Inflation and equity markets

Jupyter Notebook

Rising inflation is a natural headwind for equity markets in economies with inflation-targeting central banks. As consumer prices accelerate, expected monetary policy rates and discount factors tend to increase more than dividend growth. Over the past three and a half decades, there has been a strong negative correlation between changes in reported inflation and simultaneous global equity futures returns. A similar negative relationship is evident between seasonally adjusted CPI trends and concurrent returns.
Furthermore, inflation dynamics have shown predictive power. Short-term changes and trends in consumer price growth have proven to be valuable early warning signals for serious market downturns and leading indicators of recoveries. Also, inflation-sensitive strategies have performed on par with long-only portfolios during stable periods. Overall, they enhanced risk-adjusted returns by improving the timing of equity risk exposure.

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Macro factors and sectoral equity allocation

Jupyter Notebook of factor calculation Jupyter Notebook of factor analysis

Returns of major equity sector indices relative to the overall market plausibly depend on macroeconomic trends. Certain economic developments, such as the state of the business cycle, relative price trends, or financial conditions, drive divergences in business conditions. We test the predictive power of plausible point-in-time macro factors for the relative performance of the 11 major equity sectors in 12 developed countries over an almost 25-year period since 2000.
While not all plausible simple macro hypotheses are supported by the evidence, “conceptual parity scores” that simply average all (normalized) factors have displayed significant predictive power for relative returns of most sectors. The joint risk-adjusted returns generated by relative allocation across all 11 sectors are sizable, with a Sharpe ratio of over 1. This suggests that macro factor-based allocation may more than double the risk-adjusted returns of standard equity portfolios.

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Macroeconomic trends and financial markets: theory and evidence

Trend detection is one type of macroeconomics-based trading strategy (other types are fundamental value estimates, implicit subsidies, and endogenous market risks). Macroeconomic trends predict asset returns for two principal reasons: They affect investors’ attitudes toward risk and influence the expected risk-neutral payoff of a financial contract. The market impact of macroeconomic trends is typically more pronounced over longer horizons (such as months) than over shorter horizons (such as days). The relevance and predictive power of point-in-time macro trends have been demonstrated in applied research for all major asset classes: fixed income, foreign exchange, equities, commodities, credit derivatives, and cross-asset return correlation. The alignment of macroeconomic trend information and trading positions is often simple and straightforward. However, the logical transformation of the information states and hedging of target positions are sometimes essential.

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