Henrik Lumholdt Asset Allocation VII. The Four Phases Framework Pgina 3 The Macro-Markets Interface Which macroeconomic data constitute market drivers? A short answer is: those which relate to growth, inflation, and monetary policy since they connect directly to corporate earnings, valuation, the yield curve and capital flows Those which do not meet this criteria are mostly ignored Data relating to issues like e.g. an economys fiscal situation, its external accounts or productivity growth will be taken into account if, and only if, they become critical to growth, inflation, and monetary policy A few examples: Pgina 4 The Macro-Markets Interface Extreme leverage in the banking sector was disregarded until delinquencies and defaults in the subprime market prompted a credit crunch to the detriment of growth Fiscal deficits and public and private debt levels were ignored for several years until markets sensed a real risk of default, pushed up interest rates and forced a fiscal consolidation on governments among the European peripherals, to the detriment of growth Deteriorating current account fundamentals were disregarded right up to the point where central banks were forced to defend the weak currrencies in the EMS with higher interest rates in Ultimately, all macro data have to pass the test of exerting an immediate (over, say, the coming 3-12 months) impact on growth, inflation or monetary policy or be disregarded Pgina 5 The Macro-Markets Interface Pgina 6 This empirical reality is what gives relevance to models like the one presented in the following It offers a pragmatic, simplified, yet powerful, approach to translating the macro-backdrop into a strategic scenario for the main asset classes equities, bonds, and commodities The input of the model represents a synthesis of the macro-scenario from the point of view of the market, ie. as it relates in its most compact form, to growth, inflation, and monetary policy The Macro-Markets Interface Pgina 7 The Four Phases Model Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria John Templeton Pgina 8 The Four Phase Model The Four Phases Model uses the output gap and short term interest rates as determinants for the performance of the following asset classes: The data belong to the US economy and markets exclusively Data on output gap and interest rates are quarterly, spanning the period of Equity Fixed income (long-dated gvt. Bonds) Commodities Pgina 9 As discussed previously, when the economy grows at a rate above its longer term potential, it either diminishes a negative output gap or adds to a positive output gap; when it grows below it either increases a negative output gap or reduces a positive one This gives rise the four phases of interest to us: The Four Phase Model Pgina 10 The Four Phase Model Phase I Phase II Phase III Phase IV Negative and decreasing Output gap Positive and increasing Output gap Positive and decreasing Output gap Negative and increasing Output gap Pgina 11 Phase I Phase III Phase II Phase IVPhase I Output gap Inflation The Four Phases and Inflation Phases of the Economy PhaseOutput Gap Growth vs Trend Inflation INegative & narrowing IIPositive & widening IIIPositive & narrowing IVNegative & widening Pgina 12 The Four Phases Framework Still, the general tenets of the framework appear to hold up well: The 1-4 sequence of the phases is the rule rather than the exception Overall inflation trends respond to major changes in the Output Gap and exhibit a clear lag to them The phases are not of equal length The economy occasionally reverts back to a previous phase The relationship between inflation and the Output Gap is (obviously) more complex than the one depicted The empirical reality varies from the stylized illustration in various respects: Pgina 13 The Four Phases over Time 1st Oil Crisis2nd Oil CrisisCrash of 87Sep 11, 2001 Pgina 14 The Four Phases over Time Pgina 15 It depicts not just in which direction the economy is moving but it puts it into the context of where it came from, thus highlighting the importance to markets of the inertia of inflation and monetary policy trends The Four Phases Framework In the context of the Top-Down market analysis, the Output Gap has several virtues compared with a classic cycle analysis: It emphasizes the importance to markets of growth being below or above trend/potential. To illustrate, growth recessions (growth below potential) are much more frequent than outright recessions, yet clearly matter to markets As will be discussed, the real-time application of the model can benefit substantially from short term approximations. This does not strictly speaking require forecasting rather now-casting Pgina 16 Typically of shorter than average duration. Inventory accumulation stimulates growth Housing construction and consumer durables demand increase Corporate margins expand and earnings growth picks up Inflationary pressures remain absent and monetary policy, even when tightened, typically remains lax Stock market generally performs well but especially with short term rates decreasing; volatility of observations relatively low Bonds hold up in this phase when rates are falling but tend to underperform cash when they are rising Commodities tend to do best with rates falling Characterization and Performance: Phase I Note: SP500 and Bonds returns in the table are absolute not excess returns Negative and decreasing Output gap Phase I Inflat. Trend%GDP QoQ%Earn. QoQ%PE QoQ%SP500 QoQ% Bonds QoQ Rates Up -0.2%5.4%15.4%-9.4%5.3%-5.5% Rates Down -0.7%4.8%8.9%9.5%18.5%0.6% Pgina 17 RATES DOWN RATES UP Risk (Volatility) Excess Return Performance: Phase I Pgina 18 Typically of longer than average duration, normally with solid earnings growth Capacity constraints and labour shortages begin to appear; Inflation begins to pick up at some time during this phase, although the timing varies significantly In inflationary periods, commodities, which are themselves part of the inflation problem, tend to do very well Positive but moderate performance of the stock market; average volatility of observations. The exceptions are periods with the central bank still easing to get growth under way which have seen stocks do very well Higher rates are more often the case, giving rise to multiple contraction Bonds typically underperform cash, the exception being periods with falling rates Note: SP500 and Bonds returns in the table