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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.

The below post is an updated summary of the section “The importance of macro trends” of the Macrosynergy research site.

Why macroeconomic trends matter for markets

Generally, all market prices are part of an economic equilibrium. More specifically, macroeconomic trends influence asset prices for two reasons: They affect investors’ attitudes toward risk and shape the expected risk-neutral payoff of a financial contract.

  • Risk aversion rises in recessions due to a focus on preserving limited resources. Standard economic theory proposes that the marginal utility of income increases as income falls. When household income declines and fear of unemployment rises, each incremental dollar becomes more valuable. The fear becomes more acute near the lower limits of living. Similar aversion to breaking downside thresholds can be observed in the financial industry. There is even a special concept of “loss aversion,” which is not the same as risk aversion (view post here) because the aversion is disproportionate toward drawdowns below a threshold.
  • The effects of macroeconomic trends on risk-neutral expected payoffs of securities are ubiquitous and often obvious. For example, inflation directly impacts the real return of nominal fixed-income securities; as inflation rises, the real purchasing power of fixed-income payments decreases. Similarly, macroeconomic trends such as economic growth and relative price-wage trends influence the earnings prospects of stocks. Also, financial conditions affect the default risk of credit. External balances and relative prices of goods and services matter for exchange rate dynamics.

The importance of macroeconomic information is principally recognized by many investors. They monitor economic data releases and employ economists for deeper analyses. Empirical studies show that bond and equity markets are more likely to post large moves on days of key data releases than on other days (view post here). However, the influence of economic data on market price changes tends to be stronger over longer time horizons. This is because macroeconomic developments and their effects are often more persistent than non-fundamental factors, such as market sentiment or order flows. Therefore, macroeconomic trends are a significant explanatory factor of medium to long-term price trends.

