262 Systematic Investor Series ft. Alan Dunne – September 23rd, 2023

[00:00:00] Intro

You’re about to join Niels Kaastrup-Larsen on a raw and honest journey into the world of systematic investing and learn about the most dependable and consistent yet often overlooked investment strategy. Welcome to the Systematic Investor series.

[00:00:23] Niels

Welcome and welcome back to this week’s edition of the Systematic Investors Series with Alan Dunne and I, Niels Kaastrup-Larsen, where each week, we take the pulse of the global market through the lens of a rules-based investor.

Alan, wonderful to be back with you this week. How are you doing? How is Dublin treating you at the moment?

[00:00:39] Alan

Very good. Good to be back. Lovely sunny Friday here in Dublin and looking forward to more rugby. Rugby World Cup at the moment, so that’s the big focus outside of the Federal Reserve and the volatility of markets.

[00:00:53] Niels

Absolutely. Hopefully in that order, I imagine.

All right, well, we have thanks to you a very solid lineup, I have to say, of topics that we will be tackling today. But as you know, before we do, I’m always curious to know a little bit outside the topics we’re going to talk about. What’s been on your radar the last few weeks since we last spoke?

[00:01:18] Alan

Yeah, I guess we’ll get into it in terms of the bond market and treasuries, etc. But it is interesting how there’s been a couple of articles out in the last while talking about the concerns around the treasury market again and the basis trade and the BIS highlighting that the magnitude of that trade was basically long cash treasury securities, short the futures, and that this was a trade that effectively almost blew up in March 2020 and the Fed had to intervene. But obviously, we’ve seen lots of money flowing into these multi-manager platforms and this type of trade seems to be very popular in that cohort. So, interesting.

There was also an article about leverage more generally in the market. So it’s just interesting how there is this concern about what we’re seeing in terms of the amount of risk-taking out there and potential spillovers, something that maybe we hadn’t seen for a while, but certainly something I’m focusing a little bit more on at the moment.

[00:02:23] Niels

Yeah. I know we’re going to jump in to your big macro view right now framework, but I was wondering, this has been a week tha,t I think in fairness, has been focused on Jerome Powell and what he had to say about the outlook of interest rates. But I was kind of wondering, what if the Fed was wrong when they said that inflation was transitory and it turns out that the current deflationary pressures are transitory? What do you make of that?

[00:02:53] Alan

Yeah, it’s possible, I guess. As in everything in the markets and economics has got different viewpoints. We’ve already had significant disinflation on the manufacturing goods side so you might say, well, maybe a lot of that has already run its course, and maybe from here, is this a risk to the upside? Obviously, we’ve had energy prices moving up as well in the last while and there’s concerns around food prices and weather-related concerns. We’re in an El Nino this year, etc. So there are reasons for being cautious.

Equally, we might talk about some of the guests we’ve spoken to on Global Macro. Chen Zhao was one, and he was making the point we’ve already had a big fall in inflation, but we might not have seen the impact of monetary tightening yet. So if you took that perspective and we did see the slowdown to come that we might see an even bigger fall in inflation, that still was his viewpoint. So I don’t know. I mean, who knows? You can make arguments on both sides.

I think, probably, a safe assumption is there’s probably greater volatility of inflation rates over the next number of years than we’ve seen certainly in the last decade, which in itself would be influential on markets. Going back in time, Jeremy Grantham at GMO had a model that modeled the level of PE ratios for the US market and a key input of that was not just the inflation rate, but the level of inflation volatility, with higher inflation volatility generally associated with lower multiples. So I think that would seem a reasonable assumption. But whether you’re in the disinflationary or the resurgence of inflationary camp, you can make arguments on both sides.

[00:04:46] Niels

Well, at least that’s why there are markets. There needs to be people believing in both sides of the argument in order to trade, so I guess that’s fine.

We’re going to stay with macro for a while in the first topic that we’re going to be debating. But before we do that, I thought I would just run through a few things that’s going on in the trend following space, so to speak. We are kind of three quarters through August. So far, so good, I would say.

Looking at the markets just from the last week or so, there are kind of the same themes. Bonds have been under a lot of pressure. T bonds down two big figures since last week. But then also, of course the equities have come down quite a bit and I think energies have given up a little bit of their gains, at least some of the markets as far as I can tell. But from a trend following performance, it has been fairly good so far. But if we look at the attributions, I would say the downside, definitely, equities taking a breather and therefore been putting a bit of pressure in terms of giving up open profits for trend followers.

Currencies could have been a little bit tricky depending on your weights. Mexican peso, which has been a good trend, came off this week. British pounds have been selling off. So depending on your system speed, they could have been causing a little bit of downside pressure. But on the other side, the positive side (and I think these are pretty strong sectors for many trend followers), it’s the fixed income markets first and foremost.

I think the continued sell-off given what’s coming out of the Fed at the moment has certainly helped trend followers as I expect most of them are still short. But then also energies have done pretty nicely. Of course, this is because of the higher prices that we’re seeing at the moment. Grains have done okay as prices continue to slide, so that’s not where the inflation is coming from at the moment. But actually, live cattle, for those who are interested in prices of meat, is having a pretty strong uptrend at the moment, as is orange juice and sugar.

