In a previous article I wrote about how market strategists are fond of publishing their market predictions at the beginning of each calendar year, as well as how making such market calls can be a risky business.
The problem with views is that my guess is just about as good as anyone else’s. The betting ratios of most macro hedge fund managers, the type of hedge funds that make large discretionary directional bets in financial markets, are not significantly better than 50-50. The successful ones tend to those who are skilful in expressing such views and in managing their bets, as in having the discipline to cut losses whenever their bets go wrong.
A successful macro hedge fund manager needs to get three things right with their bets:
After all, any broken clock is correct twice a day. If one holds on to any bet long enough, eventually it will probably appear correct. The question is primarily one of how much it may cost to hold onto the bet versus its potential payoff and/or any other lost opportunities.
The point of this article is not about stating my views (with the usual caveat that they can be completely wrong), but to illustrate how one may structure bets in the market based on a set of market views.
The US economy will continue to stagnate until at least 2012 or perhaps even 2013. US unemployment statistics may start dropping slowly. The Fed will keep its funds rate at its near-zero range for most of 2011 and continue with its quantitative easing (QE2) programme. Unhappy about QE2, foreign central banks will begin to make noises even when there are no clear alternatives to buying US treasuries, yet the yield on 10-year US Treasury bonds will continue to stay low. Just watch out for what may happen to the yields of US dollar-based fixed income assets when QE2 eventually comes to an end (as it must). A significant portion of the money pumped by the Fed into the US economy is now recycled by ‘carry trades’ to seek higher yields elsewhere globally. Such transactions put downward pressure on the US dollar, so equity and commodity markets around the world will strengthen, thanks to unusually low US dollar-based funding rates.
Underweight US Treasury bonds and US dollar-denominated bond holdings. Short the US dollar. Long global equities. Long equity options or exchange-traded funds (ETFs) on US sectors that are likely to lead the US in an economic recovery, such as high technology and biotechnology.
The US unemployment rate may dip, partly because of individuals leaving the labour force altogether – this is a well-known statistical aberration. As for fixed income assets pricing off the US dollar sovereign yield curve, the only way to go is down, given the already ultra-low yield on US Treasuries. In particular, there can be serious difficulties in attracting demands on US dollar-denominated asset-backed and mortgage-backed securities once QE2 comes to an end. The US dollar will face downward pressure from its use as a funding currency. However, exactly when and how one can take advantage of the anticipated adjustment can be a difficult call, as long as emerging Asian economies continue to ‘manage’ their exchange rates against the US dollar, and the tradable US dollar currency index (DXY) is calculated against the currencies of six industrialised countries/regions facing similar economic difficulties. Regardless, the ability to borrow cheap in a funding currency that is likely to depreciate at loan maturity translates into a value proposition that few wealthy investors and hedge fund managers can resist. That means equity and commodity markets around the word, especially those related to emerging markets, will benefit. Within the US equity markets, the focus should be on sectors where the US holds natural competitive advantages. Recovering global demands will eventually translate into orders and hirings in those sectors in the US. Such a view can be expressed by using longer-dated out-of-the-money call options on such sectors or ETFs on those sectors.
The Obama Administration
Ahead of a possible re-election bid, President Obama will need to make certain compromises to show some policy results. With Republican leadership in the House, the likelihood for any substantive climate or energy policy agenda will stay low. The implementation of the Dodd-Frank banking reform legislation is expected to be weak. The US will face a leadership crisis in the G-20 process for global financial regulatory reforms, leading to different blocs of countries proceeding with their own and often-conflicting financial reform initiatives.
Long financials. Long traditional energy producers (e.g. oil, gas, coal) by using sector ETFs.
In short, we expect to see an increasingly dysfunctional Obama administration. Financials will get more breathing room with a weak implementation of Dodd-Frank, and with the G20 countries having a hard time agreeing on a consistent set of global financial reforms. Traditional energy producers will also benefit as soon as global energy and commodity demands resume, while the Obama administration will struggle to come up with a clear energy policy agenda.
Driver of Global Recovery
China will continue to lead in the global economic recovery. The renminbi (RMB) will continue its ‘managed appreciation’.
Long RMB by buying Chinese sovereign bonds or Panda bonds. Long low-beta China-linked equities.
The practical problem is that most of us may not meet the eligibility requirements to hold either the RMB directly or buy RMB-denominated bonds. At the same time, asset managers with Qualified Foreign Institutional Investor status (QFII, which allows foreign investors to make direct investments in RMB-denominated securities) are carefully guarding their precious quotas. A practical alternative is to gain exposure to low-beta (meaning low correlation to the overall Chinese equity market) China-linked equities listed in Hong Kong. Since the Hong Kong dollar is effectively pegged to the US dollar, any RMB appreciation against the US dollar should be reflected in equity pricing quoted in Hong Kong dollars, even when there are no equity price movements in the underlying RMB-denominated assets. As one example of low-beta China-linked equities, there is an emerging class of ETF investments that specialise in Chinese infrastructure, and infrastructure plays tend offer return characteristics that are more bond-like than typical equities.
The crisis on the Korean peninsula will come to some form of eventual resolution. The situation is likely to ‘get ugly before it gets pretty’.
Gain long exposures to the Korean market after the next major skirmish or contained conflict.
South Korea has proven its leadership in certain manufacturing industries, although the country is still in the process of redeploying resources to become a world-class innovator in the higher value-added industries. In the event that some of these manufacturing assets are disrupted or even destroyed in a contained conflict, the know-how is still available that will allow for a relatively fast reconstruction of its manufacturing capacities. However, any such bets should be relatively small because it is never easy to pick the low when ‘riding a roller coaster’. One way to express such a view is by using South Korean ETFs to diversify away any company-specific or sector-specific risk.
More of the Same for Europe
European governments will continue to drag their feet over the sovereign debt crisis. That may result in a longer-term economic malaise in Europe.
Underweight Europe. Long volatility.
There is simply no political will in Europe to resolve the sovereign debt crisis with swift and decisive policy actions. Only when the situation turns from bad to worse will European countries with healthier economies, such as Germany, step up. With the S&P 500 Volatility Index (VIX) now back in the teens, one way to protect your portfolio against another potential shock scenario due to the European sovereign debt crisis is to go long on futures on a volatility index such as the VIX. Typically, the VIX is lower-bounded by the actual volatility experienced in the market (or the so-called realised volatility), so one can get a solid upside exposure when starting with the VIX in the teens. However, participation in the VIX contract is not costless – there is a steep ‘implied carry’ penalty from rolling the VIX futures contract at regular intervals. One way to make such a bet is to by buying a modest amount of volatility-linked exchange-traded notes.
Once again, a successful macro hedge fund manager needs to get three things right: direction, timing and implementation. The point of this article is to illustrate how an experienced former market professional may go about implementing bets with a given set of market views on direction and timing. Readers are encouraged to first come up with your own views on direction and timing, and then apply a similar logic to place your own bets in the market as part of your annual portfolio review.
Nonetheless, this is not a purely hypothetical exercise: I intend to put my money where my mouth is, by placing real-dollar bets against these views using a very modest pot of cash sitting in an individual retirement account1 (IRA) account. That way, in my next market review to be written at the end of 2011, there will be a more interesting discussion of which of my bets have worked and which ones have failed.
1 Readers should bear in mind that a retail IRA account is not a professional trading account and there will be practical limitations to making effective implementations.
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