  • In the fixed-income market, empirical work has suggested that deviations of major economic data from analyst expectations can explain more than a third of quarterly bond price fluctuations in the U.S. (view post here). By contrast, daily data surprises explain only 10% of market fluctuations. Medium-term returns of government bonds seem to be predictable through nowcasted economic growth, excess inflation relative to the target (view post here), excess domestic macroeconomic demand (view post here), nominal import growth (view post here), and measures of financial market tail risk (view post here). Over the longer term, bond yields seem to move almost one-to-one with expected inflation and the estimated equilibrium short-term real interest rate (view post here).
    Equilibrium theory helps explain how macroeconomic trends and expectations for future short-term interest rates shape the yield curve (view post here). Stable components in GDP growth and inflation drive long-term yield trends. Transitory deviations of GDP growth and inflation cause cyclical movements in yield curves. Moreover, there is evidence that bond returns contain significant risk premia for regime changes related to economic growth and inflation in an economy (view post here).
    Moreover, research claims that a single fundamental divergence may explain most of the decline in equilibrium real interest rates from the 1980s to 2010s. On the one hand, the propensity to save surged due to demographic changes (view post here), rising inequality of wealth, and the reserve accumulation of emerging market central banks. On the other hand, investment spending was reduced by cheapening capital goods and declining government activity (view post here).
  • In the foreign exchange space, theory and evidence support a positive relationship between growth differentials and FX forward returns (view post here) and a close link between relative industry cycles and exchange rate dynamics (view post here). Currencies of countries in a strong cyclical position are expected to appreciate against those in a weak position. Also, macroeconomic indicators of competitiveness of currency areas are significant predictors of FX forward returns and a solid basis for pure macro(economic) trading strategies (view post here). Standard FX carry signals can be significantly improved by enhancing them with information on economic performance, leading to the advanced concepts of “modified real carry” and “balanced real carry” (view post here).  Similarly, standard FX trend following can be improved by considering macro headwinds (view post here).
    Deviations of currency values from their medium-term equilibrium give rise to multi-year exchange rate trends. Over time, exchange rates between areas of similar economic development have been observed to revert to their mean values, and adjustments have occurred mainly through changes in the nominal exchange rate. (view post here).
    External balances, which describe transactions between residents and non-residents of a currency area, also predict exchange rates and FX returns. Modern international capital flows are mainly about financing rather than goods transactions. The patterns and risks associated with international capital flows and financial shocks shape FX return dynamics (view post here). For example, a large negative international investment position of a currency area encourages FX hedging against that currency, particularly in times of turmoil, and hence positive but pro-cyclical FX returns (view post here).
  • As to equity markets, research supports a close link between macroeconomic developments and the two key components of stock valuation: earnings and discount factors. As a result, research has found many applications of macro indicators for the prediction of broad equity returns:
    • When stock prices increase, they contribute to the growth of household wealth and create favorable conditions for corporate investment. This, in turn, leads to a rise in aggregate spending, tighter labor markets, and potentially inflationary pressure, all of which are headwinds for positive equity market trends. Therefore, broad macro trends help predict market trends’ sustainability (view post here). For example, stronger consumer spending and tighter labor markets undermine monetary policy support and typically indicate a shift in national income from corporate to households. Private consumption strength has negatively predicted local-currency equity returns in the past and has been valuable for the timing of equity market turning points (view post here).
    • Inflation is another valuable equity trading signal. In past decades, even the simplest inflation metrics have served as warning signals at the outset of large market drawdowns and as heads-ups for opportunities before recoveries. The evident predictive power of inflation for country equity indices has broad implications for using real-time CPI metrics in equity portfolio management. (view post here). Also, a downshift in expected inflation can have multiple effects on equity markets: it raises average company valuation ratios, such as price-earnings ratios and credit default risk, at the same time. This combination of higher valuation ratios and increased credit risk can contribute to a relative asset class trend, where investors shift their preferences towards equities compared to other asset classes (view post here).
    • Improving bank lending conditions bolster aggregate demand in the economy and the creation of leverage. Both augur well for corporate profitability and forthcoming earnings reports. Indeed, signs of strengthening credit supply or demand in bank lending surveys have positively predicted equity returns in past decades (view post here).
    • Intervention liquidity expansion is a helpful predictor of relative equity market performance across different currency areas  (view post here). This indicator captures the monetary base expansion resulting from central bank open market operations in FX and fixed-income markets. Equity markets with more expansionary operations have an advantage over those with less liquidity supply.
    • Measures of macroeconomic uncertainty, i.e., unpredictable disturbances in economic activity, serve as predictors of equity market volatility (view post here).
    • Finally, the prices of equity factor portfolios seem anchored by the macroeconomy in the long run. This implies predictability of equity factor performance going forward (view post here) and explains why macroeconomic indicators can be used for equity factor timing, i.e., when to receive and pay alternative non-directional risk premia (view post here). Put simply, macroeconomic conditions may influence the probability that a specific investment factor will yield good returns. This is consistent with the evidence of momentum in various equity factor strategies (view post here), i.e., past equity factor returns have historically predicted future returns. Moreover, some research shows that macroeconomic factors, such as short-term interest rates, help predict the timing of exposure to equity convexity, i.e., stocks whose elasticity to the market return is curved upward and that outperform in large market moves (view post here).
  • In commodity markets, macroeconomic trends mainly industrial demand and financial investor preferences. There is strong evidence that macroeconomic data support predictions of short-term energy market trends (view post here). Valid macro indicators include shipping costs, industrial production measures, non-energy industrial commodity prices, transportation data, weather data, financial conditions indices, and geopolitical uncertainty measures. Macroeconomic indicators of industry sentiment, production, and inventory growth have also helped predict base metal futures returns (view post here). Changes in manufacturing business confidence can be aggregated by industry size across all major economies to give a powerful directional signal of global demand for metals and energy. (view post here).
    Meanwhile, the big cycles in some raw material prices have been driven mainly by “demand shocks,” which seem to be related to global macroeconomic changes and have had persistent effects for 10 years or more (view post here). Precious metals prices have a long-term equilibrium relationship with consumer prices and are natural candidates for hedges against inflationary monetary policy (view post here).
  • In credit markets, macroeconomic trends influence attitudes toward default risk and actual default probabilities. When systemic stress is high, investors require greater compensation for exposure to corporate default risk. This explains why measures of systemic macro default risk predict low-grade bond returns negatively (view post here).
    Selling protection through credit default swaps (CDS) is akin to writing put options on sovereign default. In sovereign CDS markets, default risk depends critically on sovereign debt dynamics. There is strong evidence of a negative relation between increases in predicted debt ratios (under current market conditions) and CDS returns. (view post here).
  • The correlation across asset markets also depends on macro factors. The most prominent example is the correlation between equity and bond returns. Economic policy is a key macro force behind it (view post here). In an active monetary policy regime, where central bank rates respond disproportionately to inflation changes, the influence of technology (supply) shocks dominates markets, and the correlation turns positive. In a fiscal policy regime, where governments use debt financing to manage the economy, the influence of investment (financial) shocks dominates, and the correlation turns negative.

