Applied Financial Macroeconomics and Investment Strategy: A Practitioner’s Guide to Tactical Asset Allocation (Global Financial Markets)

by Robert T. McGee

That’s why, with each passing day, the globalizing world economy looks more like the US economy and less like the North Korean economy. People prefer prosperity to starvation. They prefer hope for their children’s future to a bleak stagnation. The United States is the largest, richest economic bloc, with the most integrated diversity of the world’s people living in peaceful harmony under one government.

Our focus up to now has been on the United States and its business cycle. Partly that’s because it is the world’s biggest economy with a disproportionate share of the world’s financial assets denominated in its own currency, which happens to be the world’s premier reserve currency. For all these reasons, the US economy tends to play a significant role in the global business cycles.

As per capita incomes have increased in the emerging world, the United States has seen its services account surplus rise from inbound tourism. This is another benefit of having such a diversity of people, including significant diasporas from all the major countries and cultures on the globe.

The country’s close ties with so many people around the world also create business connections around the world that offer the United States a major comparative advantage and bolster its claims to being a microcosm of the globalized world.

That’s because a small US trade deficit means slower growth in foreign holdings of the global reserve currency. This tends to put upward pressure on the dollar and cause financial strains in certain countries that find it harder to finance their balance of payments.

Unfortunately, the growth in the monetary base during the Depression was not sufficient to offset the collapse in the money multiplier, as banks that were worried about runs on deposits hoarded excess reserves instead of lending them out.

Since longer-term rates reflect the future trajectory of expected short rates, an inverted yield curve is often a signal that tight policy has come close to its end.

Recessions are bad for equities because profits are very cyclical and tend to drop sharply in a recession. This, combined with tight credit conditions, raises the specter of growing credit defaults and bankruptcies. On the other hand, the best time to buy equities is when the recession has reached an extreme point at which its end is in sight.

The key point is that the yield curve has been the most reliable gauge of whether monetary policy is tight or easy. Most other metrics of the policy stance have been much less reliable. For example, a common mistake is to gauge policy by whether the Fed is raising or cutting rates. The problem with this perspective is that monetary policy can be “behind the curve.” This was consistently the case in the 1970s, when the Federal Reserve was too slow raising rates as inflation rose ever higher.

A more recent example of how interest rates can be a misleading gauge of the monetary policy stance comes from the European experience following the 2008–2009 financial crisis. ECB officials and most market participants talked as if policy was very accommodative in 2012 and 2013 because interest rates were quite low and had been cut.

When the banking system is shrinking, the central bank’s balance sheet is declining, the money growth rate is decelerating, and inflation is falling toward zero, these are all classic signs that policy is too tight regardless of the level of interest rates. If rates are at zero, then this scenario cries out for quantitative easing. Bernanke knew this. The Bundesbank orthodoxy ignored the obvious.

In addition, 2-percent inflation creates a margin of safety over deflation, which is particularly destructive in a highly leveraged modern economy and as a result has become anathema to modern central bankers.

Why is deflation particularly destructive?

Finally, we would note that 2-percent inflation combined with 2-percent or 3-percent real growth coming from labor force and productivity growth implies a 4-percent to 5-percent nominal GDP growth world. Alternatively, zero inflation with the same real growth potential implies nominal growth below 4 percent, which seems to be the lower threshold for normal US economic performance.

Why would a higber nomin be a positive thing if the growth can simply be attributed to inflation anhwahs? Wouldnt we strictly care about real economic growth?

As we’ll see in chapter 5, a low and stable inflation rate also seems to provide for the best returns on equities. It should not be too surprising that the best backdrop for the real economy is also the best backdrop for equity returns.

It does not, however, stand up to scrutiny. If policy was “too easy” by the Fed’s stated criteria, high inflation would have been a problem. Instead, as noted above, the low rates that the Fed set were necessary to keep inflation from turning into deflation.

By other criteria, interest rates may seem too high or too low. For example, in recent years, savers have complained that rates are too low, forcing them into risky investments in search of yield. Of course, this complaint was notably absent in the early 1980s, when real short rates were quite high by historical standards. In that case, homebuilders barraged the Fed with complaints about overly tight monetary policy.

The cycle in inflation is closely tied to the cycle in wages. In turn, the cycle in wages is closely tied to the cycle in unemployment. Simply put, wage pressures are weak when unemployment is high and there is a lot of slack in the labor market.