My own trend barometer has finally moved a little bit higher. It’s, I wouldn’t say a breakout, but it’s at 52. So that could be a little bit interesting and exciting for trend followers from a performance perspective. In terms of numbers as of Wednesday, BTOP 50 Index up 2.44% for the month, up 2.07% for the year. SocGen CTA up 2.79%, pretty strong, up 1.18% for the year. SocGen Trend up 3%, up 60 basis points for the year, and the Short-Term Traders Index up about 1% for August, down 2.4% for the year. In terms of equities and bonds, MSCI World down 3.35% for the month, but still up 10.89% for the year. World Government Bonds, as mentioned, having a rough time, down 1.53% yet again in August, and the S&P 500 is down almost 4% but still up almost 13% for the year.

All right, Alan. Now, it hasn’t been that long, but it was in August. There was a little get-together in the Midwest, in Jackson Hole to be precise, and one of your guests that has been on the podcast, Barry Eichengreen, was commissioned back in February to produce a paper for the Jackson Hole conference to present and discuss it with the heads of central bank. I think the paper was called Living with High Public Debt.

I think their thesis is that high public debts are not going to decline significantly in the foreseeable future and countries are going to have to live with the new reality as a semi-permanent state of affairs. These are not normative statements of what is desirable. They are positive statements of what is likely, according to their paper. So take us into this debate and your thoughts on this.

[00:09:22] Alan

Sure. Yeah. I think this is interesting. The topic is interesting in itself from the perspective that the whole point on Jackson Hole is it gets together key policymakers and economists to talk about what they perceive to be the most topical point of issues of today. So the very fact that policymakers are talking about high debt levels and looking for guidance from people like Barry Eichengreen.

He’s written a book on public debt. He’s also an economic historian so he’s well placed to comment on the trajectory of debt in a historical context. So the fact that they’re focused on this at the moment is telling in itself. Particularly I guess from the perspective of it’s been interest rates bonds that have been the key move in markets. The 10-year yield is up to 4.5% in the US just this week, the highest level since 2007. So 16 years ago, would you believe? So it is quite significant that we’re seeing these shifts back to what I suppose people of our generation would probably call this more normal levels of yields. But for anybody who came into the markets after the financial crisis, no doubt seemed like very high levels of yields.

The point of Barry Eichengreen’s paper is to look at the current trends and debt levels and understand what’s driven them. They also talk about the holders of debt and how that shifted over time, and then also to make observations around can debts be reduced at all and how is this likely to play out over time. Specifically, they talk about conditions for debt sustainability, which I think is going to be something that we’re going to hear a lot more of in the next while now because rates are moving up and because we’ve already had a surge of indebtedness and large budget deficits over the last number of years.

So in terms of some of the interesting points they make, if you were to look across the advanced economies, broadly speaking, debt to GDP levels were pretty stable prior to the global financial crisis. In some countries, they had come down and might have been somewhere in the region of 40% to 60%. But since then, we had a global financial crisis and the policy response after it. Then we had a period back in the 2010s, austerity was to the fore, that whole philosophy, you might remember.

There was the paper from Rogoff and Reinhart where they had an error in their spreadsheets. But notwithstanding that, the view was once debt to GDP gets above 90%, it can be problematic. So the general economic thinking of the time was austerity was a good thing and necessary. So debt to GDP levels were broadly stable I would have said through the decade, but then obviously, what you did have was very low interest rates. So people started to say, well, debt is manageable, it doesn’t really matter, and having these very high debt levels.

Of course, we had the emergence of modern monetary theory at a time, which you don’t hear a whole lot about these days funnily enough, and then a big surge of spending post-COVID and a jump up in debt levels again. In the US now, the debt to GDP level is about I think it’s 120% of GDP, but 20% of that is held by federal agencies. So debt in the hands of the public is about 100% of GDP. The question is, is this here to stay? Are we likely to see these debt levels come down and what are the implications?

They look at historical episodes of how high debt to GDP levels get addressed or how they have done historically. They take a very long-term perspective. They look back through the centuries. What you tend to find is, debt levels tended historically to jump up when countries went to war. So the US after the Civil War, Britain after the French Napoleonic wars, France after the Franco-Prussian War. Back in those days, they did tend to then run budget surpluses to bring the debt to GDP levels back in line.

The point from Eichengreen is that that’s unlikely in the current environment. This was all back in the Victorian era of sound finances to point out, but that was before politically, it was difficult to pull back. There was no welfare state back in those days. So they were saying, in the current political environment, it’s hard to see us back to an environment where governments are going to start running primary fiscal surpluses on an ongoing basis, particularly when you look at the US at the moment where the economy is very strong and is still running a big budget deficit, which is not what you expect. You expect fiscal revenues to be strong when the economy is strong.

So in terms of the mechanisms to address debt, running a surplus is one. They say that that’s unlikely. The second typical way you might try and address high debt levels, and you hear this from a lot of commentators, is financial repression. So basically, you kind of force savers to buy bonds or accept a lower rate of interest than the market rate. So that can be either manipulating interest rates via QE, forcing say post offices, etc. to buy bonds or banks to buy bonds, or else putting caps on deposit rates.

