US 10-Year (CMT) Treasury yields have been declining (on trend) since November 1st. Pundits’ recent call for high interest rates for longer appears disconnected with the reality of market pricing and macroeconomic fundamentals. These calls implicitly assume that the continuation of improvements in future real economic growth prospects will lead to persistently high inflation. While possible, this scenario for growth and inflation seems unlikely, according to our models, principally because it ignores the impact of growth uncertainty. By contrast, in our models’ most likely scenario, certainty about slow long-term growth and benign long-term inflation expectations imply lower interest rates … for longer.
Pundits’ skepticisms about monetary authorities’ ability to harness inflation without growth recession continue to defy empirical observations and modern (common sense) economic thinking. According to our models, major economies’ macro fundamentals and market pricing are consistent with more certainty about well-anchored long-term inflation expectations. To reiterate our view, this (pundits’) cognitive dissonance relative to fundamentals and market pricing is driven by an obsession on the short-term effects of past monetary policies and old (pre-70s) economics theory. Instead, according to actual experience and modern economic thinking, it is the long-term expectation of real economic growth and the credibility of future policy path anchoring long-term inflation expectations that matters.
Analysts and pundits increasingly doubt monetary authorities’ ability to harness inflation pressures without leading their economies into a recession. However, our models suggest that current macro fundamentals and market pricing are consistent with well-anchored long-term inflation expectations and a decline in global long-term growth uncertainty (i.e. increased certainty) about a slow, but improving global long-term real economic growth trend. In our view, pundits’ cognitive dissonance relative to fundamentals and market pricing is driven by an obsession on the short-term effects of past monetary policies and old (pre-70s) economics theory. Instead, according to modern economic thinking and actual experience, it is the long-term expectation of real economic growth and the credibility of future policy path anchoring long-term inflation expectations that matter. This note addresses the first part of the issue: global growth expectations. A subsequent note will focus on the policy credibility and inflation expectations question.
The US CPI rose 3.7% in August from previous year, according to the latest release. Up from 3.2% in July, some analysts and investors continue to fuel doubts about the credibility of monetary policy. However, these doubts are misconstrued in our view, as they excessively focus on realized inflation rates and short-term effects of past policies. They also ignore fiscal considerations. Instead, our models suggest that it is the expected, longer term path of fiscal and monetary policies and their anchoring effect on long-term inflation expectations that matter. According to our models, government finances and bond markets pricing are consistent with a decline in long-term inflation uncertainty about benign long-term inflation expectations of about 2.1% - barely above the Fed’s long-term target rate of 2%.
US real GDP grew at the solid pace of 2.4% over Q2 (annualized quarterly rate), according to the Bureau of Economic Analysis’ first estimate. Despite being above expectations, some analysts and investors remain concerned about the possibility of a “hard landing” of the US economy with severe equity market corrections. However, in our view, these concerns are misplaced - they are being primarily driven by an excessive short-term focus on past monetary policies’ effects on the economy and markets. Instead, investors are better advised to analyse the sources of long-term growth and inflation uncertainty, envision alternative macro scenarios, and trace their impact on portfolio returns in a systematic fashion. According to our models, the current environment only implies a 16% probability for a “hard landing” scenario, down from 20% at the start of the year. In fact, macro fundamentals and markets pricing rather point to a “soft landing”, characterized by a decline in uncertainty about a slower long-term real GDP growth of about 1.9%.
Recent advances in artificial intelligence such as generative language processing (Chat GPT 4) have generated hype but also raised concerns about its economic and financial benefits. To grapple with these questions, our macro-consistent models and framework suggest focusing on the long-term and tracing the wider economic, market and environmental impact of AI. By contrast to recent misplaced commentaries overjoyed by the potential benefits of AI, our models reveal a more nuanced picture. The continuation of the current trend in AI, increasingly (excessively?) focused on labor displacing automation, is likely to erode TFP growth, real economic growth and portfolio returns in the long run. Conversely, investments in AI that target improving efficiency of current occupations, reallocation of resources, and developing new technologies could contribute to sustainable TFP growth, and hence higher long-term expected real growth and returns.
