Macro: What The Larger Funds Care About

Many traders trade solely on the basis of technical analysis. I want to ask you for a few sentences of introduction of what macro analysis is and what it can give them.

Macroanalysis is the art and the science, is the mix of both of trying to figure out the big puzzle, which is global economics and global markets.

Macroeconomic analysis is focused in trying to understand what are the interconnections between economic cycles, asset market pricing, and potential cross asset opportunities out there.

There will always be discrepancies. There will always be opportunities. There will always be economic cycles moving in different fashions between countries, and macro trading and macro analysis are the ways to exploit these opportunities.

An interesting example to discuss might be the current situation in China, which you have written a lot about recently. Give us some examples what impact can it have in other countries?

Yes, I think that’s a great example, Dariusz. So, let’s reflect on where China is today in their business cycle. They had a demographics boom in the late eighties, late nineties, and early 2000. Chinese population grew aggressively and China joined the WTO as well. The Chinese economy had a strong structural growth push coming from strong demographics and the productivity announcement entry into the WTO, so, all of a sudden China had access to global markets and a younger population. That’s great for growth. At some point, the magic exhausted itself.

This was somewhere after the great financial crisis in the United States, by 2010, 2011, the working age population in China wasn’t growing anymore and China had already become the largest trade partner of many countries out there. The marginal return of this growth enhancement, of WTO entry and strong demographics wasn’t there anymore. What did China do? Well, they levered up.

They did what every other economy had done in the past, like Europe or the US or Japan or the UK. They used leverage to grow. Debt, basically. They indebted their economy, not the public sector but the private sector.

Corporate in China added an enormous amount of leverage and then when they exhausted the leverage push around 2016, it was the time for households in China to lever up. Chinese households brought in quite a lot of debt mortgages in this case, because they were lured by the prospect of higher housing prices in China. China had a property sector boom, somewhere between 2015 and 2020.

What happened there is that this was the only way for the average Chinese worker to participate into the profits, basically, of Chinese economic growth. In China, wage growth is not the thing and consumption is not the thing. The Chinese share of consumption contribution to total GDP is about 35%. In the US, it’s about 75%. In Europe, it’s over 60%. In China, you don’t become rich with wages. The only way to participate into this economic boom was to buy housing and hope that house prices kept going up, up and up and up, and they did but it also created a bubble. Then Xi Jinping, somewhere in 2021, 2022, applied a clampdown of regulation on the most leveraged sectors out there in China, the most bubbly ones, the housing sector and the tech sector.

And now, the problem is that you need to deleverage such a market. You need to count down a roaring bubble and it’s very hard because the Chinese housing market was valued at $50,000,000,000,000 in 2021. It’s bigger than the US stock market capitalization, so you’re trying to bring down or to, let’s say, deflate enthusiasm in an extremely large market. That is propped up by credit, by debt, by mortgages.

The risk is that you don’t control the situation very well and that you generate what is happening now in China, which is that property developers are going bust like Evergrande, which is that households have indebted themselves to buy 2 or 3 apartments, these apartment projects aren’t even finished. They’re stuck with a mortgage but they don’t even have an asset against it because the house is not finished.

What it causes is a bit what happened in Japan in the in the 19-nineties, where you have a real estate deleveraging. You basically burst a housing bubble. Chinese economic growth suffers because the property sector is one of the biggest contributors to GDP growth in China.

Coming back to your original question, what happens then is the Chinese economic growth slows down. It happens that China is the largest trade partners of many countries out there. The trade flows between China and the other countries slow down. Germany, for example, relies a lot on China as a trade partner. You can see that German GDP growth is coming down already as a result also of Chinese weakness.

The second way that Chinese weakness can spread into other countries is through the fact that China was a big investor in other countries for the last 20 years. They accumulated so much surplus by selling cheap manufactured goods around, they accumulated these surpluses, and they reinvested these surpluses in other countries. The biggest recipient of these investments are countries like Australia, Brazil, Canada, Southern Eastern Southern East Asian countries. They will be lacking this investment from China for the next few years and it slows down domestic growth as well in these countries.

This is one example of how macro analysis is important because it helps you understand both the cycle in China and then the interconnections of what happened and what’s happening in China, across other countries as well.

Excellent explanation, thank you. From the trading standpoint, how would you use this situation to trade?

Normally, one of the rules that I use is to not proxy trade. If your view is that Chinese economic cycle is weak, you shouldn’t be trying to trade this theme with other assets that are correlated with China. You should trade it with China. You should be the closest possible to the source of your idea. If your idea is bonds, you trade bonds. You don’t trade equities because bonds are doing that. You trade bonds. If in this case your idea is China, then you should trade China.

I’m going to make an exception here because Chinese markets and the Chinese economy in general is quite centrally planned. That means that the authorities have a big footprint basically in markets and they can direct state owned banks or state owned enterprises to do certain things. And that can basically cause reactions in markets which are not necessarily correlated with your theme.