Back in the US in the 1960s, ’70s, early ’80s, I think they had Regulation Q which capped interest rates. Again, the point about this is that the environment was different then. It may be more difficult politically to do this now. So they’re skeptical on the ability of financial repression. The third way you can address high debt is through higher inflation. You often hear this, that you can inflate away the debt and maybe the central banks are happy to have higher inflation just to allow that.

Again, they are kind of skeptical of this point as well from the perspective of they point out that it’s generally unanticipated inflation that will do that for you. So if you get a surprise of inflation like we’ve had in the last couple of years, that can be helpful in bringing down the debt because your debt to GDP level, the GDP side has increased in nominal terms by the higher inflation. But if you get persistently high inflation, then interest rates will factor that in, so your debt service costs rise. So again, they’re kind of skeptical on the ability of higher inflation to be used to address high debt levels. So in sum, they’re kind of saying that high debt levels are here to stay for all of those reasons.

An important point around this is, what level of debt and deficits are sustainable or where it does it become unsustainable? They talk about this relationship, r minus g, which is something you hear economists talk about all the time (well, economists who focus on this issue), and r is the real interest rate and g is the real growth rate. Basically, what you want to have for greater debt sustainability is higher growth relative to the interest rate, because if you’re growing strongly, you’re going to generate more fiscal revenues and that will cover your debt service costs.

Whereas on the other hand, if interest rates are too high and your growth level is too low, the value of the debt is going to be increasing over time because your fiscal revenues are growing slower than your debt service costs. So r minus g is really important. They run some calculations and point out, for the US at the moment, with a debt to GDP level of 100%, the numbers are very easy to show that basically, you need a primary deficit. A primary deficit of 1% is okay. That’s sustainable over time.

But the problem is, at the moment, the primary deficit for 2023 is projected to be 2.9% in an economy that’s already very strong. So without anything else, the US should be trying to fiscally consolidate at the moment, but that would be proven even more challenging say if we went into a recession because you’re going to have more spending and less revenues and you tend to see your budget increase over time. That’s not to say it’s going to spiral out of control, but that does highlight the fact that the trajectory is on a negative path at the moment.

We’re nowhere close to the kind of variables that you would like to see to get to sustainability and you already have a high level of stock of debt. So it’s all very significant from that perspective. I think that’s partially why we’re seeing the move in treasuries that we’re seeing this week. This is a factor that people are starting to focus in on to a greater extent. For example, if you look at US Treasuries and you look at the term premium for 10-year bonds, so that’s the difference between the return you get under 10-year bond versus if you just rolled T builds for 10 years.

Normally, you would expect it to be a positive term premium reflecting the volatility of holding the bond. Actually, it’s been negative for a number of years. I think that’s related to QE and scarcity of bonds, but that’s starting to shift now. The term premium has gone from negative to positive, and people are saying, well, ordinarily, you might expect it to be positive, 50 basis points or 1%. But again, that’s reflecting maybe people starting to reassess the safety of the asset and this term premium being built in.

Of course, the problem with that is at higher level of yields, the numbers become self-reinforcing in a negative sense because the higher rate means your debt service costs increase, etc. So it becomes a vicious cycle. It’s not in into a negative spiral by any means at the moment, but certainly, the trajectory of travel is negative.

[00:19:33] Niels

Yeah, that was a great recap. Of course, when you hear all of this, and I completely agree with you, I think that even though actually… And I will applaud Jerome Powell for that particular point, and that is he’s been pretty consistent in his messaging in the last, I don’t know, 12 months or so in terms of higher for longer and all of that. Now, of course, the debt looks like it’s going to be higher for longer according to Barry. But you do wonder why investors haven’t wanted a higher premium for buying long-term debt.

Of course, it makes it even more inconceivable why people in Europe bought 100-year bonds at zero interest rate. I don’t think it went negative, but the 100-year bond was not very positive in terms of the yield and you just think that is absolutely crazy. So, interesting.

Now, you’ve had some really interesting conversations on the podcast lately. Also going back a little bit further, I remember your conversation with Bill White, but more recently, of course, David Rosenberg and Chen Zhao. I feel, I remember, that they had different views on these types of issues.

[00:20:54] Alan

Absolutely. I think this is one of the points where people do have different views. If you go back to the Bill White conversation which was probably around this time last year, it was more around not so much debt sustainability, but I suppose the dollar’s reserve status and the attraction of the US as a destination for investors. Obviously, the consensus view is the US preeminence is here to stay, but what would change that? That might be around things like the trajectory of debt or the debt ceiling negotiations, that type of thing.

As I’ve been talking about this relationship between interest rates and GDP, we’re talking about this on a long-term basis as opposed to where the Fed Funds is at the moment. Yeah, I guess on the other side of the equation, people like Chen Zhao saying that he felt that r-star, which is the other buzzword that’s in the market at the moment, that’s the neutral real interest rate, that r-star actually hasn’t changed that much. The Fed would have said it’s about 0.5% or something like that, 0 to 0.5.

Now, obviously, if that’s the case, real interest rates now are up to 2%, so that means monetary policy is tight so you should expect to see a slowdown in the economy. Whereas, actually, if r-star has crept up a bit, then monetary policy isn’t as tight. So nobody knows. Economists can speculate around this. Chen’s view was that basically, he thought nothing structurally had changed. Okay, we’ve had COVID, but really, in terms of looking at the supply of savings versus the investment demand for funds, that there’s still a surplus of savings. That’s fair. That’s one viewpoint.