The slow pace of the decline continues to fuel uncertainty about the path of future monetary policy, and its ability to tame future price increases in a context of rising wages and stronger labor markets. In our view, recent analyses drawing on the 1970s wage-price spiral experience are misconstrued and do not serve investors nor policy makers well. The key question for investors is whether the Fed’s 2% target for long-term inflation is credible or not. Instead of obsessing on recent realised inflation figures, investors are better advised to focus on long-term expectations of inflation and their drivers. Accordingly, our models suggest that both the recent trends in bond markets and government finances (declining debt-to-gdp ratio) are consistent with a long-term inflation expectation of 1.8% - a much closer rate to the Fed’s target rate.
The US dollar appreciated 14% year-to-date against major world currencies (annualized, in inflation-adjusted and trade-weighted terms), even reaching parity with the Euro. Market commentaries have been quick to emphasise potential risks to financial and economic instability posed by a surging, strong greenback. However, investors should be well advised to examine the long-term, macro sources of currency trends. According to our models, the continued appreciation of the US dollar was driven by the relative increase in US long-term real economic growth expectations and relative decrease in long-term growth uncertainty compared to its major trade partners. Going forward, the strength of the US dollar and global financial stability will continue to depend on US relative real economic growth prospects.
Long run performance of investment portfolios is primarily driven by large, negative and persistent shocks to real economic growth. In turn, long run investors should be well advised to adjust their strategic allocations, away from cap-weighted market equities to growth-sensitive factors and sectors, to their tolerance for macro uncertainty. In addition, long run investors could also benefit from dynamically aligning their growth-sensitive (and defensive) allocations with changes in macro uncertainty. In other words, while short-term market timing is challenging, valuing and hedging macro uncertainty does matter in the long run, in theory and in practice.
It is challenging to systematically time financial markets, mostly because the uncertainty about expected asset returns is large (and especially so during period of macroeconomic and market stress). As a result, investors are well advised to remain wary of strategies that rely on an elusive ability to accurately time financial markets. Instead, investors should align their long-term (strategic) allocations with their tolerance for uncertainty and long-term macro conditions. They should also explore the potential benefits of hedging changes in macro uncertainty with low cost solutions.
The solvency issues of US public defined benefit plans are well-documented. Extraordinary investment performance in 2020 and 2021 combined with generous Federal funding have certainly relieved some of the funding pressures, in part by compensating for low contribution rates for the previous decade. However, investment performance alone is unlikely to provide sustainable relief. At a minimum, public pension funds should regularly use scenario analysis, and develop contingency plans based on those analyses. Better would be a careful re-examination of the process used to set target investment returns.
US real GDP decreased at the annualised rate of -0.9% during Q2 2022, according to the advanced estimate of the Bureau of Economic Analysis. This negative growth rate follows the annualised -1.6% contraction already experienced during Q1 2022, and is certainly not welcome in the current context of increases in interest rates, the war in Ukraine and high inflation. However, the key question for investors is whether this decline in real GDP will prove to be temporary, or should they be bracing for a more catastrophic scenario of persistent and larger declines? Our models suggest that the risk of persistent, large negative shocks to real GDP growth over the next year have not changed significantly since June 2021, and that bond (and equity) markets continue to price in a growth slowdown, consistent with market perceptions of continued sluggish long-term growth trend.
The 2022 experience has so far been rather dismal for US stock markets, with YTD losses now approaching the 20% mark! While this is certainly no good omen for equity investors, the recent commentaries putting an obsessive blame on inflation (and by misconstrued extrapolation, central banks) are not helpful either. Worse, they do not serve investors, corporate planners nor policy decision makers well. By contrast, our models point to the rise in real (inflation-adjusted) interest rates as the likely culprit. In turn, our models indicate that the increase in real rates has been driven by a relative decline in uncertainty (i.e. increased certainty) about sluggish long-term real economic growth.
