Gautam Samarth (pictured), deputy fund manager for the M&G Episode Macro strategy, reckons that the flexibility of discretionary macro strategies to be both long and short different assets and to tactically scale in and out of positions is going to reap dividends, given the current state of flux in markets.
Discretionary macro strategies were very much in vogue in 2022 after a stellar performance that year on the back of trends such as the strengthening US dollar and rising interest rates, although they were largely flat last year as many of them were caught flat-footed by the collapse of Silicon Valley Bank.
In contrast, a 60:40 portfolio returned 17.2% last year, although Samarth dismisses any suggestion that this undermines the case for including discretionary macro strategies in a portfolio.
Instead, he points to the fact that the current macroeconomic model is undergoing a shift as governments globally seek to prioritise labour more at the expense of capital, arguing that the ensuring volatility creates the right conditions for discretionary macro strategies to thrive.
“When regime change is up for grabs, those valuation bands are going to be wide,” he said. “As the market prices in new regimes, there tends to be much more volatility. To be able to be more tactical, even if you don’t know where neutrality is going to end up, to be able to make money out of that range of valuation switches is quite key for a strategy like ours.”
Different macro strategy
Notwithstanding the fact that Episode Macro shares the ability to be both long and short assets and scale in and out of positions nimbly, the strategy is actually quite different to most of its peers.
Episode Macro eschews the forecast-based approach that underpins most other macro strategies and instead is firmly rooted in behavioural psychology, seeking to exploit movements in prices that are potentially behaviourally or emotionally driven.
This has meant that its returns have differed from most of its peers and it has largely outshone other discretionary macro strategies in the past few years (see chart). In 2022, for example, it switched from being short US Treasuries and equities to being long those assets towards the end of the year, which reaped dividends at a time when most of its peers remained short those assets throughout the year.
At its heart, the strategy is price contrarian with a focus on reacting to how others invest, rather than seeking to obtain an informational edge, albeit the starting point for the strategy is valuation.
The scope of the strategy is primarily at the macro level including equity indices, government debt and foreign exchange, although the strategy does not invest in commodities directly.
The strategy involves a lot of scaling, meaning that when positions work for them, the team reduce the size of those positions, while at the same time, they often increase their positions on setbacks. As a result, stop losses do not feature in the strategy and the strategy is willing to tolerate temporary setbacks.
Performance of late
Its performance last year was decent compared with its peers as it generated an 8.87% return as it was less caught off guard when Silicon Valley Bank struck given that its managers had already started scaling back their bond and equity exposure.
“It’s not that we knew that was going to happen. It was just that we’d seen a reasonable rally in risk assets. Most financial assets looked pretty neutrally priced and slightly more euphoric given what had happened, so we reduced the number of bets in the book,” said Samarth.
The main reason for the strategy’s outperformance last year though was the managers’ decision to extend duration at mid-year, eventually taking its duration up to 14.5 years, the highest it has ever been for the strategy.
The strategy is largely flat so far this year as the adverse impact of its bond positions has been offset by its decision to go long China equities just as they began to rally, which is very characteristic of the strategy.
Its managers had realised that Chinese equities had looked cheap for a long time but it was only towards the end of last year as stock markets globally began to rally due to new-found confidence about the prospect of disinflation and Chinese equities actually fell that they decided to open a position.
Its managers first opened up a 5% position in China equities in December before increasing this to 15% in January. In line with their strategy’s ethos, they have scaled back their position to 10% as it has worked in their favour.
“By January, there was an uninvestible view of Chinese equities. Anytime you hear that an equity market is uninvestible after it’s fallen 25%, is a pretty good sign there’s an episode happening out there,” he said.
Disaster myopia
Unsurprisingly, Samarth currently takes the view that the markets are being somewhat complacent about the potential headwinds facing them, something he refers to as disaster myopia.
“If you look at recession probability models, Bloomberg had a recession probability model that hit 100% in November 2022. Right now, these recession probability models are falling down. Nobody’s talking about that. So, we think that disaster myopia is something that is at play right now, which is that people have forgotten about the risks of slowdown,” he said.
He points to pockets of nervousness in markets, particularly around the elections in Mexico and France, although overall he notes that this does not negate from the fact that investors are surprisingly sanguine.
Where this leaves Episode Macro currently is relatively cautiously positioned, particularly through exposure to long dated government bonds, although the strategy also added exposure to two-year and five-year Treasuries in April.
The strategy considered buying Indian equities around the time of the sell-off shortly after the election, although ultimately decided not to as the panic proved to be short-lived. Its exposure to equities is otherwise limited aside from China and some relative value trades.
“Our way of approaching things is you want to be paid some protection, you want to have some things in the book to protect you against some left tail risk events. That’s why we still have some of the longer dated government bond positions on because if you do get presented with left tail events, those assets could rally pretty meaningfully,” he said.