I’m a bit skeptical of that myself. But I think if you think about the investment that will be needed for the greening of the global economy, etc., you can debate will that happen or not, but I think my view is it will do and I think we’ve grown more accustomed to government spending and bailouts and checks and we will see more public spending over time, so that would be another source of investment demand. So yeah, there are different viewpoints.

Equally, going back to conversation we had, David Rosenberg was of the view that we will start to see a shift back towards austerity. But again, politically hard to know if that’s the case. We’ve obviously had a period in the US, particularly when Biden came in initially where you had the ability to initiate policy, very unusual that you had the presidency, the House, Congress in its entirety.

So once we get past the next election, we could be back to stalemate, and it could be back to a different set of policies. But this whole debate about r-star, it is key to this. But yeah, it’s like the old joke about economists. You put so many into a room and you get all the different viewpoints, isn’t it?

[00:24:08] Niels

Indeed, indeed. Now, let’s pivot a little bit and bring it closer to what we normally like to talk about, which is trading, investing and stuff like that, partly I guess inspired by a paper from Aspect Capital on FX. But also, you could say in line with what we just talked about and all the big changes we see in the global economy and perhaps the fact that a lot of countries are starting to kind of be a little bit out of sync with each other now from an economic point of view.

One sector that has been really difficult for trend followers to deal with in the last 15 years, except maybe for the last year or so, has been foreign exchange. It’s a big sector. It’s a very liquid sector. In fact, there used to be a lot of FX-only funds, which we’ll probably talk about as well. But Aspect came out with a paper that you highlighted to me, and since I know you worked in the FX markets, perhaps you can give us a sense how the FX markets, the trading of FX markets have evolved over the years from a macro perspective and then we’ll take it from there.

[00:25:25] Alan

Aspect’s paper is the Currency Phoenix, so it’s about the re-emergence of FX trading as a positive source of returns. They split it up into periods prior to 2008, 1990 to 2008, 2008 to 2021, and since 2022. I think it’s useful to give a little bit of context on the macro backdrop. If you go back to the 1960s, it was Bretton Woods. The dollar was the anchor, currencies were pegged, and then, in 1971, Nixon let dollar flows and the currencies went to floating exchange rates.

Now, for a lot of that period, there were still capital controls in place and currencies weren’t completely convertible. But as went into late ’70s into the 80s, that became less the case. You had the growth of the major financial centers like London, so you had much more free financial flows. Back in those days, obviously we were all focused on Paul Volcker and his tightening cycle in 1980s, late ’70s, early ’80s, and that inspired a big dollar rally. So the 1980s was a period of big volatility in currencies. You had the dollar rally that was ultimately reversed by the Plaza Accord, and then a big dollar sell-off and you had the Louvre Accord.

As you went into the 1990s, that continued up to a point in the early 1990s you’ll remember, Niels, where in the markets you had the exchange rate mechanism in Europe and periodic blow up to that, and then convergence trades, and a lot of opportunities. Obviously, you could trade not just the dollar against the Deutsche Mark, but you had all the European crosses, like it used to be called Mark-Paris, the Mark against the French Franc and all of that.

So there was a lot more opportunity in currency trading from the number of opportunities but also from a macro perspective because you had German unification and Germany raised interest rates and that didn’t suit the rest of Europe. So that tended to leave a lot of tension within the system, so a lot of volatility. That was a good period in terms of the opportunity set for FX traders. Then we got to the global financial crisis and into the post-financial crisis era, and then obviously, what we saw was interest rates around the world all converged to zero.

Investors and traders in the market used these interest rates as a key signal in their models for trading, but basically, rates everywhere converged on zero. We had very little volatility in GDP. It was kind of a synchronized economic cycle. All the economies expanded or contracted pretty much at the same time. No great divergences across the economic cycle and low volatility in interest rates and inflation and in GDP. So not a lot going on and obviously not much in terms of carry to generate either.

Obviously, in that period as well, whereas back in the 1990s you had a lot of cross currencies to trade, the euro came in in 1999 so that took away all of that. So generally speaking, currency trading has got more difficult, I would say. But since then, the last few years, it’s kind of been back to the future, back to the good old days. We’ve seen obviously bigger swings in currencies, obviously dollar-yen last year, a big move up and then a reversal.

What’s behind that? Obviously, the re-emergence of carry as a driver. So Japan keeping rates close to zero, negative actually, I suppose, at the short end, US rates up to 5.5%, so a big carry for us there. More divergences in the economic cycle, stronger growth in the US, much weaker growth in China, investor flows as a key driver, and much more macro uncertainty and interest rate uncertainty. Obviously, I think from a trading perspective, you touched on it as well, there used to be a lot more dedicated currency traders.

BarclayHedge has an FX Trader index. It was up 9% last year. That was its best year since 2003. The five-year annualized return is ticked up to its highest level in a couple of decades as well. But they also publish a number of programs in the index and there’s now 31 currency programs in the index. But if you go back to 2008, there was 145 currency programs in the index. So people maybe new to the CTA space might know that, that actually, there used to be a lot more distinct currency traders and there used to be a lot more currency traders in banks as well.

