INSIGHTS
                     
Macro Strategies During the Return of Volatility

Feb 2018 by Joe Burns

Macro Strategies During the Return of Volatility - CoverWith the Fed still projected to conduct three target rate hikes this year, where do markets go from here, and what should investors do about it? While nothing is certain, a few things seem likely.

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Investors around the world rejoiced February 16th as global stock markets finished the trading week by bouncing back from the strongest volatility spike in years, which erupted earlier in the month over concerns that rising inflation would trigger the end of easy monetary policies that followed the financial crisis.

Those cheers may well cease if volatility returns this year, and there is sufficient evidence that 2018 has more gyrations in store. Sophisticated investors such as financial advisors and qualified buyers should pay especially close attention to macro strategies, since such alternative investments have been known to outperform when equity benchmarks struggle.

But first, it’s worth looking at where markets have been recently and contemplating where they might head in the near future.

SHIFTING EXPECTATIONS

As prospects for the U.S. economy improved last year, the Federal Reserve steadily hiked its target rate.1 In January, inflation expectations began to rise due to gains in the Consumer Price Index and robust wage growth, as Treasury yields also started climbing.2

In late January the S&P 500 peaked, then over the next two weeks fell into correction territory only to regain significant ground the following week. Stock markets in Europe and Asia moved in similar fashion over that time period. Meanwhile Wall Street’s fear gauge, the VIX volatility index, more than doubled before receding back toward calmer levels.

With the Fed still projected to conduct three target rate hikes this year, where do markets go from here, and what should investors do about it? While nothing is certain, a few things seem likely.

GROWTH MODE

U.S. corporate earnings and consumer demand suggest prices and wages will continue to climb as the American economy remains strong in the near-term. Granted, as the expansion approaches a decade since the bottom of the financial crisis, questions abound regarding how long before recession strikes. Even so, there is little evidence of an immediate economic downturn. This supports the view that inflation appears poised to hit or exceed the Fed’s long-term target of 2%, as the central bank raises rates.

Secondary market yields on three-month Treasury bills reached 5.2% in 2007, then dropped to nearly zero from the financial crisis through 2015. Since then three-month bills have crawled above 1.6%. Ten-year yields went from 5.3% to as low as 1.4% before gaining to around 2.9% in February. The 10-year minus 3-month yield curve went from negative territory in 2007 to well above 3.7% during the crisis, and had dropped to as low as 1% by December. A flattening yield curve has historically been an indicator of increasing risk of recession, and/or increase in market volatility.

In addition, the Fed’s goal of returning to more normal monetary policy includes gradually reducing its balance sheet by rolling over ever fewer Treasuries and mortgage securities. The Fed started the fourth quarter of 2017 with a balance sheet runoff of $10 billion per month, and is raising the cap $10 billion per quarter until it reaches $50 billion per month. The balance sheet is estimated to drop from $4.4 trillion at the start of 2018 to $2.6 trillion by the start of 2021.

"NORMAL" ONCE MORE?

Arguably, markets have not experienced “normal” conditions since Lehman Brothers collapsed in September 2008. Going back to an environment of higher rates and a smaller Fed balance sheet could trigger something akin to the 2013 taper tantrum, when the Fed’s announcement that it planned to begin tapering asset purchases resulted in surges in both the VIX and 10-year Treasury yields.

If the Fed miscalculates the proper path to normalization, it could derail the economy, trigger a premature recession, and face pressure to halt rate hikes. Financial markets abound with additional factors that could enhance future volatility:

• Rising deficits, of potentially $7.2 trillion over the next decade,3 to fund the new U.S. tax cuts and President Donald Trump’s massive $1 trillion infrastructure spending plan.4

• The falling value of the U.S. dollar compared with other currencies as the global economic expansion raises prospects for Europe and emerging markets.

• Fluctuations in the prices of commodities such as oil, cryptocurrencies such as Bitcoin, and passive ETFs that follow the herd mentality.

• The shifting landscape of international trade relations, which may be moving from an era of multilateral agreements to an era of bilateral agreements.

There are signs correlations among asset classes could soon diverge and global markets might cease to move in unison. In January, on average, emerging market equities returned 8.3% while developed market equities returned 5%, commodities returned 2% and U.S. fixed income returned -1.2%.5

Taken as a whole, these considerations make now a prudent time to study the possible advantages of macro strategies.

ALTERNATIVE APPROACH

Taken as a whole, these considerations make now a prudent time Historically, hedge funds have exhibited strong performance that makes them a worthwhile alternative for investors. Macro managers did enter a challenging period as the financial crisis faded and the long-lived economic recovery took hold. But hedge funds have enjoyed an uptick in performance since the second half of 2017. If the world does enter an era of higher volatility and lower correlation across global markets and asset classes, macro managers will be poised to succeed.

Of course the strong start to 2018 might be short-lived for some hedge funds. For example this could be the case for those that have gone long on equities and short on bonds, or long on the dollar while going short on emerging market currencies.

Hedge funds also face ever greater challenges from automation. Machines likely will continue to alter the traditional discretionary macro approach by shortening trading cycles and creating higher “volatility of volatility” — prompting macro managers to exit trades before they can fully monetize them.

To be sure, not all macro strategies are created equal. Due diligence is essential to finding and selecting hedge fund managers capable of delivering the proper results. Investors with access to institutional-level due diligence and high quality investment funds may bene t from advanced tools that minimize the time and effort spent searching, while maximizing the efficiency of the selection process.

END NOTES

(1) https://apps.newyorkfed.org/markets/autorates/fed%20funds#Chart12

(2) https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yieldYear&year=2018

(3) http://www.foxnews.com/politics/2018/02/12/trump-budget-aims-to-jump-start-construction-cut-red-tape.html

(4) https://www.whitehouse.gov/sites/whitehouse.gov/files/omb/budget/fy2018/fact_sheets/2018%20Budget%20Fact%20Sheet_Infrastructure%20Initiative.pdf
https://www.nytimes.com/interactive/2017/11/28/us/politics/tax-bill-deficits.html

(5) https://am.jpmorgan.com/us/en/asset-management/gim/adv/insights/guide-to-the-markets/viewer


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