In this case, one can make a small exception to the rule and say “well, if Chinese economic growth is weak and I cannot express it in China, where can I express it?” Then you look at correlations and you look at assets that are correlated to Chinese economic growth historically and for a macro reason they are correlated. You find commodities, for example, like crude oil or copper are correlated to Chinese economic growth and then you find currencies like the Australian dollar or the New Zealand dollar that tend to be correlated with Chinese economic growth.

One way to approach this is, every time the market gets enthusiastic about a Chinese miracle rebound based on something, you can take the opportunity to lean against it tactically and say “well, I don’t believe in it because I think China is deleveraging and economic growth will be weaker, and therefore, I will be shorting certain currencies that are highly correlated with Chinese economic growth”.

So, there are problems that cannot be covered by, let’s say it politely, public relations strategies.

Yes. One of the things about global macro is that you need to understand the policy maker incentive scheme. The central bankers, the politicians, etc. They are very, very important in driving interest rates and market behavior, and each policymaker, be it a politician or be it a prime minister or be it a central banker in certain countries, they will have a certain agenda and different incentive schemes to switch their reaction function accordingly.

A good portion of macro is being able to understand what different policymakers want and in China, being a highly centrally planned economy, it’s even more important at that point.

In this example, from a trader standpoint, if you would like to trade several markets using this knowledge, where would you expect the strongest move, the most momentous one?

I would say that the normal answer will be in Chinese markets but as we said, it can be a bit backstopped by policy makers. Then I would have to look for proxies, and then I would say, currencies that are highly sensitive to Chinese economic growth. I mentioned a few before. The Australian dollar, the New Zealand dollar, the Korean won, the Thai baht. All these currencies that are highly correlated to Chinese economic growth.

Then generally speaking, cyclical commodities like copper, usually tend to be very correlated with China. It can be that in this case, the market has already learned the trick. So that if China announces something on a headline, they know they’re only trying to prop up their domestic market. They are not going to all of a sudden build bridges in the middle of nowhere and have more demand for copper.

I tend to look at currencies. I think it’s the best way to express it. The Brazilian real, the Australian dollar, the New Zealand dollar, these are the best ways probably to express the theme.

I’m trying to understand the consequences of this this bigger picture. There will be no surge in demand. So, there will be no moving price for example copper?

Yeah.

How can you use macroanalysis to detect strong or preferably strongest movements now?

One way to do this is, for example, to look at economic cycles and then look at the market interpretation of these economic cycles. Sometimes there are divergences between the two, so you study the economic cycle and you can do that by looking at various metrics.

My models generally rely on 3 main metrics: trying to predict where growth is going to go, trying to predict where inflation is going to go, and trying to predict what the Federal Reserve or central banks will be doing. These are the three axis of my macroeconomic analysis.

Then against this, you have market consensus because as a trader, you have to remember that you don’t trade solo, you trade against other market participants.

There is always a set of information which is priced basically into markets and it incorporates a certain expectation about growth and about inflation, how many cuts the Fed will do and so on, and so forth. That is your benchmark. That is your standard point of reference. Your macroeconomic analysis and your models might differ and deviate from that and that can provide with some signals for you to have a certain view against the market or not. Today, for example, we have economic consensus which is perfectly sitting in the soft landing camp.

Actually, in some cases you’re going to have growth around 2% in the United States by the end of the year, and you’re going to have inflation around 2,5. You know, a pretty hot economy by any standard, despite the fact that the Federal Reserve has kept interest rates at 5% or higher for now few quarters in a row. Then the market is priced with a few cuts, like 2 or 3 this year. That’s basically where we are. This is what’s priced in asset classes today, in bonds, in stocks. You have this set of information being priced as we speak.

My models instead are pointing to the fact that there is a chance that growth might end up being lower than this. It’s not gonna be 2%, it might be lower, and that inflation as well might end up being lower and going towards a 2% area. In other words, that nominal growth will be lower than when the market thinks it is.

If you have this deviation in expectations between your model and when the market is pricing, you can generate these deviations to think about trade opportunities.

If nominal growth slows a lot versus what the market expects, what happens? Well, certain stocks that are highly dependent on economic growth to do well. If this economic growth doesn’t materialize, they won’t be doing well.

Then you can short certain sectors of the stock market that are highly cyclical and you can decide instead to go long other sectors of the stock market that are more high quality. They don’t really depend on the cycle. There are more established business models, anti cyclical, like a consumer staple, a good brand of supermarkets. It will always work. It doesn’t really need strong economic growth to do particularly well.

You can do these relative value macro ideas, where you say “I’m gonna prefer a certain sector of the stock market that fits my view of growth and inflation that is divergent from what the market thinks growth and inflation is going to be” and you can short a certain sector of the stock market that needs that growth and inflation.

If you think it’s not gonna materialize for example, you have a deviation that you can try to exploit with the trade idea.