Obviously, the other upshot of the global financial crisis was Dodd-Frank, and a lot of prop desks were dissolved. Prop desks and banks historically used to trade currencies very heavily. So all of those themes are very much consistent with what Aspect point out in their paper. Basically, what they do, as I said, as they split their data between 1990 to 2008, 2008 to 2021, and then since 2022, and they look at the performance of carry trades and momentum strategies in those periods.

What it shows is that in that 1990 to 2008 period, you saw very positive performance around momentum and carry, the zero interest rate period, very negative, and we’ve seen a very strong period of performance again since 2022, particularly for momentum, but also for carry as well. And then they show, in terms of those key drivers, interest rates, GDP, dispersion, inflation distribution, central bank uncertainty, they have various ways of quantifying that and they’re showing that on each of those, that we’re seeing a stronger market backdrop and that’s reflected in the one-year performance of these.

Also, they look at the success rate of the strategies as well. The percentage of markets with a 2 Sharpe over a rolling one-year basis has increased. So what’s going on? I think we’ve had a confluence of factors here. We’re seeing a better macro environment, which is conducive to currency trading. We’re also seeing probably fewer managers in the space, so I think that’s interesting as well. The opportunity set is probably better if you were traders, and all of those things combined is seeing better opportunities. That’s obviously not just for specialists in the space, but for as you say CTAs more generally.

If you go back to the winter for CTAs or the lost decade, whatever you call it, probably the two sectors that were most challenging I would say were commodities and currencies in that period. We’re seeing obviously we’ve had better moves in commodities, but we’re also seeing better opportunities in currencies, which is obviously helpful for CTAs. But also, it’ll be interesting to see more managers may be coming back as dedicated FX traders as well.

[00:32:59] Niels

Yeah, absolutely. I think that is actually quite interesting to see whether it will spark a new wave of currency managers. That leads me to another discussion, which I’ll bring up in a second. Before I do that, just two comments. I actually do remember the breakup of the ERM specifically because back then as a young 20-something, I remember being asked to come on Danish television on the day it was announced that there was a breakup. I’m not sure I was the best qualified for doing it, but it is something that stuck in my mind having to do it.

But anyway, what I would say about the Aspect paper, what I love about it is the visual that they have where they show these three periods and where you can so clearly see visually how narrow the inflation range was in that period from 2009 to 2021, which of course, they called the ZIRP period. I think this is something that I think we as managers, trend followers in particular, have argued that it was an unusual period. I am of the belief that when we look back at this period, we will conclude that that was the odd one out, even though back then, people called it the new normal and thought that’s how it’s going to be in the future, but I just don’t subscribe to that. So, yeah.

Now, finally, because you mentioned this, it’ll be interesting whether there will be a new breed of specialist managers, in this case in the foreign exchange markets. I don’t know if you caught wind of the Transtrend paper that Nick and I discussed last week. But actually, in that, Harold does talk about whether you need specialists to trade markets or whether you should just leave it in the hands of a rules-based trend follower to do it for you. So I don’t know if you caught that.

[00:35:01] Alan

I didn’t, but it is something I was thinking about in this context as well. Investing say with respect to FX, investing in distinct FX managers was something that was, I don’t know if I’d say popular, but certainly reasonably common. It might seem unusual now just to be an FX specialist when you can trade across macro, but I guess you did tend to have a lot of people coming out of banks and they naturally had that FX background.

Secondly, from an investor perspective, often banks or asset managers or corporates naturally have FX exposure and then they have that question of will they hedge it or will they do a currency overlay. Then if you go into the currency overlay, then you’re naturally immediately taking on some level of currency risk. So it’s an easy step to taking on maybe a currency program as part of your portfolio?

I think in general, why you have specialists, it’s an interesting one. You obviously have specialists in the commodity space as well. Obviously, they bring intimate knowledge of the sector. Whereas with trend following, diversified trend following, you’re not getting any unique insights on individual markets. The insight is that markets trend over time and you apply it to lots of markets. So I think it’s a different skill set by allocating to a specialist.

Also, for whatever reason, you might have the view that that asset class is particularly attractive at the moment. So if you felt that we’re going to see more volatility in currencies, particularly over the next number of years, it may make sense to trade or to allocate to a specialist currency manager for that reason. You might see because there’s been a kind of an exodus of managers in the space that there could potentially be a better opportunity in that space. That could be another reason for allocating to a specialist.

Equally then, obviously, from a multi-strat, multi-manager perspective, from the perspective of being diversified, you will always get good diversification between having diversified CTAs and some niche specialist strategies within there. So I can certainly see the case for it, not to say one is better than the other.

[00:37:28] Niels

Of course, the euro could break up and suddenly we’ll have more currencies again. But at the moment, the trend has also been that there are fewer and fewer currencies to trade anyways. So we’ll see.

Now, we’ve got a couple of other topics that I think we want to dive into. I think I want to, as far as I remember, I think the next one we wanted just to have a quick talk about was return expectations, but do correct me if I’m wrong.

[00:38:01] Alan

There was also the article we saw on the Chinese market, so I don’t know if you want to talk about that.

