Mark Rzepczynski, Author at IASG

If you wanted to focus on three longer-term macro factors that will drive overall commodity prices, it will be global growth, the dollar, and liquidity. The determination of long-only allocations in any asset allocation should focus on these three. Trading issues will be driven by volatility and market shocks.

The talking heads in the media spend significant time making political predictions. Even many Wall Street economists fall into the trap of giving political forecasting advice instead of digesting the economic data. The outcomes and impact of elections; pundits usually don’t know. The time of geopolitical risks and wars; pundits don’t know. The cultural changes that will impact markets; pundits don’t know. Unfortunately, the media does like the experts who are doubtful and equivocate. Pundits, however, are not often stupid. They provide significant amounts of information, background, and data. It is just that their ability to make good forecasts is poor. The advice from the forecasting expert Phillip Tetlock, the author of Superforecasters and Expert Political Judgment: How Good is It? How Can We Know? is very simple, “Don’t listen to them”. Their overconfidence will cause investor decisions to go awry. They place too high a probability on their views.

Motivated cognition – we believe what we want to believe. We will also believe based on who we are and who we want to be. Our goals and needs shape our thinking. Facts do not change our goals when we have motivated cognition. Investors rationalize and filter evidence presented to support their views. Motivated reasoning will generate confirmation biases.

Where is that inflation? Central banks have this fixation on 2% inflation as both a goal and a signal. Policies have been structured for the magic 2% and signals for balance sheet action are based on the inflation hitting 2%, yet current inflation has not been able to reach this number. Growth expectations have been moved higher, yet there seems to be continued economic slack that will not allow product prices to push beyond 2%. Hence, central banks have held to current policies. (An exception was the Bank of Canada this month.) The result has been further asset price appreciation and more leverage. This combination will have to be adjusted, but not today. Nevertheless, markets are still hyper-sensitive to monetary policy musings.

There are two communication problems with global macro investing. First, the stories used to explain the global macro economy are confusing, contradictory, and haven’t proved to be true. This is an outgrowth of the poor forecasting of macroeconomics in general. Second, the stories used to explain the investment process especially for quants goes over the head of most investors. A discussion of techniques is not an explanation for how returns can be generated. Managers need to work on their narratives to ensure that investors understand what they do and why they make money.

If you tell me I have increased equity risk, I can adjust my asset allocation way from stocks and determine a good hedge strategy. If you tell me there is more interest rate risk, I can adjust my bond exposure and determine a hedge. But, if you tell me I have geopolitical risks, the choices or options become more complex. Geopolitical risks just don’t happen often so we don’t have a lot of countable events. Increased political risks will usually mean risk-off, but how this plays-out through a portfolio is less clear. It calls for more careful portfolio construction and diversification management.

HFR has announced a new set of risk parity indices. The set of indices includes risk parity strategies at different volatility levels and for both institutional levels and smaller funds. These investable indices represent 25 different products with $110 billion in AUM. The risk parity portfolios are generally comprised of four sectors which are given equal risk weight: equities, credit, interest rates, and commodities.

While stocks were mixed with performance down for the month in with growth, value, and small cap benchmarks, there was a general increase in hedge fund returns for August. Equity-focused hedge funds gained from the added dispersion in returns across sectors and individual stocks. Evidence suggests that active management relative performance increases when the correlation across stocks decline.

MiFID II is coming with less than four months to go until the start date in January 2018, yet money mangers and hedge funds are scrabbling to find the right regulatory structure and the right way to manage the costs of the business. MiFID requires an unbundling of brokerage from research costs. Asset managers will either have to pay for research or bill clients. Many managers have yet to make or disclose their intentions on how research costs will be handled. A topic that has not been fully covered is an understanding of the cost generating the investment returns based on the process employed.

August showed growing dispersion across styles, sectors, countries, and bonds. For example, there was almost a 5% difference between holding the emerging market and value ETF’s (EEM-IWN) For sectors, there was an 8 percent differential between energy and technology (XLE – XLK) and a 3.5% difference in bonds between long-term Treasuries and high yield (TLT – HYG).

Many of our trend indicators were mixed coming into last month but continued gains in currencies and a strong bond rally positively contributed to performance for many CTA’s. The current trend indicators suggest continuation of these existing price moves. We take a representative sample of markets in a sector and count how many have up or down trends to form a sector estimate. The sector estimates can be strongly up or down or more neutral with a bias up or down as indicated by our arrows.

Many CTA managers posted gains for August based on strong bond moves in the US and up trends in European fixe income. Currencies continued to add to profitability albeit the decline in the dollar has a flatter slope than previous months. Gold trading was profitable for those who traded it in tandem with currencies. Equity index trading was a more difficult sector given mid-month spikes in volatility and a reversal in direction during the second half of the month. Commodity trading was mixed for many managers with profitability associated with market allocation and style of trading employed. Oil trended lower while refined products and natural gas were slightly up for the month. Hurricane Harvey volatility affected position-taking at the end of the month. Industrial metals have continued their summer upward trends which has caused renewed interest in this sector.

The book, The End of Theory: Financial Crises, the Failure of Economics, and the Sweep of Human Interaction by Richard Bookstaber touches on the important idea that markets are driven by a diverse set of agents who have different objectives, levels of rationality, rules for making decision, and market power. The book makes a strong case for throwing out the existing theories that often rely on representative agents in order to more effectively explain the messy business of modeling financial markets.