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Sunday October 24 2021
Global Macro Investing
  Articles by Dion Friedland
  Protection Against An Aging Bull
  Reducing Market Risk with Merger Arbitrage
  Interview with Dion Friedland
  Taking the Mystery Out of Hedge Funds
  About Special Situations Fixed Income
  The Kingdom of Hedge Funds
  Distressed Securities Investing
  The Case for Convertibles
  Private-to-Public Investing
  Global Macro Investing
  Market Neutral Long/Short Equity Trading

by Dion Friedland, Chairman, Magnum Funds

The conventional approach to buying stocks and bonds is to study companies and industries and base investment decisions on fundamentals such as quality of management, strategy, competition, market share, company profits, and P/E ratios. A less conventional and more challenging approach is to make investments based not on these "micro events" affecting companies but on macro events.

Macro events are changes in global economies, typically brought about by shifts in government policy which impact interest rates which, in turn, affect all financial instruments, including currency, stock, and bond markets. Macro investors anticipate such events and shifts and profit by investing in financial instruments whose prices are most directly influenced by these trends. Accordingly, they participate in all major markets (equities, bonds, currencies, and commodities), though not always at the same time, and often use leverage and derivatives to accentuate the impact of market moves. It is this use of leverage on directional bets, which often are not hedged, that has the greatest impact on the performance of macro funds and results in the high volatility that some macro funds experience.

Macro investing is perhaps the most publicized of hedge fund strategies, even though only a small percentage of hedge funds are macro funds. That's because macro hedge fund managers such as George Soros, Julian Robertson, and, formerly, Michael Steinhardt have made headlines for making highly leveraged, high-stakes investments, often with great success. Most notable is when Soros bet $10 billion, much of it borrowed, in 1992 on the proposition that the British pound would be devalued. His investors reaped a $2 billion profit (and some believe his shorting of Sterling caused its drop and subsequent pullout of the European Monetary Union). But these macro managers misfired in 1994, most notably when some placed huge, unhedged bets that European interest rates would decline, causing bonds to rise; instead, the Fed raised interest rates in the U.S., causing European interest rates to rise and investors who bet that European interest rates would go down to lose money.

Not surprisingly, macro investing is perceived by many to be a high risk, volatile investment strategy. This perception has been fueled and, indeed, exaggerated by the media, which take great glee in reporting whenever a well-known hedge fund manager suffers a significant loss.

How do macro investors spot trends and confirm them as worthy of an investment? There are numerous approaches. George Soros in his book The Alchemy of Finance shares his currency theory technique. If a huge deficit is accompanied by an expansionary fiscal policy (higher government spending and taxation) and tight monetary policy (higher interest rates to stem borrowing), the theory has it that the country's currency will actually rise. This is what happened to the dollar in 1981-84 when money was attracted into the U.S. by a tight monetary policy. Using this theory, Soros protégé Stanley Druckenmiller went long on the Deutsche mark to the tune of $2 billion after the Berlin Wall came down in 1989. Seeing that West Germany was about to run up a huge budget deficit to finance the rebuilding of East Germany and that the Bundesbank was not going to tolerate any inflation, Druckenmiller predicted - quite correctly and lucratively - that the price of the Deutsche mark would rise.

Historical patterns obviously also come into play in identifying trends and inflection points. In late 1989, for example, Druckenmiller turned bearish on the Japanese stock market in part because the Nikkei index had reached a point of overextension that in all previous instances had led to sell-offs. More recently, Princeton Economics International (PEI) predicted the July 1998 stock market correction, among a host of other economic turning points, using an artificial-intelligence-enhanced computer model that compares more than 30,000 current economic statistics daily to data over a more than 100-year period. As early as 1994, PEI reported in several issues of its publication, the Princeton Capital Markets Review, that a shift in capital flows worldwide would likely signal an important turning point for the U.S. and European markets on July 20, 1998.

Felix Zulauf, of Zulauf Asset Management in Switzerland, anticipated the 1987 stock market crash by looking at shifts in monetary policy. He describes his process as follows:

In 1985, the G7 intervened to break the pronounced rise of the U.S. dollar (USD) because it created problems for the U.S. economy and a rising risk of major misallocation in the world economy. After the successful intervention…the USD kept falling. A USD crisis emerged in 1987 and, consequently, U.S. interest rates rose strongly and the Federal Reserve was forced to tighten money to support the "greenback." At the same time, global equity markets went from one record high to the next, and stocks traded at record valuations in the U.S., Japan, and Europe. Tight money in combination with record high valuation is a prescription for a cyclical correction for stocks. When finally our proprietary momentum indicators also turned down in the summer of 1987, it became clear to me that the risk of a cyclical decline that usually measures around 25 percent would at least be likely. Hence, as head of the institutional portfolio management department at the largest bank in Zurich, I called my portfolio managers and told them to liquidate all equity holdings. I felt pretty sure the market would not take any prisoners, as a new product, portfolio insurance, meant that there would be indiscriminate selling on any weakness once it appeared. The rest is history.