[00:38:07] Niels

Yeah, go ahead. Yeah, definitely. That was the Reuters article where it came out, as they call it, to highlight and exclusive story. “China scrutinizes quant strategies as market weakness stokes public anger, sources say.” Of course, we don’t know what sources they are. But they do talk about, in this article from Reuters, that the China Securities Regulatory Commission has been checking several major brokers over the past weeks about short selling activities and trading strategies of their quant clients and managers essentially that are using derivatives and data-driven computer models and I think whether they will impose some restrictions or not. But it is kind of an interesting little topic. What did you make of it?

[00:39:00] Alan

Yeah, I think when I saw the headline, it seemed to be a bit more dramatic maybe than it seems once you dig into it a bit more. Particularly it does mention a couple of trend following managers there as trading in the futures, Winton and Two Sigma, the story references. But actually, I was in touch with a contact in China around it to get his perspective and he did point out that this is something that came up a couple of years ago as well in 2021 and tends to come up when the local equity market is performing poorly. Basically, the market has been struggling.

The Chinese authorities have initiated various policies to support the economy and the market and it’s still been a tough market and it is heavily retail-dominated. So it does seem to be looking for maybe a scapegoat for why market performance has been poor. I don’t think it’s necessarily going to trigger any action against futures traders in the local market at this stage, but it seems to be more directed at trying to understand who are the potential short sellers in the market more than anything else.

So the headline did seem to be quite a bit more dramatic and concerning but remains to be seen. I think it does seem to be a case of a reaction to poor equity market returns more than anything else.

[00:40:37] Niels

Oh, yeah. This is of course nothing new to us in Europe because we’ve had short-selling bands as well during crises, so that’s definitely the normal reaction. So as you say, maybe the headline was just there to sell some clicks. Anyways, there’s another article that we may want to get into as well. But am I correct now that you wanted to just talk a little bit about the paper from Pictet?

[00:41:07] Alan

Yeah, exactly. I guess one of the things we talked about the last time was looking at the return forecasts of the various asset classes and making the case for managed futures and trend following in the context of where forward return expectations are for the major asset classes. So I was making the point that if you took the CAPE, which is the cyclically adjusted price to earnings ratio, which is around 30, and derived future return expectations from that for equities, I think it would be around 5%, 5.5%, something like that.

But interestingly, since then, a couple of pieces came across my desk, one from Robeco. It’s kind of a structural outlook on the major asset classes and return expectations. There was another one from Pictet, and then actually just yesterday or today, GMO’s, they periodically report or publish seven-year asset class returns, and that was out as well. So it’s more of an independent or this is what the market is saying around where they see returns going forward.

The Robeco paper was interesting in terms of not just giving return expectations, but it gives a bit of context, and equally with the Pictet paper. It was interesting reading the two papers, they talk a lot about the structural factors out there in the markets at the moment. So for Robeco, it’s how fiscal policies present a challenge to central banks, basically the idea at the moment central banks are tightening but we’ve got fiscal stimulus and that there’s an inherent tension between the two and how’s that going to play out?

You’ve got the dominance of capital as the production factor is being challenged by labor. Obviously, we’re seeing that in the US with the strikes at UAW at the moment, and we’re seeing the structural trend back towards reshoring, and politically, profit maximization can’t be the only goal of companies and we’ve got this initiation of a global minimum corporation tax. So on a lot of levels, capital maybe will be more challenged, whereas over the last decade, that was all favorable.

They also highlight the geopolitical developments between the US and China. For all of that, it seemed like a fairly risky environment. The return expectations still looked reasonably positive. Equally, on the Pictet side, they were looking for US equities to deliver 6% annualized going forward. So not too bad, a little bit less than the long-term returns, and in Europe, 8%. they were a bit more optimistic on the outlook for bonds.

But equally, they were pointing to some of these structural trends as well around wages versus capital, how inflation is likely to be higher over time and more volatile, how debt sustainability, as we mentioned already, is becoming more of a theme. We’ve got this theme towards re-industrialization. You’ve got a shrinking labor force. Everybody points to the wildcard of AI as a thing that might bail everybody out and make the world a better place and boost returns and productivity. But failing that, it looks a more challenging environment.

So if you were to summarize those, Pictet at 6% for US equities. I’m trying to see, I think I don’t have the Robeco one in front of me for a second, but it was reasonably 6% or 7% from memory. On the other extreme, GMO are looking for US large-cap to be negative 2.7% in real terms now. I think they have inflation at 2.3%, so slightly negative even in nominal terms for US equities. So even there, you see a wide range in terms of the expectations for equity. So anywhere from flash to plus 6%, 7% for US equities over time.

Bonds on the other hand, people have become obviously more positive on bonds given that yields are higher now. So notwithstanding that maybe the greater risk in terms of volatility and mark to market, the starting yield for US Treasuries is at 4.5% would point to 4.5% to be a reasonable return expectation over the next number of years. So it’s in that context that we’d have to think about, well, what’s the case for allocating to diversifying strategies like managed futures and trend following.

As I said before, obviously, the benefit from managed futures at the moment is obviously the higher cash rates that we’re seeing. No matter how many times you say this, it seems people don’t understand it or just can’t get their head around it. But actually, one article that did was an FT article recently which did talk about the challenge for hedge funds going forward in a higher rate environment but how CTAs would be one strategy that would benefit.

