Macro renaissance: The opportunity ahead for investors

The world's financial markets are rapidly transitioning in new and, for some investors, uncomfortable ways. Interest rates are rising, impacting valuations; market and economic volatility is elevated; and asset class correlations look very different from the past decade. Sound familiar? Probably not. Sound challenging (from an investment standpoint)? Yes, indeed.

Yet for active managers, we see reason to be optimistic about the potential to generate alpha in this evolving environment, and particularly for managers of long/short strategies. Alpha generation may be accelerated in periods like this, as market uncertainty leads to greater asset price differentiation that skilled managers can exploit. Looking across active investment styles, we believe macro strategies stand at the epicenter of this alpha opportunity. Historically, macro investing has shown the potential to thrive when volatility rises, and when economic and asset trends create recognizable patterns and dislocations. Importantly, the macroeconomic forces influencing markets today appear likely to be in place for years to come. Simply put, we think we could look back on this as a multi-decade macro investing renaissance.

The end of the low-inflation era and the market implications

Our thesis on the attractiveness of macro investing centers around the belief that the low and stable inflation environment the world experienced over the past 20+ years is changing. That period was characterized by a series of positive supply shocks and supported by powerful forces, including technology, demographics, and globalization — all of which fostered improvements in global productivity. Those conditions gave markets and policymakers the impression that supply was endlessly elastic and able to adapt to any level of demand. With inflation low and stable, central banks saw very little risk in targeting full employment (at the expense of rising inflation expectations). Loose monetary policy translated into low and even negative interest rates that propelled asset prices upward, supported high valuations (Figure 1), and depressed market volatility. A passive investing nirvana if you will.

Fast-forward to today and we find a world that has fundamentally changed and, in the process, sent shock waves across financial markets. The concept of elastic supply has been challenged, as rapid fluctuations in demand have stressed the system to, at times, a breaking point. Global inflation has reacted by hitting highs not seen in decades. As noted, we do not view these economic developments as cyclical or transitory. Instead, we believe that even if central banks manage to pull prices back from current historic levels, inflation will remain elevated and more volatile, driven by a number of structural megatrends including deglobalization, decarbonization, and demographic shifts (read more here). Faced with higher inflation, central banks will have to adjust their policy tactics. Instead of oscillating between a subset of economic stages (“Goldilocks” and “Trough”), they will be forced to be more reactive and manage policy through an entire cycle (Figure 2).

Figure 2

Our macro investment team has noted that this regime shift has a number of implications for economic and financial market performance:

1. Economic and market volatility will likely remain elevated, with uncertainty about the direction of the cycle forcing investors to consider a wider distribution of cyclical outcomes and policy responses. This is likely to require greater emphasis on a probabilistic approach to investing.
2. The fundamental underpinnings (e.g., leverage) of every asset should once again become the financial system's “law of gravity.” Excessive liquidity will no longer float all boats and structural forces like deglobalization will raise operating costs for companies and governments. This should create more explicit winners and losers, with the outcome more quickly reflected in the price of each organization's tradable assets.
3. Correlations among equity and fixed income markets will at times be positive. There may be extended periods when growth and inflation are moving in different directions, forcing central banks to accept a trade-off between the two. When they choose to focus on inflation, that may mean more periods when equities are struggling at the same time as yields are rising (i.e., bonds are struggling), similar to what took place in the 1960s and 1970s (Figure 3). In other words, there may be long stretches of positive correlation between equities and bonds, a big change from recent years that would leave bond returns less likely to act as a reliable hedge on equities. The traditional 60% equity/40% bond portfolio could very well struggle in this environment. 
4. Risk-adjusted returns could be lower for traditional assets. As we transition into a period of more regular and perhaps rapid changes in the cycle — more like what took place during the latter part of the 20th century — our historical analysis suggests that Sharpe ratios on equity returns should be lower and more variable.
5. Staying liquid will become paramount for many investors. More volatility implies an added layer of complexity and fluidity around investment decision making. As such, we believe there will be a higher value placed on being nimble and liquid as holding periods in traditional asset allocation frameworks may need to be shorter. 

Figure 3

With challenge comes opportunity

We believe macro investment strategies are well suited for this environment. They are designed to look across various liquid asset classes for long and short opportunities that develop at the intersection of prevailing economic conditions and current market pricing. Macro investing is a highly heterogeneous category, meaning there are many substyles and strategies employed, with varying potential for uncorrelated returns, downside mitigation, and liquidity. Given their focus on economic trends, macro strategies have performed well in periods of elevated uncertainty and market volatility, on an absolute basis and when compared to other alternative strategies (Figure 4). The most recent period of elevated market volatility was no exception.

There is the other side of the coin, of course. Specifically, history suggests that macro strategies would be expected to deliver more average return outcomes in periods marked by lower volatility and little price differentiation among financial assets — along the lines of what we witnessed in the decade following the global financial crisis.

Figure 4

Interest in macro strategies has increased notably over the past six to 12 months, as investors look for strategies that can address the challenges outlined above, including the need for return enhancement, diversification, and liquidity. Because there is no “one size fits all” macro strategy, investors conducting a manager search should clearly define the investment attributes that matter most (e.g., return enhancement vs. downside mitigation). In addition, we think it is critical to fully understand a macro manager’s specific offering, including team structure (e.g., single portfolio manager vs. multi-manager), investment philosophy and process (what’s the “edge”?), resources, capacity limits, and terms (e.g., fees, expenses, and liquidity).

Renaissance (the French word for “rebirth”) periods have historically rewarded those able to identify economic and societal changes that will dramatically influence the future state of the world. We believe we are transitioning into one such period, with meaningful implications for investors. If we are right, we think macro strategies may be well positioned to capitalize on what could be an interesting and distinctive time for the global economy and financial markets.

Please refer to the investment risks page for information about each of the following risks:

• Alternatives risk 
• Capital risk
• Risks of derivative instruments
• Manager risk
• Short selling