Research

Our research seeks to exploit the most recent advances in financial economics, and connects factor returns to macroeconomic conditions. Our goal is to produce and implement differential portfolio advice.

Markets Are Pricing In A Growth Slowdown

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.

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Why Did Stock Markets Fall?

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.

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Cryptocurrency Isn’t A Hedging Vehicle

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.

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Inflation: Risk or Opportunity?

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.

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Persistence of High Macro Uncertainty

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.

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Should Any Capital Be Allocated to Crypto Currency?

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.

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Why Is Hedging Downside Risk So Expensive?

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.

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Portfolio Advice Should Include Savings

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.

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Putting Bonehead Asset Allocation Behind Us

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.

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Long-Term Equity Returns: Higher For Longer?

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.

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Interest Rates: Low For Longer?

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.

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Long-Term Growth Prospects Still Look Anemic

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.

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There Is No Private Equity Premium

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.

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Three Reasons to Invest in Private Equity

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.

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Long-Term Inflation Risk Has Increased

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.

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Should We Worry About High Equity Valuations?

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.

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Should We Worry About Inflation?

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.

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Dollar Tantrums

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.

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Why Is US Inflation So Low?

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.

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Macro Uncertainty and Corporate Dividend Payouts

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.

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China Long-Term Macro and Market Prospects

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.

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Covid-19 and Global Macro Uncertainty

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.

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Covid-19 and Risk Management

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.

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Covid-19 Long-Term Macro and Market Scenarios

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.

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Covid-19 Macro and Markets Infections

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.

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Brexit or No Brexit

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.

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Whither Real Growth in Europe?

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.

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Bond Markets Don’t Point To a US Recession

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.

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Investors - Stop Obsessing About a Recession

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.

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Managing Private Equity Risk

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.

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Private Equity Is Growth Sensitive

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.

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Real Growth Matters For Asset Markets

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.

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Less Macroeconomic Uncertainty

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.

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Markets Discount High Inflation

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.

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Differential Portfolio Advice:

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.

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More Low Inflation or Stagflation?

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.

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Slow Growth is bad news for U.S. Pension Investors

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.

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Sluggish Long-Term Prospects for U.S. Economic Growth

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.

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The End of Asset Price Reflation?

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.

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Factor Investing and Portfolio Strategy

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.

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Disruptive Forces in Asset Management

This paper argues that the combination of market bifurcation and new technology are disrupting the asset management business.

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Factor Investing

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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