But even at very modest Sharpe ratios of maybe 0.2 or 0.3, if rates are going to be, okay, they might not stay 5.5%, but if they stay at 4% going forward over the next number of years, it doesn’t take a whole lot in terms of Sharpe performance to generate returns that are comparable at least to equities. Obviously, we know that by construction only that they have a low to negative correlation. So it was really a sense check on my own calculations. I was probably a little bit more pessimistic in terms of my forward expectations for US equities maybe at 5% to 6%.

In the streets, you’ve got anywhere from the more negative from GMO up to 6%, 7%. Certainly, people are more upbeat on the outlook in emerging markets from a valuation perspective. But obviously, people then highlight a lot of that as China and it’s a bit of a coin toss as to how that is going to play out, but people have to take that kind of China geopolitical risk. But yeah, so I mean, yes, returns not as strong as historically, not as strong as the last 10 years would be reasonable expectations. Certainly, the outlook for diversifying strategies looks solid in that context, I would say.

[00:47:59] Niels

Yeah, I thought actually the FT article was interesting, because again, as you said, it can be hard for people to quite understand why it benefits people like trend followers so much that we actually have a reasonable positive real interest rate or maybe nominal interest rate. The beauty, of course, is that if you’re a trend follower or a CTA and you’ve structured your product well in a UCITS format on an offshore or onshore format, then all the free cash, somewhere between 70% to 90% of the money invested, should be earning nowadays north of 5% in dollar terms, and that obviously goes straight to the investors. So that is very important of course.

Now, one thing I don’t know about, Alan, but I don’t know enough about these multi-strategy funds but it did come up a couple of weeks ago when I spoke with Andrew. His view was that in those kinds of strategies where perhaps they use a lot of leverage to have all these small parts of teams managing the money so that the overall leverage probably is quite high in notional terms. If they trade cash products perhaps, it could be even higher, then higher interest rates are not beneficial like it is with a trend following strategy. Do you have any insights to that argument?

[00:49:36] Alan

Yeah, I was having this discussion with a client recently on the same topic, kind of discerning which strategies would do better. Obviously, strategies where you have to pay a funding cost say for either borrowing or for borrowing security to short sell, all of those pressures, in terms of the higher rate environment, would be felt. I think it’s probably true that a lot of the multi-strats as I mentioned at the outset do run highly leveraged strategies, so in terms of the basis trade, but that is more getting the leverage via the futures because you’re long cash and then short the futures that way.

But in general, I think it is a point that people are looking at now more closely that it will be a point of differentiation across the hedge fund space and multi-strategy space that if you do have to borrow securities in the same way as you have to borrow cash, there’s a cost associated with that and that cost is going up.

[00:50:47] Niels

Every time I see bonds behave like they have again this week, I am reminded, Alan, about our conversation with Roy Niederhoffer about whether CTAs could make money in a rising interest rate environment. So if people don’t know what I’m referring to, they should go and listen to that conversation, which was great. Roy is a great guest. Now, the last topic on our agenda for today I have very much been looking forward to because you have been traveling a bit and you’ve gone to these fancy events, one of them in Paris.

I don’t know how many times I’ve mentioned SocGen on the podcast, but I did not get an invite to this event despite all my free advertising I give them every week. But you did get an invite, which was great. I’m really curious to know, what are the topics that people are talking about? What are their concerns? What are they optimistic about? So if you can share a little bit of the insights, that would be super interesting.

[00:51:50] Alan

Yeah, it was obviously a primarily manager event. But there was an investor panel where it was interesting just to get a sense of what investors were thinking and then obviously, from speaking to investors at the event, certain themes emerged, and also a couple of interesting things on the manager side, at least one which I’ll come back to. But I would say from the investor side, what the allocators and investors and consultants as well working with investors were highlighting is certainly one, this challenge for hedge funds in a higher rate environment. I think this is the fact that we’ve gone from zero to 5.5% in the US very quickly and we’re still seeing people adjust to that in terms of as we’ve talked about before.

If you went back two, three years ago and made a case for diversification, it was very much around bond substitutes. Why would you hold bonds when the yield is so low and you’ve got this duration risk when you could invest in something like trend following or managed futures which can give you diversification and you don’t have that inherent risk? Now we’re into a different environment. People can see the attraction of fixed income from any traditional investors. So hedge funds that were maybe relatively low vol but low return, if they’re not able to generate returns in a higher rate environment suddenly become less attractive relative to fixed income products. So that’s certainly emerging as an important theme.

It was very much the same as in that FT article that the allocators and multi-strats and multi-managers and real money investors are giving that feedback to many hedge funds to say no point in taking that risk if the returns are not going to be any better than you would get in a traditional market. So the challenge of generating returns, and then secondly, obviously, the competition from fixed income. I’m sure that’s something you feel as somebody representing a managed futures strategy and trend following strategy.

Obviously, yields are back up, so that becomes more interesting for people who maybe have a natural bias to invest in traditional assets. Obviously, not just treasuries, but T bills, but also then credit is a little bit above that. Now, you can debate how diversifying all of these will be in the event of a significant downturn in markets. Maybe, maybe not. But certainly, I think that competition from fixed income is definitely real.

