Global macro hedge fund manager John H. Burbank III, the chief investment officer of $4.1 billion Passport Capital, gave a grim prediction for how monetary policy will end in the US and China.
“It is our strong opinion that within the next year we could see a major Chinese devaluation of its currency and a US recession,” Burbank wrote in his fund’s first quarter investor letter dated May 5.
He continued: “It is for certain in seven months we will see a U.S. election whose outcome may provoke or have discounted one or both. China will enter their liquidity crisis with likely the largest amount of non-performing debt in the world; the U.S. will enter its recession with the smallest rate reduction potential in history. For both it will be a normal ending after decades of extending their booms with the first quarter’s flip-flops possibly being their final policy moves."
"We think this is a time full of peril and repositioning that heralds either the start of a new market reality (i.e., inflation and too much liquidity) or the beginning of the liquidation," he said.
That said, Burbank, who profited from his 2007 bet against subprime housing, believes that there’s the potential to make money ahead.
“Our culture of seeking both to take and manage risk leads us to believe that there are substantial return opportunities ahead, and we expect to see them once this massive dose of central bank anesthesia wears off financial markets. In particular, we continue to believe that the U.S. dollar is the key macroeconomic variable driving risk appetite, and that it will resume its rise once markets embrace the fundamental truth of the consequences of divergent monetary policies.”
'We felt 2008 had returned'
Burbank’s Passport has had a challenging 2016. The fund had been among the top performers at the beginning of the year with all three funds in the positive territory in January. Those gains were erased by what Burbank characterized as a "policy-induced rally."
Passport’s $1.9 billion global strategy fund ended the first quarter down 7.5%, while the $445 million special opportunities ended down 3.93%, and the $1 billion long/short strategy fund ended down 2.54%, according to performance data compiled by HSBC.
Burbank, whose funds also had a strong 2015, went into 2016 with the expectation that the market was going to fall. It did. The market was in a free-fall from January through mid-February.
Surprisingly, though, the market erased its losses and turned positive for the year in March after the Federal Reserve abandoned plans to raise interest rates. Meanwhile, China moved to stimulate, rather that reform its economy.
“Our overall positioning for well over a year has reflected serious concerns about the consequences of the ending of Quantitative Easing (QE) in the U.S. Investment funds began 2016 either both informed and cautious of broad deflationary risks facing global markets, or oblivious and positioned poorly for them,” Burbank wrote.
He continued: “We believed 2016 would mimic 2008 with widespread deleveraging into illiquid markets. We therefore entered the year defensively with liquidity, long U.S. dollars, yen, rates and mostly U.S. large cap stocks, and short a variety of risk assets that we believed would suffer as funds realized the extent of the market’s problems (not limited to declining reported S&P 500 earnings down -19% from Q3 2014).Three weeks later we were well-rewarded for our prescience; three months later we were hurt for it after an extraordinary policy-induced rally — yet earnings continued their decline.”
Handicapping Central Bankers
One of the challenges, particularly in macro investing, has been handicapping central bankers.
“The timing of central bank’s (U.S.) and government’s (China) attempts to cushion financial markets and the world economy was virtually impossible to forecast, and the boundary point of 6% nominal growth for China and 1810 for the S&P 500 (or 20.5x GAAP ’15 earnings) difficult to comprehend,” Burbank wrote.
“Harder still to assimilate, after the lack of advance notice provided by China or the Fed on their policy flips, was the market’s racing onward to discount even more action ahead if needed. Liquidation became covering, momentum unwound, and investing now verges on moral hazard. Informed of the likely future economic growth path, one has trouble taking risk, yet betting against desperate policymakers now leaves one almost equally irresponsible. Unlike predicting secular changes in industries or evaluating the merits of corporate decision-making, logic and research don’t work as well for predicting action of government officials, particularly if you don’t trust their models.”
In the letter, Burbank noted that they raised the fund’s liquidity profile and reduced short positions to cyclical and marginal businesses in an effort “to weather this period of heightened central bank intervention.”
He noted that right now we’re in a period of monetary policy convergence between the US and China.
Burbank quoted comments made in late-March by Fed Chair Janet Yellen at the Economic Club of New York where she noted that the price of oil was reaching a “tipping point for some countries … [that] could have adverse spillover effects to the rest of the global economy.”
“The Fed policy response now seems to be a function of global growth concerns rather than domestic considerations. This essentially brings forth a period of global monetary policy convergence rather than the anticipated divergence, as a response to the negative global consequences of a strong U.S. dollar over the last year and a half,” Burbank wrote.
Burbank expects that the US and China will “approach their own denouements which will separate them again.”
'Hard to Recommend Longs'
In the current environment, Burbank— whose fund uses a combination of micro, macro, and quantitative approaches to investing—said at the SALT Conference that it's “hard to recommend longs.”
During his SALT panel, Burbank did recommend a pair trade with a long in Tencent (0.700.HK), a social media company in China that trades in Hong Kong, and a short of the exchange-traded-fund FXI (FXI), which tracks large cap Chinese companies.
According to Passport’s most recent 13-F filing, the fund went long on a 5 million call options on FXI.
The filing also shows that Burbank massively increased his bearish bet against the US stock market during the first quarter by adding puts on 4.8 million shares on the SPDR S&P 500 exchange-traded fund (SPY). At the end of the quarter, Passport owned puts on 5 million shares of SPY. Famed fund manager George Soros’ family-office hedge fund also doubled down on its bet against the S&P 500 in the first quarter.
Burbank, who lives in San Francisco, started Passport in 2000, toward the end of the dot-com bubble. Previously, he worked at hedge funds in the Bay Area, where he focused on emerging markets during the Asian financial crisis. He was among the fund managers who successfully bet against the subprime housing market in 2007.
Julia La Roche is a finance reporter at Yahoo Finance.