This note documents the dependence of cryptocurrency returns (as proxied by Bitcoin) on equity market returns. The note shows that over the course of 2022, the sell-off in Bitcoin can be partially accounted for by the general equity market sell-off. Moreover, Bitcoin’s negative return is significantly larger than either the government bond market or a standard currency pair such as USD/EUR.
April’s CPI inflation rate figure - an annual rate of 8.3%! - is likely to add to the anxieties about future inflation. In our view the potential claim that central bankers have been derelict in their duty is a red herring. Instead, investors would be well advised to 1. Differentiate between demand- and supply-side drivers of inflation 2. Evaluate their exposure to these different sources of inflation risk 3. Manage exposures to demand-driven inflationary shocks with market-based vehicles and assets with long-term cash-flows that are invariant to these shocks, and 4. Treat supply-side inflation shocks as opportunities.
Developed equity and bond market gyrations are primarily pricing in a continuation of macro uncertainty – a delayed economic recovery. Despite the dramatic surge in commodities prices over the past month (led by the war in Ukraine and heavy economic sanctions imposed on Russia) long-term inflation expectations in developed economies still remain rather benign, as priced by their bond markets and our models. Going forward, long-term investors are well advised to focus on the (fiscal and monetary) policy responses to the crisis, and their perceived impact on the long-term drivers of real GDP growth - total factor productivity (TFP) and labor force growth - and inflation (government finances). Our models suggest that under an adverse, prolonged period of stagflation over the next 10 years, a globally balanced equities and bonds portfolio could lose as much as 100bps per year on average relative to our baseline scenario.
Since the introduction of Bitcoin in 2009 crypto currency has occupied the imaginations of many investors, in large part due to its relatively high returns. However, a number of open issues remain. From the practical perspective, investors’ main question is determining how much capital to allocate to crypto currency versus other investments. In this note, we propose to address the issue of capital allocations to crypto currency through an analysis of alternative portfolios’ risk budgets. The primary conclusion is that given its high volatility and positive correlation to equity markets, crypto currency can have a disproportionate contribution to overall portfolio risk relative to its allocation. Ultimately, what drives allocations to crypto currency are investor-specific attitudes towards total portfolio risk and views on investment-specific returns and risk.
The Covid-19 pandemic has induced a dramatic increase in equity options skew – the market cost of insurance against downside risk. According to our models, this increase in options skew is consistent with an acute rise in macro uncertainty priced in ultra-low negative real bond yields. Real bond prices reflect the cost of insurance against negative, persistent shocks to real economic growth. Going forward, our models suggest that long-term investors should look beyond equity valuations and market risk (VIX). They should focus on alternative recovery scenarios for real economic growth and their drivers – total factor productivity (TFP) growth and labor force growth – and trace their impact on cash-flows, returns and portfolio decisions.
Portfolio decisions comprise not only decisions about how to invest - the investment portfolio - but also about how much to invest - contributions (or savings). Traditional portfolio advice has the tendency to focus on the former and largely ignored the latter. In our view, savings decisions - how much and when - matters as much as the allocation strategy itself in improving financial wealth outcomes.
The use of portfolio choice models to advice investors on asset allocation is a ubiquitous feature in the investment landscape. However in practice, most of these models effectively treat investors as being the same. Moreover, the disposition of the investment assets is treated separately from the savings decision. In turn, this standard approach leads to a one-size-fits-all to the positioning of investment strategies. This note explores an alternative approach to address these issues. This alternative takes seriously the ideas of capital market equilibrium - for every investor who chooses to overweight an asset class (relative to market capitalization weights), there must be an investor who chooses to underweight - heterogeneity across investors, and the importance of managing macroeconomic shocks. In our view, this alternative approach provides a robust foundation to differentiated portfolio advice.