A third theme was just in terms of emerging managers and a scarcity or certainly lower levels of emerging managers launching new programs given the rise of the platforms. Obviously, it is harder to start in business now as a small hedge fund or CTA, and often, talent is being hoovered up by large platforms on favorable terms to people that make it difficult for them to start off by themselves. But if you are an allocator who’s looking for emerging talent, that is a factor making it more challenging.

Fees is back, seems to be back as a topic again, particularly around performance fees and in relation to high watermarks and whether performance fees are after interest, etc. Interestingly, there was still comments about some clients being unwilling to go back into managed features even after the good performance because the scars of the past are still there. So I was kind of curious to hear that even after a strong run that we’ve seen in the last few years, some people still have memories of the more difficult time. So they I’d say were kind of the main themes from an investor perspective.

On the manager side, one of the things that I would say is that, on the volatility side, it was just notable how, I won’t go into the details, but the dispersion trade has really become something that’s become very popular in that space. So this is basically looking at trading the volatility of single stocks versus the volatility of the index. So your long single stock volatility, short index volatility, it proved to be a fantastic trade in 2022. And unsurprisingly, lots of people are talking about it as a great source of opportunity. It is diversifying relative to traditional assets.

But it’s just interesting how it wasn’t something that you heard a whole lot about but certainly a lot of managers that are emphasizing as a great source of opportunity. So they were some of the key takeaways.

[00:56:53] Niels

Yeah, great insights I think from the investor side, which of course I’m keenly interested in. I don’t think those topics necessarily are new. Although I will say, I’m kind of surprised that we still have to defend our industry and that people will say, oh, I’m not going to go back to that asset class because I had a bad experience, as if it’s the industry that’s the problem. Sometimes, it’s also the way people select and how long a time they actually give the investment to play out. I can’t imagine that a lot of people would say, well, I’m never going to touch a bond just because last year was a disaster for fixed income investments, but then that’s the reality we live in.

On a personal level, you said whether I come across this argument about bonds and the competition, I would say yes, but I think when you take the time to actually explain them, what we talked about earlier, that they’re not really giving up anything. If yields go down, that’s going to benefit them from the fixed income side or the cash management side of the funds they invest in. I think most people realize that. So I haven’t seen, on our side at least, people leaving just because of bond yields going higher.

But I think from our conversations on the podcast, for quite a long time now, there is this hope, bias, desire to buy the bonds, so to speak. People that I respect a lot, global macro type people, boy, have they been wrong in their timing. Just like CTAs were “dumb enough” to just stay long when bond yields went to zero and below zero in Europe, luckily, we’re dumb enough just to stay short as long as prices move down and not having been tempted to buy into this incredible downtrend in price that we’ve seen and continue to see. Of course, at some point, it will change and so will we.

Anyways, Alan, I think this was a wonderful conversation. I really appreciate all the preparations you’ve done. Another thing I want to just acknowledge, Alan, with you is that you’re going to allow me to take a little bit of holiday coming up soon without bringing a microphone on the road because you kindly agreed to sit in and host the Systematic Investor series starting in early October and for three weeks. So first of all, thank you for doing that. I think the audience will be super excited about it. Of course, you have some of our resident co-hosts lined up for the conversations. I will be listening keenly to see where you take the topics and the conversations.

But I really do appreciate that because it is, although I’ve done it for a long time, traveling and recording over the weekend from a hotel room somewhere, I think nowadays the pressures are a little bit more that we want to keep the quality high and therefore it’s in much safer hands with you, so I appreciate that.

[01:00:25] Alan

Yeah, absolutely. Looking forward to it. It will be interesting to get the co-host perspective. It should be a lot of fun.

[01:00:31] Niels

Absolutely. Of course, when I come back, I will expect viewership and listenership to be sky-high from all the great content that you’re going to produce.

Now, if you enjoy these conversations, as usual, you should go to your favorite podcast app and leave a rating and review because they do help a lot for more people to discover the podcast. I will say, because I of course know the guests that are coming up in the next few weeks, they are super interesting and not necessarily guests that you find on all the podcast circuits, so I think you will enjoy that.

Next week, before I leave, I am joined by Mark. If you have any questions for Mark, you should email them to info@toptradersunplugged.com and I’ll do my best to get him to answer you when we record next Saturday.

That’s it from Alan and me. Thanks ever so much for listening. We look forward to being back with you next week. In the meantime, as usual, take care of yourself and take care of each other.

[01:01:42] Ending

Thanks for listening to the Systematic Investor podcast series. If you enjoyed this series, go on over to iTunes and leave an honest rating and review and be sure to listen to all the other episodes from Top Traders Unplugged. If you have questions about systematic investing, send us an email with the word “question” in the subject line to info@toptradersunplugged.com, and we’ll try to get it on the show.

Remember, all the discussion that we have about investment performance is about the past and past performance does not guarantee or even infer anything about future performance. Also understand that there’s a significant risk of financial loss with all investment strategies and you need to request and understand the specific risks from the investment manager about their products before you make investment decisions.

Thanks for spending some of your valuable time with us and we’ll see you on the next episode of the Systematic Investor.