Monetary policy contributed again when Zulauf, who is also a member of the Barron's Roundtable, predicted the Japanese equity market would peak in early 1990. After central banks flooded the credit system in the wake of the 1987 crash and equity markets recovered, the Japanese market that had already risen the most during the whole decade recovered the most quickly, jumping to new record highs in 1988 just a few months after the crash. During that time, books were written about the Japanese way of doing business and people joked that clocks ticked differently in Tokyo than in other parts of the world. The truth, however, Zulauf understood, was that because Japan ran a large surplus on its trade and current account, the yen strengthened and Japan kept that strengthening under control by supplying plenty of liquidity to its credit system. A tremendous boom in stocks and real assets ensued, with the property of the Emperor's Palace in Tokyo worth more than all property and real estate of California and stocks trading at 70-80 times inflated earnings. After the new central bank president decided that enough was enough and started to tighten the monetary screws during 1989, short rates almost doubled and bond yields rose from about 4 percent to 6 percent in late 1989 and later to nearly 8 percent. It was clear to Zulauf that the bubble was ready to burst.

Says Zulauf, "I was buying puts on the Nikkei in late 1989 and recommended the same strategy in the Barron's Roundtable of January 1990. I explained that I expected the Nikkei to be cut in half. At that time it traded at 39,000. It collapsed immediately and fell to the low 20,000's in the same year and to around 15,000 in 1992. Over the last 10 years, the return from Japanese equities has been negative."

David Gerstenhaber, manager of the Argonaut Fund, also looks at monetary trends and credit cycles. For example, he anticipated in early 1996 that interest rates in countries like Italy and Spain would begin to converge downward toward those of other European economies as a result of the expected European Monetary Union. So he began concentrating his fixed-income investments in these high-yield markets while selling short French, German, and U.S. bonds - a move that contributed to his fund earning more than 75 percent for the year.

Gerstenhaber uses another technique called "macroeconomic arbitrage." He describes it as follows:

"Because developing countries' credit ratings typically lag behind fundamental improvements in their economic performance, risk premiums in the form of relatively higher interest rates, even on dollar-denominated obligations, regularly exist in these countries' capital markets. Similarly, even the healthiest developing countries regularly experience capital shortages and, in turn, high interest rates due to their rapid growth. Periodically, these high interest rates overcompensate either for reduced quality or for the risk of currency depreciation. Based on ongoing, fundamental analysis of local political and economic data, we are well-positioned to detect and capitalize on these opportunities. At such times, we seek to take advantage of the spread between the high interest rates in selected emerging markets and the lower levels prevailing in the U.S. and other advanced countries."

There are probably as many approaches to identifying and capitalizing on macro trends as there are macro hedge fund managers. But all the players and their approaches have several things in common. First, as mentioned, macro players are willing to invest across multiple sectors and trading instruments. They move from opportunity to opportunity, trend to trend, strategy to strategy - whatever kind of investments that expected shifts in economic policies, political climates, or interest rates make attractive.

Further, they all see the entire globe as the playing field and are well aware that events in countries or regions can have a domino effect across global markets. Witness how the problems which first surfaced in Thailand in the fall of 1997 spread to other Asian countries and economies and, subsequently, even emerging markets as far away as Russia and Latin America. More recently, beginning in July 1998, this knock-on effect impacted the European and U.S. equity markets (negatively) and bond markets (positively) due to the flight to safety. Zulauf had correctly anticipated this negative impact of Asia on the U.S. and European economies as early as January 1998 when he told Barron's readers that the U.S. and European equity markets would be in for a hard landing in the second half of 1998. He was able to profit from his understanding of the impact that the destruction of wealth in Asia would have on the global equity markets by shorting the European markets in the second half of 1998.

To quote Martin Armstrong, founder and chairman of Princeton Economics International, "It is becoming increasingly obvious around the world that economic or investment analysis can no longer be conducted on a purely domestic basis. The speed with which capital is capable of moving means that any economy can be disrupted by international capital flows due to external considerations."

This understanding is a cornerstone of macro investment strategies.

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