Macro Moving Markets More Than Ever
Regius Magazine: Joint Article with Quant Insight
© 2022 Regius Magazine
Mahmood Noorani, CEO, Quant Insight (email@example.com)
Omega Point Contributors:
Bottom-up fundamentally driven equity investors are flying blind
Now that we have your attention, we should qualify the statement above before angry emails from the investment community start pouring in. Global equity investors across family offices, asset managers, pension funds, and hedge funds have traditionally focused on picking stocks based on company fundamentals. But over the past decade, markets and asset prices have become increasingly data-driven. As a result, in its purest form, the fundamental stock-picking approach is an increasingly risky proposition. Instead, many fundamental investors use overlays based on preferences for regions, sectors, and so-called “style” factors such as value, growth, momentum, quality, yield, and countless others. Adoption of this hybrid approach started to take root decades ago but has accelerated in recent years to keep pace with vast amounts of proliferating data and the rise of passive and quant strategies dominating market flows.
But in this day and age, macro may well be the biggest boogieman for portfolios worldwide (or unsung hero, depending on your side). Macro is an increasingly dominant force influencing stocks, sectors, indices, and equity portfolios.
By macro, we mean shifts in regional and global economic growth, changes in inflation and inflation expectations, changes in central bank monetary policy including Quantitative Easing (QE) and Tightening (QT), EM volatility, real interest rates, energy prices, and the like.
Macro Matters Even for Single Stocks
As we have seen over the Covid crisis, changes in GDP growth, inflation, and monetary policy have profound and lasting impacts on asset prices. These macro forces even impact single stocks. But don’t just take our word for it. In October 2021, Procter & Gamble announced disappointing earnings and put this down to the impact of higher inflation, noting that its future prospects remained vulnerable to higher global inflation.
Simply put, company earnings are very often determined by prices and sales, which in turn are intimately connected to economic fundamentals, financial conditions, and risk aversion. The impact of these three varies by company, sector, and index. For example, cyclicals and industrials tend to be highly sensitive to economic fundamentals such as GDP growth. Financials, banks, and utilities tend to be more sensitive to interest rates across the curve (part of financial conditions). Small-cap, innovation-intensive companies such as biotech, tend to be less driven by broad macro forces. Therefore, it becomes imperative for equity investors to understand which macro factors are driving their portfolios and to what extent.
Going back to the PG example, the company’s stock price sensitivity to US Inflation Expectations turned negative in June of 2021, many months ahead of the CEO’s disappointing message to equity analysts. Moreover, the sensitivity has become steadily more negative since and is the top negative macro factor for PG among the 25 that we track.
So, the mathematical relationship between inflation and PG’s stock price started to discount that rising input prices would impair the company’s stock price (from margin compression) well before investors with the even most profound micro fundamental understanding of the company.
Having said this, while the above relationship to inflation is a drag on PG, the stock has rallied 11.11% in the last six months (while the S&P is down -1.9%) in a rising inflation environment! This rally occurred because assets never respond exclusively to one dimension. PG is a defensive stock that is even more heavily impacted by rising Volatility and USD TWI, both of which have rallied as well.
Price Movements Reflect Flows
But there is another, simple reason that bottom-up fundamental analysis on its own may be less useful for investors. In 2019, JPMorgan estimated that US equity flows were composed of the following:
60%: passive investors
20%: quantitative investors
20%: fundamental equity investors / other
AUM (assets under management) has been shifting from active to passive strategies over the last 12 years. Approximately USD1.5T AUM has made its way into passive strategies since. The critical point here is that passive investors do not analyze single stocks. Instead, passive flows are driven by (yup, you guessed it!) – economic fundamentals, financial conditions, and risk aversion. By definition, equity price movements reflect the flows, and passive investors dominate flows, not bottom-up fundamental investors.
There is a lot more high-frequency data available on macro variables. For example, daily real GDP estimates are now available for 20 countries. These estimates provide a best guess on current quarter real GDP tracking, which updates daily. Inflation markets provide data on inflation expectations for 1 year ahead to 10 years for several major economies. Corporate bond markets provide information on corporate borrowing costs and implied default rates. And there are many others.
Given that we have daily data on all these key macro variables and asset price movements, it is now possible with data science and processing power to extract the underlying relationships between macro and asset prices. Quantifying these relationships isn’t straightforward, but it’s not all that hard either. It requires the application of well-known techniques to de-correlate all the macro data and then identify deep relationships. It is not the same as looking at correlations between two variables either. Instead, it involves combining all macro data and then attributing asset price movements to these key macro factors. A longish time horizon is needed (e.g., 12 months) to find stable relationships and remove the inevitable noise in the data. Furthermore, the framework must be adaptive because relationships shift over time as investor behavior shifts.