As can also be seen in Exhibit 3.10, wage growth tends to breach the 4-percent level in the years right before recessions start. That’s not a coincidence. With long-term productivity growing about 2 percent, wage growth greater than 4 percent implies inflation of over 2 percent (4 percent nominal wage gain minus 2 percent “real,” or productivity-justified, wage gain). To stop inflation from rising too far above its target, the Fed clamps down on the economy when growth is generating excessive wage pressure—that is, wage growth that is too far above productivity

The bottom line is that inflation depends on the excess of wage growth over the growth rate of labor productivity.

As discussed above, this inflation target comes from a post-World War II consensus view among economists that 2 percent is a better inflation target than zero. Inflation too much below 2 percent raises the risk of deflation, and inflation expectations much above 2 percent are considered destabilizing.

To summarize exchange-rate determination, theory and empirical evidence show that the dollar’s exchange rate against different currencies tends to fluctuate in the short term according to the manufacturing cycle and “flight-to-safety” considerations, and in the medium term according to deviations from purchasing power parity and relative differentials in growth and interest rates. In the long term, the short- and medium-term effects wash out, leaving inflation differentials and relative purchasing power parity to be the ultimate determinant of the dollar’s value against other currencies.

The gap between the US response to its long disinflation trend and those of Japan and Europe has provided a valuable social experiment in economic policymaking.

Conventional wisdom identifies currency strength with a strong economy, and the yen was the strongest currency in the world until “Abenomics” changed Japan’s deflationary monetary policy. Unfortunately, while Japan had the strongest currency in the world since 1990, it also had the weakest economic performance of any major economy, with nominal GDP flat during this period accompanied by mounting government debt. The argument for zero inflation as a policy target is not bolstered by Japan’s experience. Japanese equities were the worst performing of any developed economy for over 20 years.

With inflation close to zero and growth averaging only around 1 percent, Europe was at risk of a prolonged Japanese-style stagnation with zero to 1-percent nominal growth compared to 4 to 5 percent in the United States. If this situation persists, the euro could take the place of the yen as the world’s strongest currency. This assumes Japan can successfully hit its new policy target of 2-percent inflation and Europe continues to miss the 2-percent mark. If Japan lapses back into deflation, it would join the Eurozone as a strong-currency, stagnant economy.

The bottom line is deflation risk favors high-quality fixed income over equities, something we’ll see when we discuss asset performance in different economic environments.

There are times when “fear and loathing” dominate credit valuations, and times when complacency rules and investors are willing to take much more risk for very little incremental return.

An upward-sloping yield-curve anchor assumes a slightly positive long-term inflation rate. In contrast, a long-run expectation of sufficiently high deflation would create a persistently negatively sloped or inverted curve, as in the United States during the post–Civil War era of the late nineteenth century.

To summarize, valuation anchors are the first step toward establishing fundamental asset values, whether for currencies, bonds, or stocks. Some asset values are more easily estimated than others. There are several ways to value real estate that establish useful anchors (for example, the capitalization rate simply discounts the net rental streams at a required rate of return to estimate the present value of the property).

These are generally short-term deviations from anchor valuations caused by business cycle pressures on average valuation. This is the basis for a lot of tactical allocation decision-making.

Since longer-duration portfolios lose more when interest rates rise and gain more when interest rates fall, a higher tactical allocation to fixed income and maximum extension of duration within benchmark limitations makes most sense when rates have peaked and are set to decline.

This was a “bear-flattening” phase with interest rates rising across the maturity spectrum (“bear” phase), but with the overnight rate increase exceeding the ten-year rate increase by about 110 basis points (“flattening”).

The flatter the yield curve, the tighter the policy stance. With a tight monetary policy, the risk of recession becomes greater than the risk of inflation. The yield curve inverts if the market senses that the Fed has gone too far and a recession is imminent.

The particular interest rate that influences the price of a long bond is its own coupon rate relative to the coupon rate on a new issue at par. It is the change in this relationship that causes fluctuations in the market price of a long bond.

As a result, when interest rates bottom during the recovery phase of the business cycle, the spread between the 30-year bond and the 10-year note tends to reach its cyclical peak. Then, as monetary policy moves from maximum accommodation to “normalized” rates, the 10-year yield tends to rise more than the 30-year yield, compressing the spread. Finally, in the last stage of a monetary policy tightening cycle and yield-curve inversion, the 10-year yield can actually rise above the 30-year yield, as seen in the late 1980s, late 1990s, and 2006.

