In the post-crisis world, no investor can afford to ignore macro considerations. But for global macro hedge funds, anticipating macroeconomic trends and their impact across different asset classes is their bread and butter. I was therefore eager to speak with John Brynjolfsson, the head of $700 million global macro hedge fund Armored Wolf. Prior to founding Armored Wolf, Brynjolfsson spent 19 years at PIMCO, where he launched and grew the Real Return platform from $0 to $80 billion in third-party assets.
I met John (@Brynjo on Twitter) in Armored Wolf's office in Irvine, Calif., where he showed me his amphitheater-style trading room in which the portfolio managers all sit facing a row of large flat screens displaying (among other things) the returns across the firm's different strategies. The atmosphere was not unlike a university library -- quiet and focused.
In part one of the interview, Brynjolfsson describes some of the challenges for investors inherent in the current environment, why the eurozone crisis is a source of opportunity, and three areas of opportunity he is looking at now. (Part two, which provides a rational investor's framework for gold, is here.)
Different world, different market
First, how has investing changed since the onset of the financial crisis?
John Brynjolfsson: Historically, investing has been all about identifying segments that would benefit from consumer demand or industrial investment and the management teams that were doing things right and investing in those and profiting from good insights. After 2008, the environment has been much more characterized by forecasting and predicting what the government, regulators, bailouts, international coalitions, the Fed and currency policy would do to various sectors of financial markets. Certain skills are needed for that -- they're a little different than other investing skills.
How does one deal with this kind of complexity? As Brynjolfsson explains, the market has taken a reductionist approach:
The challenge is that most of these variables we now feel or now observe are being driven by just one variable. The term that market participants have used is called risk on, risk off. So, when a major policy decision is made that is perceived by the market as being helpful, in terms of the more liquidity or some developments that suggest that investors are gaining confidence, what happens is all of these global markets trade together.
So, you can see this in the correlation data. For example, the correlation between an individual company in the S&P 500 and the S&P 500 Index
as a whole historically has been between 40 and 60 percent. In recent years, over the past three years or four years, since 2008, that correlation has climbed very high, sometimes as high as 90 percent [see the graph below for the S&P 500's Implied Correlation Index in 2008.] And generally that correlation is higher. But it's not just higher between one company and the S&P 500. It's also higher between, let's say, commodities and equities. (INDEX: ^GSPC)
Europe: Risks... and reward
Arguably the most important contributor to the risk-on/risk-off dynamic these days is the eurozone, which hosts a slow-burning crisis that provides the market with a constant stream of news flow and occasional flare-ups, as policymakers with different (and sometimes competing) interests struggle to come up with a solution. While most investors are focused on the risks the crisis presents, Brynjolfsson also sees opportunity:
As an investor, we're looking for asymmetric risks. In Europe, I think we have a terrific investment opportunity created by an environment of denial. And the best way to create asymmetrical returns is if you identity a large group of policy makers and a large group of investors that are in denial.
We don't think the European policy makers are willing to acknowledge the huge dichotomy between reality and their vision of the world. The local politics in Europe is, universally, much more nationalistic and locally oriented than the bureaucrats and, in many cases, unelected leaders of the European Union. So the unelected leaders of the European Union, and the senior executives of the banks are convinced that their vision for a unified Europe is what all of the local people want. And they're plowing ahead with that vision.
Whereas, both in Germany, which is seen as the core, or the funding nation for Europe, and the periphery, which is generally the borrowers in Europe, both in the core and the periphery, there is a feeling that, "Hey, we're willing to be a part of a unified continent, if it serves our interests. And we're willing to stick it out, as long as it feels good. But when it stops feeling good, we're going to vote to go a different path."
Three opportunities in the current environment
Getting down to brass tacks: In the current context, how does one make money? Brynjolfsson outlines three areas of opportunity. The first is in bonds:
In the case of slowing China, problems in Europe and some of the scenarios in the U.S., you generally profit by forecasting that interest rates will tend to fall in that environment. Inflation will tend to be on the low side; obviously, demand will not exceed projections, and that tends to be disinflationary, so we profit by positioning for a fall in interest rates.
That strategy has been fabulously successful over the past five years, as bond yields have fallen to historic lows (see graph below). While that decline has prompted repeated warnings from analysts and pundits concerning a bond bubble, Brynjolfsson's observations suggest that being long bonds could well continue to be a winner, at least on a short- to medium-term time horizon.
Among major currencies, it's a case of identifying the weakest hand in a group that all hold bad hands -- or owning "alternative" currencies:
To some extent, all the currencies look miserable, because all central banks around the world are trying to create liquidity to offset the deleveraging and the disinflation. We can profit from that by seeing which countries are the most vulnerable, in terms of being forced to monetize and debase -- we think that would be Europe. [We can also profit] by looking at alternative currencies, like gold. We're not in love with gold right now, but, in any case, precious metals are an alternative to currency.
Finally, volatility is going cheap:
Obviously, we can short [risk assets]. For people who aren't in a hedge fund, you can buy put options. Buying options makes sense when implied volatilities are low. We think implied volatilities, like on the VIX Index
currently, are relatively low, so that means that you can buy put options at a relatively attractive price. (INDEX: ^VIX)
And, indeed, the VIX Index currently sits toward the bottom of its range over the past five years. [Note that on the day the interview took place, the VIX Index closed at 16.48, 13% below Tuesday's closing price.]:
In part two of this interview, Brynjolfsson describes a rational framework for thinking about gold, an asset that has generated massive returns -- and debate. He also identifies another "alternative currency" that is more attractive than gold right now.
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