Since April 2020, global equity markets have enjoyed nearly uninterrupted gains. However, with record high valuations since the 2000 TMT bubble, and potential for inflation-driven rises in nominal interest rates, investors have raised concerns about future return prospects. Are returns bound to be lower? Or could they become even higher? To grapple with these issues, investors are well advised to focus on the long-term drivers of real economic growth (i.e. TFP and labor force growth) rather than shorter-term changes in valuations, inflation and interest rates. Moreover, they should systematically evaluate alternative scenarios of TFP and the labor force, and their impact on future bond yields and returns. Equities remain attractive relative to bonds, under our baseline scenario of continued high uncertainty about a low real growth trend, consistent with ultra-low interest rates driving high valuations. Going forward, a rise in interest rates could be inflation or real growth driven. The former channel would lead to a decline in equity returns. While the latter would further boost valuations and returns.
Investors should focus on the long-term drivers of real growth rather than nervously looking for clues about the future path of interest rates in central bank meeting minutes and short-term fluctuations in jobs and inflation rates. They should systematically evaluate alternative scenarios for the main drivers of long-term growth (e.g., TFP growth and labor force growth) and then assess the impact of these scenarios on the future path of rates. Despite the past year’s improvements in real GDP growth rates and upticks in inflation, our models’ baseline view is that nominal interest rate expectations are likely to remain low for longer, driven by the persistence of low real growth and increased long-term growth uncertainty.
After four quarters of strong real GDP growth, investors may be lulled into thinking that we’re in for a period of sustained high real economic growth. Instead, investors should pay attention to the long-term trend in real economic growth, the uncertainty about this trend, and carefully examine the sources of this uncertainty. Our models point to clear limits on long-term prospects for growth, driven by secular trends in demographics and TFP growth. These trends are unlikely to dissipate anytime soon, and contribute to increased uncertainty about long-term growth prospects. It is this macro-growth uncertainty that is important for long-term asset returns.
For both theoretical and empirical reasons, there is no separate “private equity premium” for investors to exploit. Investors in private equity should avoid being seduced by stories of high expected returns because private equity is just like every other active management strategy. Instead, investors are well advised to critically evaluate the expected alpha from their private equity managers and its costs versus alternative sources of alpha. Finally, investors should pay for alpha - not beta - identify the skills that differentiate private equity managers in alpha production, and evaluate their managers on the basis of those skills.
Investors are well advised to re-examine their motivations for investing in private equity in the first place, especially given the amount of new capital flowing into the asset class. In our view, there are economically-based reasons to invest in private equity: apparent low variability in returns, exposure to small cap with greater capacity, and exposure to higher leverage. At the same time, the main reason cited by investors for their allocations to private equity - high return expectations - seems substantially weaker. We conclude that investors should focus on portfolio solutions that match the good reasons, and find solutions that best manage their costs and risks.
US inflation risk has increased, according to our models, even if expected inflation levels haven’t changed that much when compared to pre-pandemic levels. Two factors lead to this conclusion: first, our prior for long-term real growth in the US has decreased, both in absolute terms and relative to the rest of the world; second, our models indicate that US real growth risk has increased, both in absolute terms and relative to the rest of the world. As a result, both the US public and external debt positions have become more fragile.
The US CAPE price earnings ratio hit 37.3 on May 28th, a level second only to the 2000 tech bubble highs, leaving reminiscent investors nervous and worried about an imminent correction, if not a crash. However investors should stop obsessing with valuations and instead focus on the fundamental drivers of long-term returns: long-term economic growth and growth uncertainty. While current valuations are undoubtedly high relative to historical standards, they are not high relative to bonds. According to our models, this high risk premia reflects investors’ perception of high economic growth uncertainty. Thus the big risk for equity investors is not so much that valuations are high, but rather lies in the uncertain path to recovery in long-term economic growth.
Last week’s release of US CPI figures - showing a 0.8% monthly increase - caught market participants by surprise leading to panic commentaries about upside inflation risks. However, should investors dramatically increase their expectations for long-term inflation? Consistent with bond markets pricing, our models also show that the rise in inflation expectations since January has been rather moderate and steady, up from depressed and below trend 2020 rates. Going forward, our models indicate long-term inflation expectations will be driven by prospects for long-term economic growth and government finances.
