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Macro observations for the new year

In 2020, the world was uniformly “stress-tested”, providing a clear window in which to view and uncover global cause-and-effect relationships that would be otherwise difficult to uncover in more benign times. This was the year where lots of seemingly disparate pieces of knowledge over the years came together — leaving important lessons for millennials in 2021+.

All assets have a price, which is set at the margins. Beneath the market clearing price (where the bids and asks meet) is an orderbook. The orderbook represents the depth of market participants willing to take liquidity (sell) and provide liquidity (buy). Successful investing (ie. two-way risk management to both the upside and downside) requires a deep understanding of the “dominant rulesets’’ which govern the orderbook of a particular asset. Long gone are the days of “buy low / sell high” value investment frameworks as the dominant ruleset.

Evidenced by the violent Mar 2020 draw-down and subsequent melt-up in markets through the summer, the orderbooks of many assets are now more heterogeneous than ever. Value investors have been met at the margin with a formidable mix of: (i) price-insensitive passive strategies (401k flows, target date funds), (ii) implicit / explicit volatility-linked strategies (risk-parity, vol control funds), (iii) market-making activity-driven flows (eg delta/gamma hedging of options, ETF authorized participant actions), (iv) central bank programs like QE buying “collateral” (note: collateral which underpins an ever increasing amount of secured financing activity, OTC derivatives, etc), (v) to new regulations and geopolitics that drive changes in macro balance of payments (trade and capital account) flows.

ESG is a new entrant that adds to this heterogeneity — where I believe that any “alpha” would need to come from positioning ahead of the adoption of this ruleset as the marginal price setter in the orderbooks of global assets (if it ever reaches this point).

One of the headline talking points in the mainstream financial media in 2020 was the unprecedented expansion of central bank balance sheets around the world. The logic goes that an increase in money supply, all else equal, will lead to inflation (defined as an increase in prices per unit of something). However, one important nuance that is often missed is that money printed doesn’t generate inflation (of a good, service or financial asset) until it “moves” through the economy by being spent (eg spent to set a marginal price).

To get money into the hands of people / businesses who will actually spend it, money often needs to be “(re)distributed” via intermediaries (eg. the government, central banks, commercial banks, broker-dealers, shadow banks). For this redistribution to happen, intermediaries need to use their balance sheet to facilitate. Therefore, understanding the nuances of the balance sheet plumbing (and their related constraints) is critical in predicting the overall effectiveness of various monetary, fiscal and macroprudential actions. It is also helpful in anticipating where we will see inflation or deflation.

At the height of the alphabet soup of COVID-19 relief packages announced in early 2020, it was generally possible to assess which announcements had real teeth (eg. backstopping non-HQLA markets, establishing Fed swap lines) vs which would likely have limited impact or even negative impact (eg. rate cuts, further QE of safe assets without offsetting sovereign issuance), and position one’s savings accordingly.

Most modern investors characterise portfolio diversification through the lens of asset classes — eg. holding a 60/40 stock-bond portfolio (or some levered variant of this). While this worked well as a strategy over the past 30+ years, the cause and effect of why this worked is often not well understood. The idea that bonds act as an offset to stocks in times of crisis is not a perpetual relationship.

With cyclical highs in interest rates beginning in the 1980s, each successive “financial crisis” since (spikes of volatility) has been met by Central Banks lowering interest rates (to dampen volatility and increase collateral values of bonds). Bonds therefore, have essentially acted as a “positive carry put option” in portfolios. This is true so long as rates remain above the zero-bound.

Fast forward to COVID-19, with interest rates cut to zero in most parts of the world (thus flooring the price appreciation potential of bonds going forward), alongside a increased use of bonds (esp sovereign bonds) in the financial plumbing as collateral, global investors will need to seek new long-volatility instruments and strategies that more cleanly express this “positive carry put option” going forward. The competition and intellectual debate around what fills the void for this important asset allocation element (eg. market structure/long vol arbitrage funds, store of value hard assets, Long/short FX strategies, etc) is only going to grow.

To continue to stay ahead of the curve, recommendations for podcasts and content are below. If 2020 has taught us anything, it’s that muddling through life is about identifying and continuously updating conditional probabilities to anticipate big phase shifts. While COVID-19 was an event that was impossible to predict, the trends that were accelerated by COVID-19 were clear years before and could have been pre-positioned for. Happy listening, and here’s to a fresh start in 2021.

Global Macro

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