These relationships define what we call the “macro regime.”
Fragility and Debt 2013-2016
From 2013 to the US election of Donald Trump in 2016, we saw a stable macro regime. That regime was characterized by a very high sensitivity of global equities to financial conditions. Any tightening of financial conditions was negative for equities. When the USD strengthened, this was a negative force for US equities. When the Euro strengthened, this was negative for European equities. A rise in real rates of higher corporate credit costs was also negative for equities. The roots of this regime lay in the lack of confidence from global investors in the notion of “sustainable growth”. They judged the global economy to be fragile and highly indebted and unable to grow at trend in the face of tighter financial conditions.
The 2016 Policy Shift
It was fascinating to see the data signal a shift around July 2016. This shift occurred well before the US elections in November that year. The sensitivity of major equity markets to financial conditions turned positive around July and stayed positive. This change told us that US and European equities were now positively sensitive to a stronger USD or Euro or higher US or European real rates. The global investor reaction function had shifted. On closer inspection, it became clear that the driver for this shift was a significant global policy change. Both U.S. Presidential candidatestalked about more lavish fiscal spending, and even European governments talked about less fiscal restraint. The net result was the revival of the idea of sustainable growth. The regime even acquired a name “Trumpflation .” Over subsequent years we saw the Fed hike and global equities rise alongside that. Back in 2013, for example, a Fed hiking cycle would have had a very negative impact on equities. What was fascinating was that the macro data flagged the regime change several months in advance.
Covid and the Economic Fundamentals Regime
Over the last decade or so, it has been apparent that real GDP growth is often not a significant market driver. Typically, GDP growth will sit somewhere around “trend,” give or take 1%. However, going into February 2020, markets became increasingly sensitive to real GDP growth. As Covid spread out from China and the world shut down, real GDP growth and inflation expectations became the key drivers of everything. Company fundamentals mattered little at this time. Instead, what mattered most was understanding which stocks were more or less sensitive to economic fundamentals. Governments responded with enormous fiscal and monetary stimulus, so GDP growth and inflation expectations rebounded, taking equity markets with them.
Breakdown in September 2021
As inflation hit historical highs in Q3 2021, the macro regime for equities started to break down. This breakdown occurred because inflation and GDP growth had hit an inflection point. Further rises in inflation and GDP now increased the risk of a rapid monetary tightening which would be harmful to equities. As a result, the overall picture became mixed, and as is often the case, when regimes break down, market volatility and uncertainty increase. Investors essentially reached the point where the impact of higher inflation became negative, while the effect of slower GDP growth was also negative.
A New Regime in 2022: Back to Fragility and Debt
By mid-February 2022, regime indicators pointed to a new regime. Real rates became a key negative driver. The advent of this new villain was not surprising. Inflation is now a positive force on equities in general, meaning lower inflation negatively impacts equities. Corporate credit costs are also back in the frame. This regime indicates that the worst-case scenario for equities would be a further rise in real rates, a drop in inflation expectations, and higher corporate borrowing costs. This combination may well reflect the enormous surge in corporate, government, and personal sector debt over the Covid crisis. The worst combination for a highly indebted world would be lower inflation (increases the real value of debt), higher real rates, and higher corporate borrowing costs (debt rollover risk is now huge). Only by closely watching the data and sensitivities will we get an early read on how this evolves over the coming months.
Having these sensitivities daily also makes it possible to screen and monitor those assets that are most advantageously or adversely exposed to various regimes. Our partnership with Omega Point makes this especially easy for fundamental investors. Omega Point provides an intuitive, turnkey platform and provider ecosystem that quant-enables investors to adapt to today’s data-rich, factor-driven markets. For example, in the Omega Point platform, we can easily identify the most at-risk stocks given a lower inflation, higher real rate, and higher corporate borrowing cost environment. Depending on the direction of global conflict and monetary policy, assets that meet these particular criteria are likely to experience significant macroeconomic pressures.
Netflix is the most highly-traded stock on the resulting list as of February 28th in terms of daily average dollars traded. Historically, Netflix’s stock price was relatively unaffected by inflation and rates but that started to change dramatically in January. Now, a one standard deviation move in these factors alone would have an aggregate impact of almost -12% on the stock price.
The trends shown above are far from isolated to Netflix. In today’s macro-driven environment, stocks across the equity universe are experiencing increased pressure from macroeconomic factors.
As we stated at the beginning of this piece, there are many reasons why macro matters for equities, and today those are more relevant than ever.