Download Macro Brew “Top-heavy was the ship as a dinnerless student with all

Macro Brew
“Top-heavy was the ship as a dinnerless student with all Aristotle in his head.”
- Herman Melville, Moby Dick
“Macro” is a funny term. The word is not found in a proper dictionary, although it is accepted in Scrabble (9 points) and Words with
Friends (11 points). Wikipedia thinks macroeconomics is “a branch of economics dealing with the performance, structure, behavior,
and decision-making of an economy as a whole.” (Microeconomics is more scientific, seeking to identify human commercial
incentives on a smaller, more tangible scale, such as prices tending to rise when supply falls relative to demand.)
When it comes to finance, macro is generally thought of in macroeconomic terms (“what is the macro picture?” or “he’s a macro
guy because he focuses on money supply”). Traditional practitioners of macro investing, however, tend to think of themselves a
little differently. While they may understand the positive correlation linking the size of the ECB’s balance sheet to the price of gold
(very high); they usually see themselves as “macro” because they have a view of relative value among financial products (not
necessarily macroeconomic outcomes), and because they traditionally express their views through directional and arbitrage
strategies in Rates and Foreign Exchange markets, often with a time frame in mind.
Along these lines, there is a fundamental disconnect separating finance from economics. In theory, finance is about funding capital
formation with the goal of receiving a positive return. In practice, modern investors are more interested in wealth transference than
capital formation. Relying on macroeconomic outcomes is a bit too vague for investors (even macro investors) because it does not
provide a sense of predictability or timing the way relative asset valuations often do.
George Soros made a fortune as a macro investor because he seemed to know more than most about relative value and was
astute (and informed?) enough to exploit it. Occasionally, his conviction for certain trades rose to the point where he was willing to
short a ludicrously-valued Pound until the BOE buckled (who does that!); buy European sovereign debt against Treasuries in
advance of the Euro-launch; or buy emerging market equity in advance of broader market sponsorship. Soros did not have to know
everything about macroeconomics; just what mattered most and to whom…and when.
I’ve learned a lot of lessons over the years and one of the toughest has been to understand what I know, what I don’t know, and
what is unknowable. At a daily Kopernik value meeting recently, PMs and analysts were asked to recall a quote or two that made
an impact on them. Warren Buffet’s profound quips could fill a book, as could Bernard Baruch’s, John Templeton’s, Seth Klarman’s,
and other successful bottom-up value investors we are sympathetic to. I offered two quotes. The first I borrowed from the wisdom
of former heavyweight champ, Mike Tyson: “everyone has a
“…though we can never be sure of timing we can make fairly
plan until they get hit in the face.” The second I borrowed from
reasoned extrapolations about macroeconomic outcomes.”
the pawnbroker in “Trading Places” (played by Bo Diddley) who,
upon learning that a $6,900 watch that “simultaneously tells time
in Monte Carlo, Beverly Hills, London, Paris, Rome and Gstaad,” informed the rapidly death-spiraling Louis (Dan Aykroyd) that “in
Philadelphia its worth fifty bucks.” My point was that I am growing weary of elegant, all-encompassing macroeconomic theses,
complete with political intrigue and timing (theses many of us have been guilty of considering at one time or another).
Nevertheless, it seems that most professional investors today, regardless of their market or strategy specialties and regardless of
the time-sensitive performance pressures that come with investing in the modern era, are letting their macroeconomic opinions
influence their asset positioning. We cannot know what cannot be known, and currently we know very little about the exact path
that secular macroeconomics will influence near-term market pricing because, like the rest of us, geopolitical players and the
purveyors of global monetary, fiscal and trade policies seem to be making it up as they go. The result is a reflexive, very meta
investment environment in which every action triggers an immediate offsetting reaction. Through his reflexivity theory, Soros claims
to have been able to predict when macroeconomic outcomes would occur. The rest of us have to incorporate the Heisenberg
Uncertainty Principle into our analysis (the original Heisenberg, not Walter White’s alias in “Breaking Bad”).
So what can investors know? Well, though we can never be sure of timing we can make fairly reasoned extrapolations about
macroeconomic outcomes. Economic causes and market consequences have always been straightforward, though they seldom
run according to schedule.
