Weekly Digest

Macro matters

Jernej Bukovec, CFA

20 August 2018

When I raise the issue of the importance of macro, I sometimes get the response: ‘no one has a good record predicting macroeconomic variables like GDP growth’; ‘where do you start when it comes to the many interrelated factors that influence inflation?’; or more bluntly ‘why bother?’.

I would agree; predicting these key variables – growth, interest rates and inflation – or, more importantly, the changes in those variables is extremely difficult. This is the reason why our asset allocation process also relies on bottom-up asset class valuations. We believe that over the long-term prices will follow business fundamentals and the prices you are paying today will ultimately determine your future returns.

Nevertheless, we know that businesses are not immune to changes in the macro environment and that, in the short term at least, macro does matter.  If GDP growth surprises to the downside, company sales are likely to be lower thereby pushing the market price lower. Equally, if inflation is higher than expected, the squeeze on real incomes is likely to have a similar effect by reducing consumer discretionary spending.

We approach macroeconomic research by identifying three likely scenarios: a base case, bull case and a bear case, with a view on the likely probabilities of each outcome. For each scenario, we take a view on what will happen to the key macroeconomic variables and their impact on investment returns in each main asset class.

Currently, we believe the most likely outcome for the global economy is a modest growth scenario, where contractionary forces are partly counteracted by stimulatory policies, resulting in economic variables recovering but staying below their pre-crisis norms for the foreseeable future. Our second most likely scenario is reflation, where policy measures are effective in overcoming contractionary forces, productivity levels rebound, higher nominal growth improves fiscal ratios and improving consumer and business confidence makes global growth accelerate towards its pre-Global Financial Crisis trend. The third and least likely scenario is the return of deflationary forces, where policy tools are ineffective and consumer and business confidence are destroyed causing a downward recessionary spiral.

Ideally, we would be right all of the time, know exactly what will happen to interest rates and inflation, and invest accordingly. Unfortunately, this is close to impossible and the best we can do is to: 1. Simplify the range of potential outcomes into a manageable number of scenarios; 2. Evaluate what we think will happen to the businesses and governments we invest within each of these scenarios; 3. Armed with this information, consider what we’re being asked to pay today for different investments.

There is a key distinction between a purely top-down approach to investing, akin to an investment clock – ‘we are predicting a great GDP number next quarter hence equities can only go up’ – and an approach that incorporates macroeconomics in combination with bottom-up analysis, determining what key variables like company earnings are likely to be, in a range of scenarios, while all the time paying close attention to current prices and valuations. We adhere to the latter; hence, while we don’t believe in investing on the basis of macro, we do not ignore it entirely.

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