Economic shocks have more powerful market effects if they change long-term expectations. Thus, a key factor of economic impact is whether long-term expectations are “anchored” or not. For example, persistent undershooting of inflation targets in the developed world has made long-term inflation expectations more dubious and susceptible to short-term inflation trends. This “de-anchoring” can be measured (view post here) through surveys and long-dated securities, providing valuable information on the consequences of price shocks for markets.

Aligning macro trends and market positions

The directional effect of economic change is often straightforward, following standard macroeconomic theory and market experience. For example, rising expected inflation and lower unemployment have historically translated into higher low-risk bond yields (view post here).  Also, swings in large commodity-intensive sectors, such as construction in China, have driven global prices for raw materials, such as base metals (view post here). Furthermore, export price changes in “commodity countries” help explain and even predict their exchange rate dynamics (view post here).

However, many macroeconomic trends can also have multiple effects, which need to be disentangled. For example, expansionary financial conditions can be both beneficial and harmful for future equity market performance, depending on the trade-off between positive growth impact and elevated vulnerability. On these occasions, indicators must be modified, become parts of larger formulas, and be split into different parts. For example, financial conditions can be divided into short-term impulses, such as yield compression, and medium-term vulnerability, such as increased leverage (view post here). Combinations of negative shocks and elevated vulnerability would then be clear negative signals for equity markets. Combinations of positive impulses and low vulnerability would be clear positive signals.

Global macro and market factors often obfuscate the relationship between country-specific macroeconomic trends and financial returns.

  • For example, the value of a currency typically benefits from strengthening the underlying economy relative to other countries. However, almost all currencies are, to varying degrees, sensitive to changes in global markets and the exchange rates of the largest economies. To validate and trade relative economic trends, it is, therefore, useful to hedge against such global influences or set up positions relative to similar contracts or both. Empirical evidence suggests that global FX forwards can be hedged reliably against the largest part of global market influences (view post here).
  • More generally, macro sensitivities are endemic in trading strategies, diluting alpha, undermining portfolio diversification, and distorting backtests. However, it is possible to immunize strategies through “beta learning,” a statistical learning method that supports identifying appropriate models and hyperparameters and allows backtesting of hedged strategies without look-ahead bias (view post here).

Sometimes, information regarding economic uncertainty can be as valuable as information on the economic direction. One can estimate economic uncertainty through various methods, such as keyword frequency in the news, relevant market volatility, and forecast dispersions. Such measures help to detect phases of popular fear or panic and complacency (view post here), both of which offer opportunities for professional investors. Indeed, composite measures suggest that uncertainty typically rises abruptly but subsides only gradually.
Unsurprisingly, uncertainty about the economic and financial state, in general, has been conducive to higher volatility in market prices, including commodities (view post here). Economic uncertainty can also affect directional trends. For example, there is evidence that uncertainty about external balances leads to the underperformance of currencies of economies with net capital imports (view post here).



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