Macro trends and equity allocation: a brief introduction

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Macroeconomic trends affect stocks differently, depending on their lines of business and their home markets. Hence, point-in-time macro trend indicators can support two types of investment decisions: allocation across sectors within the same country and allocation across countries within the same sector. Panel analysis for 11 sectors and 12 countries over the last 25 years reveals examples for both. Across sectors, export growth, services business sentiment, and consumer confidence have predicted the outperformance of energy stocks, services stocks, and real estate stocks, respectively. Across countries, relative export growth, manufacturing sentiment changes, and financial conditions have predicted the outperformance of local stocks versus foreign ones for the overall market and within sectors.

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Generic derivative returns and carry (for strategy testing)

Backtesting of macro trading strategies requires good approximate profit-and-loss data for standard derivatives positions, particularly in equity, foreign exchange, and rates markets. Practical calculation methods of generic proxy returns not only deliver valid strategy targets but are also the basis of volatility adjustments of trading factors and for calculating nominal and real “carry” of macro derivatives. A methodological summary for equity index futures, FX forwards, and interest rate swaps shows that generic return and carry formulas need not be complicated. However, decisions on how to simplify and set conventions require good judgment and adjustment to institutional needs.

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Equity market timing: the value of consumption data

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The dividend discount model suggests that stock prices are negatively related to expected real interest rates and positively to earnings growth. The economic position of households or consumers influences both. Consumer strength spurs demand and exerts price pressure, thus pushing up real policy rate expectations. Meanwhile, tight labor markets and high wage growth shift national income from capital to labor.
This post calculates a point-in-time score of consumer strength for 16 countries over almost three decades based on excess private consumption growth, import trends, wage growth, unemployment rates, and employment gains. This consumer strength score and most of its constituents displayed highly significant negative predictive power with regard to equity index returns. Value generation in a simple equity timing model has been material, albeit concentrated on business cycles’ early and late stages.

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Tracking systematic default risk

Systematic default risk is the probability of a critical share of the corporate sector defaulting simultaneously. It can be analyzed through a corporate default model that accounts for both firm-level and communal macro shocks. Point-in-time estimation of such a risk metric requires accounting data and market returns. Systematic default risk arises from the capital structure’s vulnerability and firms’ recent performance, as reflected in equity prices. The metric is both an indicator and predictor of macroeconomic conditions, particularly financial distress. Also, systematic default risk has helped forecast medium-term equity and lower-grade bond returns. This predictive power seems to arise mostly from the price of risk. When systematic default risk is high, investors require greater compensation for taking on exposure to corporate finances.

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Equity versus fixed income: the predictive power of bank surveys

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Bank lending surveys help predict the relative performance of equity and duration positions. Signals of strengthening credit demand and easing lending conditions favor a stronger economy and expanding leverage, benefiting equity positions. Signs of deteriorating credit demand and tightening credit supply bode for a weaker economy and more accommodative monetary policy, benefiting long-duration positions. Empirical evidence for developed markets strongly supports these propositions. Since 2000, bank survey scores have been a significant predictor of equity versus duration returns. They helped create uncorrelated returns in both asset classes, as well as for a relative asset class book.

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Equity trend following and macro headwinds

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Market price trends often foster economic trends that eventually oppose them. Theory and empirical evidence support this phenomenon for equity markets and suggest that macro headwind (or tailwind) indicators are powerful modifiers of trend following strategies. As a simple example, we calculate a macro support factor for equity index futures in the eight largest developed markets based on labor markets, inflation, and equity carry. This factor is used to modify standard trend following signals. The modification increases the predictive power of the trend signal and roughly doubles the risk-adjusted return of a stylized global trend following strategy since 2000.

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Excess inflation and asset class returns

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Excess inflation means consumer price trends over and above the inflation target. In a credible inflation targeting regime, positive excess inflation skews the balance of risks of monetary policy towards tightening. An inflation shortfall tips the risk balance towards easing. Assuming that these shifting balances are not always fully priced by the market, excess inflation in a local currency area should negatively predict local rates market and equity market returns, and positively local-currency FX returns. Indeed, these hypotheses are strongly supported by empirical evidence for 10 developed markets since 2000. For fixed income and FX excess inflation has not just been a directional but also a relative cross-country trading signal. The deployment of excess inflation as a trading signal across asset classes has added notable economic value.

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Macro factors of the risk-parity trade

Risk-parity positioning in equity and (fixed income) duration has been a popular and successful investment strategy in past decades. However, part of that success is owed to a supportive macro environment, with accommodative refinancing conditions and slow, disinflationary, or even deflationary economies. Financial and economic shocks, as opposed to inflation shocks, dominated markets, leading to a negative equity-duration correlation. The macro environment is changeable, however, and a strong theoretical case can be made for managing risk-parity strategies based on economic trends and risk-adjusted carry. We propose simple strategies based on macro-quantamental indicators of economic overheating. Overheating scores have been strongly correlated with risk parity performance and macro-based management would have even benefited risk parity performance even during the past two “golden decades” of risk parity.

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Jobs growth as trading signal

Employment growth is an important and underestimated macro factor of financial market trends. Since the expansion of jobs relative to the workforce is indicative of changes in slack or tightness in an economy it serves as a predictor of monetary policy and cost pressure. High employment growth is therefore a natural headwind for equity markets. Similarly, the expansion of jobs in one country relative to another is indicative of relative monetary tightening and economic performance. High relative employment growth is therefore a tailwind for the local currency. These propositions are strongly supported by empirical evidence. Employment growth-based trading signals would have added significant value to directional equity and FX trading strategies since 2000.

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Inflation as equity trading signal

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Academic research suggests that high and rising consumer price inflation puts upward pressure on real discount rates and is a headwind for equity market performance. A fresh analysis of 17 international markets since 2000 confirms an ongoing pervasive negative relation between published CPI dynamics and subsequent equity returns. Global equity index portfolios that have respected the inflation dynamics of major currency areas significantly outperformed equally weighted portfolios. Even the simplest metrics have served well 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 the use of real-time CPI metrics in equity portfolio management.

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