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Shelter from a Macro Storm
Raise your hand if you haven’t heard the phrase central bank omnipotence. It suggests this: everything economic – from the
unemployment rate to output growth to the general global price level of natural resources, goods and services, labor, real estate,
and financial asset markets – has become mostly dependent on the decisions of global monetary policy makers. The implication
is that fiscal and trade policies (not mention microeconomics and geopolitics) have been greatly marginalized in lieu of the critical
need for new credit needed to service debt. Even if the concept is too strong for your tastes, it is difficult to deny that it has become
almost impossible for even specialist investors to have a conversation about valuations or expected returns without first disclaiming
Fed QE tapering, US interest rates, the strong dollar, weakening Chinese PMI, declining oil prices, ISIS, Russia, Ebola, or when
the ECB will embark on its own version of QE. Where’s the capital formation? Where’s the sustainable wealth creation?
It used to be seen as an oversimplification to link the general future pricing of financial assets directly to global monetary policies.
That is no longer the case. As global economies have become more and more levered, it has become increasingly difficult to
disregard the interplay between central bank-driven funding levels and how that plays into market sponsorship of everything from
sovereign interest rates to stocks and bonds in developed and emerging markets. The growing cognitive dissonance felt by
investors is the bourgeoning understanding that monetary authorities can no longer create real economic demand by increasing
aggregate credit. Interest rates are already near zero, credit spreads are already very tight, public and private balance sheets are
already highly levered, ageing demographics in most developed (i.e., over-levered) economies do not argue for secular balance
sheet expansion (just the opposite), and equity markets are no longer forming much (if any) sustainable capital. This highly
leveraged macroeconomic backdrop further complicates potential trade-based economic growth in emerging economies.
Few dispute any of these macroeconomic truths and yet very little capital is being allocated towards the potential for a reversal
from the current path. Simply, financial asset markets seem to be implying that real growth-retarding financial leverage will not be
addressed – either by policy makers or more naturally by global economic
participants practicing daily microeconomics (i.e., reducing their real
“The biggest difference today versus prior postwealth-destroying, non-output producing debt). Most capital is still being
War economic and market cycles is that stable
invested as though we are experiencing (or soon will experience) a
interest income from good credits no longer offers
common post-War re-leveraging cycle.
safety in real terms. (Bonds may be money-good,
but their principal will be paid with bad money.)”
In the US (as the world’s largest economy and purveyor of its only reserve
currency), economic indicators seem to imply that the American economy
is relatively stable. The unemployment rate has been trending lower since 2009 (though the participation rate just hit a thirty-six
year low). Inflation is also trending lower (although prices of items like housing, autos, health care and education – items for which
one must borrow to buy – remain buoyant). Nominal GDP growth also remains positive (though not when adjusted for the ever
increasing total money supply and burden of debt repayment). We should begin taking such parentheticals seriously.
Leverage has shifted since 2009 from bank balance sheets to government and private non-bank balance sheets. This shift in the
composition of aggregate debt has shifted the burden from receivers of interest (debt in the form of bank assets) to payers of
interest. The implication is that debt service is increasingly crowding out economic activity and democratic capital formation.
US equity markets are not necessarily sending accurate economic signals. They have generally risen since 2009 on the back of
two major trends: 1) commercial bank balance sheet support, which has provided new credit to investors (which in turn has
encouraged large cap debt issuance and share repurchases), and; 2) a global flight to safety to the US dollar and financial assets
denominated in it. As the graph on the following page shows, sales per share of the S&P 500 have barely recaptured their all-time
highs set in 2008. Monetary policy has been about re-leveraging the market, not stimulating economic activity or capital formation.