are absolute not excess returns Positive and increasing Output gap Phase II Inflat. Trend%GDP QoQ%Earn. QoQ%PE QoQ%SP500 QoQ% Bonds QoQ Rates Up 1.2%4.5%16.4%-10.5%5.3%-2.5% Rates Down -0.3%4.2%2.0%24.0%25.6%9.3% Characterization and Performance: Phase II Pgina 19 RATES DOWN RATES UP Excess Return Risk (Volatility) Performance: Phase II Pgina 20 Typically of shorter than average duration Earnings growth might hold up for a while but eventually slows Inflation pressures often remain from the previous upswing and might even intensify. Monetary authorities are reluctant to ease policy =>risk of policy overshoot Generally the worst period for stocks, and empirically worse with falling rates; volatility of observations around average; multiples tend to contract Bonds perform well with falling rates but underperform when the central bank is still fighting inflation through higher rates Commodities do particularly well in this phase when rates are falling Note: SP500 and Bonds returns in the table are absolute not excess returns Positive and decreasing Output gap Phase III Inflat. Trend%GDP QoQ%Earn. QoQ%PE QoQ%SP500 QoQ% Bonds QoQ Rates Up 2.7%0.8%16.5%-14.8%1.1%-5.8% Rates Down 0.2%1.6%-3.4%-6.8%-10.4%3.6% Characterization and Performance: Phase III Pgina 21 RATES DOWN RATES UP Excess Return Risk (Volatility) Performance: Phase III Pgina 22 Typically of longer than average duration. The economic slowdown continues and may turn into a recession. Earnings growth typically slows and frequently becomes negative Inflationary pressures abate and monetary policy is typically eased The least certain phase with respect to stock market performance and volatility of observations at a maximum Rising rates in this phase consistent with positive stock market performance, but low rate of occurrence; with falling rates, earnings are typically falling as well and tend to counter the positive effect of multiples expansion Bonds do well with falling rates as both real rates and inflation expectations are reduced Commodities generally do badly in this phase Note: SP500 and Bonds returns in the table are absolute not excess returns Negative and increasing Output gap Phase IV Inflat. Trend %GDP QoQ%Earn. QoQ%PE QoQ%SP500 QoQ% Bonds QoQ Rates Up -1.3%1.7%9.8%19.5%29.3%-4.4% Rates Down -1.6%-0.3%-8.8%14.6%4.6%7.4% Characterization and Performance: Phase IV Pgina 23 RATES DOWN RATES UP Excess Return Risk (Volatility) Performance: Phase IV Pgina 24 Asset Class Performance & Rates: the data Pgina 25 Short Term Model Approximation Data for the output gap are only available on a quarterly basis and are published with a lag Locating the state of the economy with higher frequency data (rather than the quarterly basis used in the model estimation) can significantly improve the value of the model in real time application This makes it useful to operate with proxies which will indicate a likely shift from one phase to another at an early stage The following shows two such proxies one for the Output Gap and another for Growth vs Trend Pgina 26 Output Gap Proxy The monthly proxy for the output gap sums the standardized deviations from the long-term trend of labour and capital: Utilization of labour: (100 Unemployment Rate) Utilization of capital: Capacity Utilization index Long-term trend: 5 year moving average Pgina 27 Equally weighted composite of the standardized deviations from trend growth of 6 cyclical indicators All indicators measure whether the economy is growing at, below or above trend Both leading and coincident indicators are included Growth vs Trend Indicator Pgina 28 Case Study Pgina 29 Case Study: US, Q Q This is the period from the tech bubble burst and 5 years into the future The output gap is significantly positive at first owing to growth in a range of 4%-5% in previous quarters Pgina 30 Case Study: US, Q Q The level of inflation does not look too alarming but the Fed is worried about price pressures building up due to the still relatively high level of capacity utilization Still, the economy is showing signs of slowing, especially in forward-looking indicators like the ISM manufacturing index. So the Fed eventually cuts rates Pgina 31 Case Study: US, Q Q The ISM actually gave a warning signal already around the summer months of 2000 by breaking below the 50-level. By the end of the year it was lower still This indicator did not come back above 50 until 2002 Pgina 32 Case Study: US, Q Q As the economy loses pace and the positive output gap starts to close, earnings growth slows at first (phase III) and then turns negative (phase IV). But the economy eventually recovers and earnings follow suit (phase IV-II) Multiples hold up quite well and even expand during phase IV, helped by the lower rates. But they contract sharply subsequently in phase IV - II Pgina 33 Case Study: US, Q Q Even though the Fed is cutting rates (and keeping them low) phase III and IV in this period are still a bear market for stocks Bonds do well during both phase III and IV. As they enter phase II their performance slows but does not turn negative Pgina 34 Case Study: US, Q Q Does this perform conform with the predictions of the Phase model? In general yes. But there are some exceptions: The negative performance of commodities in phase III with falling rates is not the rule Both stocks and bonds do worse than average in phase IV. Note, however, that this phase, with rates declining, is the most uncertain in the framework Pgina 35 Exercise TAA Group Assignment Youre at the end of the first quarter of Year 4 in the below table Examine the data carefully and characterize the situation in terms of the economy, the central banks rate policy and its motivations, and the valuation of financial markets and their behaviour up to the present time Recommend a TAA for equities, long dated UST and commodities for the next 6-12 months. Express your strategy as overweight, neutral or underweight. If you wish you can graduate each element in your strategy as strong overweight/underweight, moderate overweight /underweight State clearly what are the key motivations for each elements in your strategy Discuss the risks to your strategy and what would make you change your mind Prepare a PPT presentation and have a group representative be ready to present your findings to the class Pgina 36 Exercise TAA The Data These data will be made available in a separate Excel file on IE campus