Since March, the US dollar lost about 8% of its value relative to major currencies. According to our models, the decline in the dollar is consistent with markets’ pricing of lower long-term US real economic growth with higher uncertainty - and not higher inflation - relative to the rest of the world. Further relative deterioration in trend growth could well lead to investors losing confidence in the sustainability of US government debt, fuelling increased inflation expectations and further USD depreciation. In the current context of resurgence(s) in Covid-19 infections, investors are well advised to monitor changes to long-term US and global growth, and their impact on US fiscal balances, the privileged position of the US dollar, portfolio returns and allocation strategies.
Despite the dramatic surge in government debt in the US - relative to GDP - our prior for long run inflation remains a rather benign rate of about 2.2%. Our prior is consistent with bond markets’ pricing of our baseline scenario of continued sluggish real economic growth and of the role of US dollar denominated government debt securities as the dominant reserve assets in the world. In this context, today’s low levels of US inflation rely on long-term stability of government finances, markets’ perceptions of macro uncertainty, and the continued ability of the US to mine the exorbitant advantages accorded the US dollar as the leading reserve currency.
As major countries have started to ease restrictions on social and business activities, investors remain rightly concerned about the speed of economic recovery and its impact on corporate dividend payouts. A delayed recovery could elevate payout risks for a prolonged period of time. This potential for large shocks to growth and dividend payouts to persist matters for long-term investors, as these shocks are at the source of long-term portfolio risk and returns. In this context, long-term investors would be well-advised to re-examine their asset allocation and savings decisions.
The Covid-19 pandemic has renewed investors’ concerns about macroeconomic and financial markets prospects in China, and their potential impact on portfolio decisions. Our models reveal that long-term real economic growth in China has been decreasing and trending at much lower rates compared to reported official statistics. These trends predate the pandemic, driven by deeper, secular factors: decreasing growth in total factor productivity, and low growth in the labor force. Going forward, investors are well advised to monitor potential changes to these long-term macro trends and trace their impact on asset returns and allocation strategies in a consistent fashion.
Even as Covid-19 cases and fatalities seem to recede in most countries, investors still face uncertainties about the choice and effectiveness of policies that prepare for a tapering of restrictions on social and economic activity. Scenario analyses coupled with macro-based models that consistently trace the impact of policy choices on macro and market conditions can help investors grapple with these long-term uncertainties. According to our models, the primary consequence of the rise in uncertainties is a rise in long-term equity risk premia.
Covid-19 naturally raises key issues for how investors can incorporate the importance of such significant and unprecedented uncertainties into their risk management processes. In our view, the use of modern macro asset pricing models together with more timely publicly available data and crowdsourced information provides a step forward in addressing the uncertainties posed by Covid-19. By doing so, risk managers can provide richer analysis for investors and decision makers.
How to make sense of macro and market trends amidst the virulent spread of Covid-19? In our view, the biggest concern is the long-term impact of health, fiscal, and monetary policy uncertainties. Our models can help investors navigate through the fog by tracing the effects of alternative policy-driven scenarios on long-term macro trends, returns, and portfolio decisions.
According to our models, the recent dramatic fall in stock and bond markets largely reflects a trending rise in uncertainty - over the past year - about low long-term real economic growth. The real worry for investors is the added impact of the covid-19 pandemic on long-term macro trends and uncertainty. Our models can help investors think through the potential effects of alternative scenarios on returns and portfolio decisions.
Whatever the form of Brexit (including no Brexit), our models suggest that markets are pricing in the prospect of a prolonged period of near-zero growth, higher macro uncertainty, and relatively high inflation. Investors should think about Brexit scenarios in the context of their potential effects on long-term growth and inflation. Our models can help investors think through the potential consequences of alternative scenarios on returns and portfolio decisions.
Bond yields in major European countries have fallen to historical lows. According to our models, bond markets in Europe are pricing in higher recession risk in the short term, and a continuation of near zero growth with high uncertainty in the long term. These long-term macro trends imply a continuation of low bond yields and high equity premium in Europe.
