market folly

Global macro hedge fund Prologue Capital is out with their most recent letter to investors. They immediately address the most volatile month in the markets this year wondering, "Was it all just a storm in a teacup? And if so, will the economic recovery continue unabated? We don't think so. Rather, recent events are symptomatic of economic and financial vulnerabilities that will remain for some time." This is an interesting stance and we'll detail how they've positioned their portfolio below.

While May was a brutal month for hedge funds, Prologue did well to avoid carnage as they were up 0.85% through May 28th. This brings their year-to-date performance to 2.80%. Prologue now manages over $1 billion and were up 18.86% in the crisis-ridden 2008 and up 12.41% in 2009.

In assessing the global macro scene, Prologue's Chief Economist Tomas Jelf evaluates the US, Europe, and UK. Economically speaking, Jelf feels that there are still two main concerns. He writes, "The fiscal accounts of most developed countries create two immediate problems. First of all, the need for fiscal consolidation is a drag on economies at a time when recovery attempts to morph into an expansion. Furthermore, governments' indebtedness limits their ability to provide the type of backstop we have seen in recent years. Second, banks have yet to clean up their balance sheets to a degree that removes solvency concerns."

Overall, Jelf notes that repairing balance sheets and fiscal consolidation takes time. As such, Prologue expects some sort of turmoil to return in future quarters/years. It's obviously hard to peg the timing of such turmoil, but they are more concerned here than they have been in recent months certainly. They are concerned that this could "create more drawn out risk asset deflation and potentially halt the recovery." This isn't the first time we've seen such concern from a global macro hedge fund. Louis Bacon's Moore Capital Management pondered a return to a bear market in their past commentary. At the same time though, Prologue fully acknowledge that this turmoil could amount to nothing more than just 'hiccups' on the road to recovery.

Focusing specifically on the US, Prologue highlights the slowdown in discretionary spending. They are also concerned by an assumed rollover in housing now that the home buyers credit has expired. Overall, Prologue expects "declining year over year inflation figures throughout 2010. That, coupled with the worsening growth momentum, may lead to a decline in inflationary expectations. Suffice to say that the Federal Reserve will keep rates on hold for a long time."

In the UK, Prologue thinks there will be ample opportunities to take advantage of given that the monetary policy outlook is quite uncertain. While inflation expectations there have risen, the Bank of England's models have led them to a continued dovish stance. In Canada, Prologue favors flatteners but also thinks that bonds are cheap relative to US Treasuries. In Australia, they've reduced their exposure to the currency until the monetary path is more lucid.

Given their macro assessment, let's see how Prologue is positioned. In their last commentary, they detailed why macro factors are positive for risk assets. This time around, they are certainly more cautious as the month of May seems to have given them cause for concern. Here are their latest positions:

- Tactically long duration in the US and Eurozone

- Continued active participation in the underwriting process of government bonds

- Cross market Fixed Income - long US vs UK

- Exploiting dislocations in futures versus cash and swaps caused by flight to quality fears

- Volatility in FX options

Unfortunately, we can't post up the actual letter due to revealing watermarks. It's always interesting to see how global macro hedge funds are positioned given the fragile nature of many economies and the constantly morphing economic landscape. Those of you interested in this macro hedge fund's views can see their past commentary. For more global macro research, we have previously detailed investment commentary from John Brynjolfsson's Armored Wolf. And to learn from some of the most knowledgeable global macro fund managers around, we highly recommend Steven Drobny's new book The Invisible Hands: Hedge Funds Off the Record.