Post-Election Macro Strategies

---

• Macroeconomic trends are now key to investment success. Understanding these forces is no longer optional.
• The dollar's global role is evolving, influenced by potential policy changes, especially deficit reduction. This shift has significant implications for investors across all asset classes.
• Active management, with discipline and adaptability, is essential for success in volatile markets. A robust process and a willingness to change course are crucial for capital preservation and growth.

When we talk about investing, we need to think beyond stocks and understand the macroeconomic forces playing an increasingly significant role in shaping market outcomes. "The game now," says Keith McCullough, "is materially dominated by the flows of the machine."

Keith, a former hedge fund manager with experience at firms like Carlyle Blue Wave Partners, Magnetar Capital and Falcon Hedge Partners, now heads up Hedgeye Risk Management, which provides macro insights to institutional investors. He also hosts a daily webcast called The Macro Show, and he is the author of Diary of a Hedge Fund Manager.

Keith believes that understanding factor exposures, options flows, and the influence of algorithms is essential. He emphasizes the importance of being a "self-directed investor," equipped with the tools and knowledge to make informed decisions rather than simply chasing narratives and stock charts. "If you're called a retail investor," Keith argues, "that generally means that you’re macro unaware." He provides valuable insights into how macroeconomic trends are driving market behavior and offers practical advice for negotiating this new reality.

The four quadrants

Keith isn't just observing the market; he's developed a framework to decode it. Central to his approach is the Growth-Inflation Process (GIP) Model, which he calls "the quad". This model helps investors understand how economic growth and inflation affect different investments. Keith has tested this framework against historical data, creating a playbook to guide investment strategies in different economic environments.

So, what exactly is the quad? It's a two-by-two matrix, plotting the rate of change of economic growth against the rate of change of inflation. This creates four distinct economic environments, each with different investment implications. As Keith explains, "If you get the rates of change of growth and inflation right, you can front run the P in the GIP." Understanding these two factors, he argues, allows investors to anticipate policy changes and position themselves accordingly.

The four quadrants are:

1. Goldilocks: Growth is accelerating while inflation is decelerating.
2. Reflation: Both growth and inflation are accelerating.
3. Stagflation: Growth is decelerating while inflation is accelerating.
4. Deflation: Both growth and inflation are decelerating.

Keith emphasizes that these quadrants aren't static; the economy transitions between them. He warns, "The biggest risk in markets is when we hit quad four (deflation)." This is because quad four often signals a slowdown in both growth and inflation, creating headwinds for certain asset classes.

Trump, deficits, and the dollar

The 2024 U.S. Presidential election presented a unique scenario for investors. Leading up to the election, the prevailing narrative was that both candidates would pursue policies leading to higher deficits. This expectation had significant implications for the bond market, with many anticipating a "higher for longer" interest rate environment.

The market, Keith observed, seemed to be pricing in a Trump victory, evident in both equity and betting markets. However, he admits, "I would have never guessed that [deficit cutting] was going to be on the table." The emergence of the "Doge" trade and the associated focus on meme coins like Dogecoin further complicated the picture.

Keith highlights the unusual market activity, linking it to potential policy shifts under the Trump administration. "Just look at the price, volume and volatility on Dogecoin," he says. "It has nothing to do with anything an intellect could tell you […] It has everything to do with what the policy was going to be."

Post-election, discussions around potential deficit reduction began to surface, challenging the pre-election assumptions. Scott Bessent, a potential candidate for Treasury Secretary at the time of writing, advocated for a 3% deficit target. This shift in expectations, Keith argues, has significant implications for the U.S. dollar.

He believes that the prospect of deficit reduction, especially against the backdrop of other countries maintaining or increasing their deficits, makes a strong dollar more likely. "I’m short euros, I’m short yens, I’m short any country that will not cut their deficit," he states. He links this dollar strength directly to potential fiscal policy: "The implications of cutting the deficit are pretty straightforward […] the dollar signal to me is the most explicit signal out there."

Keith emphasizes that it's not just the policy change itself, but its timing within the larger economic and political context that matters. "It’s this particular thing that’s happening to the deficit — cutting it instead of building it — at this particular point in cycle time that matters the most."

Managing market risk

Keith's approach to investing isn't just about identifying macroeconomic trends; it's about understanding how those trends manifest in market behavior, particularly during periods of volatility. He pays close attention to market microstructure, recognizing the significant influence of options trading on short-term price swings. "If you don’t understand how gamma works and how dealers have to reposition," he warns, "then that’s one thing we do."

He highlights the impact of zero DTE (zero days to expiry) options, noting that he monitors the "ODT picture" multiple times a day to gauge market sentiment and potential volatility triggers. He specifically mentions the concentrated nature of the options market, dominated by a few key players like Goldman Sachs, Susquehanna, Citadel, and Jane Street.

Central to Keith's process is the concept of "signals" leading the quads. He explains that economic data is inherently lagged, often reflecting past conditions rather than current realities. His signals, based on price, volume and volatility, provide a more timely indication of market direction. He recounts a telling example: "I didn’t know anything about pandemics, but my signal in January of that year went explicitly quad four. And this was well ahead." This ability to anticipate market shifts, even without understanding the underlying fundamental reasons, is a key advantage of his approach.

Finally, Keith emphasizes the importance of risk management through his "trade, trend, tail" framework. He utilizes three distinct time horizons: short-term trades (three weeks or less), medium-term trends (three months or more), and long-term tail risks (three years or less). This multi-duration approach allows him to adapt to changing market conditions while maintaining a long-term perspective. "Doing nothing," he notes, "is obviously a very good strategy sometimes too." This underscores his disciplined approach, prioritizing capital preservation and avoiding impulsive decisions based on short-term noise.

The go-anywhere portfolio

Keith advocates for a "go-anywhere" investment strategy, emphasizing diversification across asset classes. He believes that focusing solely on traditional asset allocations, like a 60/40 portfolio of stocks and bonds, limits opportunities and increases vulnerability to market downturns. "The ‘go anywhere’ diversification strategy across asset classes," he argues, "it’s where it’s at for my hard-earned capital." This approach allows investors to capitalize on opportunities in a wider range of markets, including commodities, currencies, and alternative investments.

He's also critical of passive indexing, particularly in the context of a macro-driven market. While acknowledging that indexing has outperformed many active managers, Keith points out a crucial flaw: "Indexing […] cannot tell me that they don’t have epic 20%, 30%, in some cases, 50% drawdowns." He prioritizes capital preservation, emphasizing the importance of avoiding large losses. "Rule number one," he states, "don’t have drawdowns. Don’t lose money.”

For Keith, active management, informed by a robust macroeconomic framework, is essential for mitigating downside risk. By understanding the forces driving market trends, investors can position themselves for better risk-adjusted returns. He adds, "If I could only get one thing in macro right […] I would take the U.S. dollar index all day, every day." This conviction in the dollar's importance reflects his macro-driven approach and the central role it plays in his investment strategy.

The macro advantage

Markets are driven by more than just company earnings and product announcements. Ignoring the larger macroeconomic forces at play can leave your portfolio exposed. Understanding trends in growth, inflation, and policy shifts, as well as recognizing the influence of options markets and other factors, is key to making informed investment decisions.

---

This is based on an episode of Top Traders Unplugged, a bi-weekly podcast with the most interesting and experienced investors, economists, traders and thought leaders in the world. Sign up to our Newsletter or Subscribe on your preferred podcast platform so that you don’t miss out on future episodes.