Are bonds sending proper economic signals? A fundamental case may be made that US interest rates remain low because
investors intuit real growth (GDP adjusted for inflation) to be negative for the segment of the American population that saves,
invests and starts and expands businesses. (The 2% official real GDP growth figure cited by policy makers – GDP deflated by
consumer price baskets – seeks to capture real output growth for Americans not investing, saving or expanding the factors of
production.) Bond investors are implying they are more concerned with the nominal return of principal than with the real return on
principal. While such investment behavior would seem irrational for investors fully funding bond purchase with cash in the hopes
of receiving more purchasing power at a later date, it is entirely rational for dedicated bond managers with mandates to beat the
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rate of published inflation (or beat their competition) each year. (And one should not forget the strong bid for sovereign and tertiary
debt from levered purchasers – central and commercial banks and hedge funds – enjoying a positive funding mismatch.)
S&P 500 Sales/Share
(Trailing 12 months)
Source: Standard & Poors.
From 30,000 feet, Americans gave its banking system (including the Fed) the franchise for currency creation and distribution. The
Dollar, in turn, has been the basis against which the great majority of global trade is transacted and the currency against which all
other currencies are valued. Non-US bilateral trade requires a reserve of US dollars to exchange everything from Middle East
crude oil to Asian cars and toys to Russian-made armaments. So what does it mean for the global economy when the Fed tapers
QE and threatens to reduce the size of its balance sheet? Well, it would mean a dearth of US dollars relative to other currencies,
which would naturally strengthen its exchange rate, reduce the global purchasing power of non-dollar currencies, and stress
leveraged dollar-denominated balance sheets. These dynamics would reduce aggregate global trade and GDP.
Further, were the Fed to allow interest rates to begin rising, less global capital would be attracted to financing consumption and
capital investment. (Some have speculated that the Fed might lose control over interest rates. This seems highly unlikely because
a central bank will always have more money at its disposal than bonds and other assets outstanding. After all, it can create the
money it uses to buy assets without limit.) So what is the Fed to do? Should it reduce its balance sheet and let interest rates
“normalize” (thereby letting global output fall and jeopardizing the ability of debtors to repay their obligations), or should it do
everything in its power to ensure that funding remains adequate just in case
there are renewed animal spirits? The choice so far has been the latter.
“…safety is not necessarily found today in
income producing assets or in businesses that
Regardless of which path the Fed chooses, it seems the likely outcome will
ply their wares in developed, relatively levered
ultimately be an accelerating global contraction in real output. If banking
economies (perhaps just the opposite).”
systems withdraw economic liquidity then nominal and real growth should
contract meaningfully and coincidentally. If banking systems continue to
provide sufficient liquidity, then nominal output growth may rise but debt-laden economies would still shrink in real terms. (It seems
the latter path is the better bet, as monetary policy makers would prefer to maintain the nominal solvency of their banking systems
and governments. If so, we should expect global leverage levels to be naturally reduced through the process of global currency
inflation and central bank balance sheet growth.). Although we should have very little confidence in predicting the timing of certain
outcomes, like discrete currency and capital market revaluations, we should have significant confidence in understanding the likely
outcome: currency devaluations across the board vis-à-vis the intrinsic values of certain assets and businesses.
The biggest difference today versus prior post-War economic and market cycles is that stable interest income from good credits
no longer offers safety in real terms. In an investment world bullied by currencies struggling to out-devalue each other as a means
of producing nominal economic expansion to service debt, the reliable payment of punky coupons today would be swamped by
the negative real return of principal at maturity. (Bonds may be money-good, but their principal will be paid with bad money.) By
the same token, safety is not necessarily found today in income-producing equity assets or in businesses that ply their wares in
developed, relatively levered economies (perhaps just the opposite).
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It would seem the most prudent investment objective in today’s macroeconomic environment should be the pursuit of true real
(currency-adjusted) returns. If that is not practical for investors with strict mandates, then small allocations to investments that
would benefit from a reversal of the overwhelming disinflationary consensus seems prudent. (After all, the significant magnitude of
change would capture meaningful alpha.) As always, but especially now, it might be best to identify sustainable real value, adjust
it for risk, invest for the long term, and watch the reflexive macroeconomic mayhem from the cheap seats (pun intended).
Paul Brodsky
Alternatives Client Portfolio Manager
Kopernik Global Investors, LLC
October 2014
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This letter does not constitute a recommendation, an offer to sell, or a solicitation of an offer to purchase any security or investment product.
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