Download Asset Allocation Thoughts: The Global Economy and Asset Returns

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Asset Allocation Thoughts:
The Global Economy and Asset Returns
June 2015
Macroeconomic developments are an important driver of asset market
returns. Some asset classes like equities are more growth sensitive, while
fixed income markets tends to perform better in weak markets when interest
rates fall. By accurately assessing the state of the economy investors should
be better able to forecast asset returns.
The state of the economy could be characterised by using two key
indicators - growth and inflation. These two indicators can be either
high or low, meaning the economy can be in one of four states:
• Overheating: high growth, high inflation
• Recovery: high growth, low inflation
• Stagflation: low growth, high inflation
• Recession: low growth, low inflation
While this approach is simple, classifying an economy into one of
these distinct states doesn’t adequately capture the subtleties of
business cycles or the way in which asset performance can change.
More fundamentally, it is very difficult to assess the state of economy
through looing at inflation when there is a credible central bank.
Consider the following analogy: the central bank acts like a thermostat
in a central heating system. A good central heating system keeps
room temperature constant (think: inflation) regardless of changes in
temperature outside (think: evolution of the business cycle) by altering
fuel consumption (think: monetary conditions). So observing the
room’s thermometer tells us nothing about the weather outside.
This is an application of Goodhart’s law, which states that when a
measure becomes a target it ceases to be a good measure.
We should observe little change in inflation across the cycle if the
central bank is doing its job (inflation should remain around target),
but that doesn’t mean that cycle is not moving through different
phases with very different asset market implications. Indeed it is the
response of policy to different phases of the cycle which helps to drive
the cycle and asset prices.
If we follow central banks in thinking of inflation as a function of
the economy’s spare capacity, we can characterise the cycle by the
difference between realised output and potential output. This means
we have to think both in terms of levels and changes of the output gap.
We can therefore think of the cycle as having the following phases:
1. Recession - below trend growth with a large output gap Policy eased to stimulate growth. If rates at the zero bound then
scope for unconventional policy and fiscal easing. Government
bonds outperform but equity returns are weak.
2. Early cycle - above trend growth with a large output gap Credit conditions stop tightening and monetary easing boosts risk
taking. Equities outperform bonds.
2
Asset Allocation Thoughts: The Global Economy and Asset Returns - June 2015
3. Mid-cycle - trend growth with minimal output gap Policy gradually tightened to get rates to neutral level. Equities still
perform relatively well, but margins are squeezed as workers gain
pricing power.
4. Late - Above trend growth with a negative output gap Underlying inflation pressures mounting encourages further
policy tightening eventually pushes the economy into recession.
Alternatively, possible bubble-like dynamics emerge in various
asset markets, eventually leading to a credit crunch. Most asset
markets perform poorly.
Forward-looking indicators are needed to judge how and when
the cycle is moving into the next phase, and thus which assets are
most likely to perform best/worst. To identify the important leading
indicators we would need to evaluate whether the forces driving the
cycle forward are generated internally or by external shocks.
The answer is likely both.
External factors include natural disasters, technological shifts and
changes to preferences. These are hard to use in forecasting as by their
nature they are largely random, but the policy response to these factors
should be more predictable.
Indeed good policymaking should respond in predictable ways to
events generated either externally or within the cycle and, in turn,
drive the cycle in (relatively) predictable ways. Policy both shapes and
is shaped by the cycle. Thus, better policy prediction is a way of better
forecasting the cycle.
The economist Hyman Minksy added a credit cycle which runs
parallel to the economic cycle. The central idea is that stability breeds
instability. Leverage builds up until investment returns become
insufficient to service the debt. This eventually causes a crash, forcing
deleveraging before the process starts over again. The longer the period
of stability, the more imbalances are built up. Because of the feedback
loops that exist between financial market developments and the
real economy, the two are inseparable. Therefore assessments of the
economic cycle require assessments of the credit cycle.
Ultimately, many economic events will remain unpredictable. But by
having an understanding of how developments relate to the broader
economic cycle, investors can better predict policy responses and asset
market performance. This should help to drive higher returns over time.
“So observing the room’s thermometer
tells us nothing about the weather
outside. This is an application of
Goodhart’s law, which states that
when a measure becomes a target it
ceases to be a good measure.”
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