s closing metrics, has reached an historic extreme printed a handful of times since 1971. In other words, going forward, either SP500 declines in value or SP500 realized volatility rises. Rare (mathematical) juncture in time/price (click on image).

In other words, get ready for some rock 'n roll, the silence of the VIX won't last forever, and even if markets keep melting up, all that's happening is downside risks are mounting.
So, I do agree with John Curran on one point, those who foolishly think global macro is dead are wrong. It's not dead but the problem is markets can stay irrational (thanks to central banks) longer than macro gods who are in big trouble can stay solvent.

On that note, Bloomberg's Nishant Kumar reports Brevan Howard Asset Management, the hedge fund firm co-founded by Alan Howard that’s battling an investor exodus, is planning to start two more funds, including one that is betting on volatility in the Treasuries market.

The only volatility I foresee in US Treasuries is upside volatilty in prices as yields plunge to a new secular low, sending US long bond prices (TLT) to record highs.

And Canada’s housing market is “ripe for a pretty severe correction” with Canadian Imperial Bank of Commerce the most vulnerable, according to the Big Short's Steve Eisman, a fund manager at Neuberger Berman Group LLC.

You already know I thought the Bank of Canada was flirting with disaster raising interest rates earlier this year but it seems to have backed off for now. Eisman is right to note Canada hasn't had its credit cycle yet and it's about to have one. Read Ted Carmichael's latest global macro comment to understand why Canada's credit cycle downturn is coming (keep shorting that overvalued loonie).

This is hardly news to those of us who have been warning of Canada's growing debt risks but speculation on houses continues, including here in Montreal where bidding wars are breaking out in nice neightborhoods "rich" Chinese seek to move to (as long as your house has good feng shui).

Those poor Chinese and Canadians buying houses now are in for a rude awakening and all the feng shui in the world won't help them recover the losses they will suffer over the next decade.

The coming renaissance of macro investing? Maybe but only the best will survive the coming shakeout in the hedge fund industry.

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