July 25, 2017
There is a big debate happening about the changing structure of markets. The role of passive investors and the increasing importance of data-driven investments are getting a lot of attention, and for good reasons. These are topics that we think about every day, as we try to build datasets and models to support macro strategy. We would even argue that what you can and should define as fundamentals is changing.
Let me explain what we mean by technicals being the new fundamentals (and at the end we will provide a brief business update).
In a pure P/L accounting sense financial markets are zero sum. For every buyer, there must be a seller, and for every profit there is a loss (when you include issuers in the accounting exercise). However, there are clearly positive effects from financial markets in a utility sense, facilitating risk sharing and capital provision among diverse market participants. This is because the constraints, objectives and horizons of participants can be very different.
For example, a hedge fund will focus on the P&L for each trade, but a corporate treasurer or CFO will be focused on reducing their company’s exposure to non-operational risk. Similarly, commodity futures exist ostensibly to allow producers to hedge volatile income streams, and the standalone profitability of the futures trade is of little relevance. Finally, certain market participants (for example issuers of equity in an IPO or small start-ups starved for capital) will be happy to see a technical loss on their position. Relatedly, central banks participate in the market to set policy, and influence economic outcomes; for them the P&L dimension from their market involvement is far less crucial.
Simplistically, we can divide market participants to those seeking trading profits (‘speculators’), and others with different objectives (hedging, capital raisings, macroeconomic management). In effect, speculative investors provide a service to other financial market participants – facilitating more stable income streams, favorable financing costs, policy transmission etc. In return, they expect to make a profit, in the aggregate, by taking the other side of price inelastic flows and picking up risk premia.
This process of taking advantage of deviations from market ‘fair value’ on the back of price inelastic, fundamentals flows has been a key tenet of traditional investing for decades. In effect, getting ahead of non-speculative and slower-moving flows has allowed for significant trading opportunities over the years.
However, this process in evolving. In recent years, non-speculative market participants have grown more sophisticated, and more careful about their market impact. In addition, many of the simple speculative strategies have been systematized, and are now being implemented by computers, instead of humans.
As a consequence, market behavior has shifted. One example is the relevance of current account and trade balances for currency prediction – which have gone from very important to basically irrelevant over past decades. Another example is new-issue concessions (‘tails’) in US Treasury auctions, which have essentially disappeared since around 2012, as fundamental investors have become more sophisticated, and systematic traders have entered the game.
Put differently, prior sources of alpha have increasingly been transformed into beta. And with simple market information increasingly symmetric, and passive or quantitative strategies managing an increasing share of overall capital, these trends will likely continue.
In this environment, the flows from non-speculative forces that discretionary ‘human investors’ need to get ahead of have changed. And the ‘new fundamentals’ also involve understanding quantitative and passive strategies (the ‘robots’), and their likely triggers. An ability to get ahead of flows from systematic investors is likely to be increasingly important, similar to flows like trade balances and bond supply dynamics in prior periods.
And now the business update: We have been working very hard on ‘globalizing’ our flow analysis. We will be officially launching a product called Global Flow Analytics in the coming weeks. This product combines a number of tools in the flow space aimed at providing real-time and forward-looking flow indicators specifically designed to support FX forecasting and macro strategy. If you want more information about this product, click here.
At Exante Data, we are focused on building tools to help our clients understand flow dynamics, including systematic flows from various types of speculative market participants. Previously (say 10-20 years ago), modeling the fundamentals and related non-speculative flows, would have given you an edge in macro markets. But today, you need to also model the ‘robots’ that passively generate larger and larger flows, to have a fuller understanding of asset price moves. One of our key goals is to build a bridge between fundamental modeling and modeling of ‘new fundamentals’, which includes the behavior of passive investors and predictable ‘robot traders’.
Head of Research
Exante Data LLC