John Butters John Butters John Butters John Butters Macro Analysis johnbutters.org
Two Types of Macro Analysis Macro Analysis Macro Investing Special Situations Page 3 Page 15 2
Macro Investing
Macro Investing � What do I mean by ”macro investing”? � Major markets: equity indices, interest rates, currencies, commodities. � Based on fundamental analysis. � Infrequent trading; analogous to tactical asset allocation. � Philosophy � Equity investors rely on stories; they have standard valuation models to guide them. In contrast, macro investors have no standard models and are always at risk of believing a bad story. � My approach is to focus on rational forecasting: that is, on the use of a model to make any forecast, and on the careful selection of the right model for the circumstances. Models may be quantitative or conceptual, but should be sufficiently well-defined to provide a clear answer to a given question. 4
Investment Process � Research � Daily reading and noting of a range of news and commentary. � Daily following of different markets and a range of indicators. � Creation of structured data feeds that automatically put economic releases into context. � Analysis � � � New information organised by theme market actor. � Constant conversation, with oneself and others (notebooks, daily note). � Work structured by maintaining separate databases of questions considered, models used to answer them and arguments for action. � Preparation of working papers to lay out important analyses. � No forecast without an explicit model. 5
� Example 1: Short EUR USD July 2011 � Model summary � Of interest rates: Two-year rates mainly reflect expected short-term rates. � � Of EUR USD: Driven by the two-year real interest rate differential. There had been a strong empirical relationship since mid-2010. � Of the Eurozone crisis: Fundamentally a balance-of-payments crisis. The reluctance of the private sector in the surplus countries to lend to the deficit countries implied a net capital outflow. In a single currency, the natural mechanism of adjustment was a deep recession in the deficit countries, unless private-sector net outflows were offset by official sector inflows. � Of austerity policy: A simple Keynesian IS-MP model, although I also relied implicitly on the models of Keynesian commentators. � Of the ECB: asymmetric inflation targeter with a pain threshold. 6
� Example 1: Short EUR USD July 2011 � Model implications � � Actual ECB rate hikes and further hikes were priced in to EUR USD. � Crisis measures did not address the fundamental problem. � Fiscal contraction would be contractionary: economies were likely to suffer. � Continued crisis and economic weakness would breach the ECB’s threshold. � � Therefore rates would be cut, and EUR USD would fall. � Execution � Entered the trade at the date indicated on the next page, with a stop at two 10- day average true ranges but was stopped out. Re-entered later in the month and held the trade until December 2012. � Exited after the ECB announced the LTROs. I had not fully grasped their implications when I exited the trade, but saw them as a danger. 7
� Example 1: Short EUR USD July 2011 � EUR USD (arrow shows date of investment call) Source: TradeStation 8
Example 2: Long Gold December 2011 � Model summary � Of gold: Closely related to the ten-year real interest rate. There was a very strong empirical relationship from June 2009, my rule-of-thumb date for the normalisation of markets following the global financial crisis. I was reluctant to trade this without a theoretical basis, but found it in the form of Hotelling pricing. A paper that suggested a similar explanation for the behaviour of prices under the gold standard also increased my confidence. � Model implications � Gold had fallen quite far from the level that a regression on real rates would have suggested; it had also fallen to the edge of a scatter plot of the relationship. 9
Example 2: Long Gold December 2011 � Execution � The gold price had been dropping through December, which was a good reason to be wary of going long. � However, on 29 December the price hit a new low, in the morning, on unusually high volume for that time of day and in thin Christmas markets. There was a good chance that this would give at least a good short-term entry. � Held the position until the end of January, when the market had had a good run. The price was not obviously too low, according to the model, and I felt I had made enough. 10
Example 2: Long Gold December 2011 Gold Continuous Future (arrow shows date of investment call) Source: TradeStation 11
Example 3: Long S&P 500 January 2012 � Model summary � Of equities: driven by changes in trailing earnings and credit spreads. I used a volatility-weighted composite index of these two factors; it had a relatively strong relationship with the S&P 500. � Of the ECB: asymmetric inflation targeter with a pain threshold. � � Of the Eurozone crisis (same as EUR USD example): Fundamentally a balance- of-payments crisis. The reluctance of the private sector in the surplus countries to lend to the deficit countries implied a net capital outflow. In a single currency, the natural mechanism of adjustment was a deep recession in the deficit countries, unless private-sector net outflows were offset by official sector inflows. 12
Example 3: Long S&P 500 January 2012 � Model implications � The S&P 500 had failed to rally because credit spreads were wide; credit spreads were wide because of the risk posed by the Eurozone. � Political defeat of the Bundesbank on the ECB committee lowered the ECB’s threshold. The ECB therefore instituted the LTROs. � ECB LTRO lending to banks could offset balance-of-payments deficits. The Eurozone crisis should abate and the S&P 500 should rise. � Execution � Execution of this trade was poor. Failed to enter on the date the call was made to colleagues (indicated on the next page), waiting for a larger short-term pullback. Then traded the view in copper, which failed to rise further. Finally entered the S&P 500 after a decent pullback, but the rally had already ended. 13
Example 3: Long S&P 500 January 2012 S&P 500 (arrow shows date of investment call) Source: TradeStation 14
Macro Special Situations
Macro Special Situations � What do I mean by ”special situations”? � Often in esoteric markets. � Possibility of valuation. � Low valuation provides downside protection. � Strong upside potential. � Philosophy � Come up with a solid valuation method. � Downside stresses to fundamental value or future cash flows are my favourite methods. 16
Example 1: Argentine GDP Warrants � An investment call on Argentina’s GDP warrants in November 2011. � Valuation methods � Downside stress: bad recession – GDP growth as from 1998. � Downside stress: repeat of inflationary history – GDP growth and inflation as from 1980. � Downside stress: continued growth but peso declines at 30% per annum. � Upside potential: coupons are paid and future prospects remain the same. � Conclusions � The three downside stresses implied IRRs to expiry in 2035 of, respectively, 18%, 15% and 32%. � Coupons due within 13 months represented approximately 60% of the current price. This provided both downside protection and upside potential if the market priced in further coupons. 17
Example 1: Argentine GDP Warrants Argentine GDP Warrant, Coupons Added Back (arrow shows date of investment call) 20 19 18 17 16 15 14 13 Source: Bloomberg, John Butters 18
Example 2: European Dividend Futures � An investment call on Euro Stoxx 50 2014 dividend futures in September 2011. � Valuation methods � Downside stress: dividends return to a ten-year low. � Downside stress: dividends fall as much as they did in the global financial crisis. � Downside stress: all index members simultaneously pay dividends at their lowest levels of the past five years. � Upside potential: investment-bank dividend forecasts. � Conclusions � All three downside stresses implied a value in the mid-80s. � Investment-bank dividend forecast was 154 for 2014. � The 2014 future was trading below 80. 19
Example 2: European Dividend Futures Euro Stoxx 50 Dividend Future 2014 (arrow shows date of investment call) Source: TradeStation 20
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