The inversion of the US treasury yield curve (long interest rates falling below short rates) has raised concerns of imminent large scale recession in the US and globally. According to our models, bond markets are not pricing in a recession, but the continuation of low long-term trend growth, driven by low growth in total factor productivity (TFP) and the labor force. For investors holding bonds in their portfolio, stagnant low growth also implies a prolonged period of low bond yields relative to history.
Concerns of imminent large scale recession in the US are misguided. According to our models, a recession in the next 12 months is unlikely. Rather, our models point to a continuation of low long-term trend growth, driven by low growth in total factor productivity (TFP) and the labor force. Stagnant low growth also implies a prolonged period of low equity returns and real bond yields, relative to history. In this context, investors should focus on their long-term portfolio decisions.
The findings in this paper suggest that the private equity premium varies over time, driven by changes in long-term real economic growth and uncertainty. Moreover, the effects of these fluctuations could potentially be managed by systematically changing the private equity portfolio structure, in a macro-consistent fashion, via tailored publicly traded overlay strategies conditioned on our macro uncertainty index, and/or replicating private deals.
This paper applies our models to a proxy private equity portfolio to evaluate its expected long-term return relative to the public equity market. Today’s premium has decreased by as much as 50% in the last two decades, driven by a reduction in long-term trend economic growth and, more recently, a decrease in macroeconomic uncertainty. Private equity investors should review the structure of their private equity and total portfolios in the laws and related context of changes in macro uncertainty.
This note looks at recent developments in US equity and bond markets in the context of the decade following the global financial crisis of 2008.
This note takes a long run, macro view of the recent developments in US equity and bond markets, from the perspective of our models. It argues that investors have priced in a reduction in uncertainty about long run growth and a reduction in trend growth, driven by stagnant growth in TFP and the labor force. For investors who care about long horizon returns and risk, our models point to lower long run equity returns and a continuation of low real bond yields.
This note discusses the implications of the recent increases in interest rates by the U.S. Federal Reserve for long run inflation. According to bond market pricing and our baseline scenario of continued macro uncertainty, higher inflation is unlikely. Investors worried about inflation should look beyond Fed watching, and focus on macro uncertainty and the basics of government finances. In this context, they should monitor the role of US government debt as the dominant reserve asset.
This paper provides a comprehensive framework for offering portfolio advice. This framework takes into account the impact of income risk and investment horizon. Finally, it places factor investing in the context of lifecycle investing.
This paper uses the government budget constraint to address the potential for future inflation. The paper shows that under our baseline of low real growth, current inflation levels are also consistent with current levels of government debt and monetary balances. However, application of the government budget constraint also suggests that increased deficits combined with decreased money growth could lead to stagflation.
This paper builds on our earlier work linking macroeconomic conditions to asset returns. In this paper we show that a prolonged period of below-trend real economic growth can lead to deterioration in pension funding ratios.
This note puts recent positive developments in US real GDP growth in the context of factors affecting long-term real growth. It argues that long-term trend growth has declined in the US, driven by declines in Total Factor Productivity and Labor Force growth. Consequently, growth forecasts should be dampened until there are signals that TFP growth and Labor Force growth have improved.
This paper is relevant because it explicitly ties long term returns to real growth. The paper achieves this end through the linkage between real economic growth and cash flow growth. Finally, the paper suggests that extended periods of below-trend real growth should correspond to lower expected asset returns.
This paper lays a foundation for differential portfolio advice. It shows that when investor attitudes towards risk differ, their factor allocations should also vary. As on a result, this paper provides a framework for developing the investment strategies that are investor-segment specific.
This paper argues that the combination of market bifurcation and new technology are disrupting the asset management business.
This paper shows there are differences in how factor returns are measured. Consequently, factor measurement and portfolio construction are critical to factor-based investing. Thus, to implement a factor-based approach, investors will still need to rely on skilled investment managers.
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