Indeed, many prominent institutional fixed-income managers were destroyed by the unanticipated rise in inflation and interest rates during the late 1970s and early 1980s. After all, the highest interest rates in US history (at least up to that point) looked quite enticing to anyone operating with the old mean-reversion “anchor.” The problem was that interest rates kept moving ever higher for several years in the worst bond bear market in US history to the dismay of investors who got in years too early in anticipation of an imminent mean reversion.

The issue withchasing mean reversion on a trending asset

Second, and related, there can be extended periods of nonstationarity, when the mean is trending. A fixed mean requires a stationary phenomenon. Valuation anchors lose their anchoring ability if their determinants are trending in one direction or another, causing the mean to trend as well.

Market perceptions of credit risk fluctuate in a roughly systematic way over the business cycle. Fear of default is generally greatest during a recession. As a result, the markets build in the biggest credit-risk premia during downturns.

Would credit risk premia be the spreads between high duration and low duration?

Between the extremes of excessive fear of default during recession and the excessive complacency of late-cycle optimism, there lies an actual cyclical default experience that will determine the realized returns to corporate fixed-income investments. Buying when fear is excessive and selling when it’s absent is the basic way to take advantage of the cyclical fluctuations in credit spreads.

The underlying valuation anchor that prices credit over the cycle is the cash flow generated by corporations that is available to pay back debt and interest expense. In recessions, the information flow is the most negative of the cycle, raising the most doubt about payback ability. At the peak of the cycle, the gestalt created by the information flow is most positive, and default risks seem most remote. However, by definition, it is at the peak that the gestalt begins to shift in the negative direction as the first cracks begin to appear from those who have gotten themselves overextended.

Most bad loans are created in good times, when overconfidence causes lending s...

that range for reasons we will discuss in the next chapter. The key point for now is that unlike the profit margin, the “total-return to capital” measure has been relatively stable or stationary over the postwar period up until 2010. The equity share of output has diminished as the interest-rate share increased with leverage. For bond holders, more leverage and interest expense means more risk for any given level of profit margins. As a result, spreads have been higher on average since 1965.

Obviously, it was a once-in-a-lifetime opportunity to take credit risk and get a big payoff. Normally, the opportunities in credit are much more muted. Tactical opportunities over the cycle arise as laid out in Exhibit 4.5.

Thus, market risk tends to be the highest following Fed tightening and the lowest when the Federal Reserve is most accommodative. This accommodation is aimed initially at ending a recession and ultimately at facilitating a sustainable expansion in order to avert the risk that the economy will stagnate in a deflationary morass, in which the incentives are to cut costs, lay off workers, and hoard cash, rather than spend, hire, and invest.

Excesses tend to accumulate over a business cycle until they reach “the straw that breaks the camel’s back” stage, at which point a recession begins. The tendency for profit margins to shrink, credit risk to rise, and market risk and volatility to pick up late in the cycle is not especially surprising given human nature.

The magnitude of overleveraging during the 2000s expansion is illustrated in Exhibit 4.8. The measure of non-financial sector leverage shown here is a normalized blend of household and non-financial business sector leverage created by the Federal Reserve Bank of Chicago research staff.

As credit becomes increasingly available, merger and acquisition activity heats up, the degree of leverage in deal financing, commercial-and-industrial loans, and mortgage lending tends to rise, loan covenants loosen, and payment-in-kind issuance picks up. To get more deals done, collateral requirements and subordination terms shift from favoring the lenders to favoring the borrowers.

By about 2010, the average 30-year return on bonds (1980–2010) was about the same as the 30-year return on equities for the first time in 80 years.

On average, over time, stocks have yielded more than 4 percentage points of extra return compared to government bonds to compensate for their greater average risk. However, over the past 200 years, there have been some rare examples of long periods, such as the 1980–2010 period mentioned above, when the gap largely disappeared, or even became negative, and periods when the gap exploded out to about 10 percentage points in favor of equities, such as between 1935 and 1965. There are important structural differences in the macroeconomic backdrop that help account for these significant differences in long-term (30-year) returns of stocks and bonds.

Financial stocks also have a cyclical pattern that is tied into the interest rate, credit, and leverage cycles that we discussed in chapter 4. Their earnings fluctuate with interest-rate margins, lending growth, and capital-market activity, which are all highly cyclical. In addition, asset-value fluctuations over the cycle can have big effects on the massive and highly leveraged balance sheets of big financial institutions, influencing their equity values along with earnings growth.

In the pre-Keynesian world of frequent bouts of deflation, as shown in Exhibit 5.7, the dividend yield had to exceed the Treasury yield in order for investors to be enticed to keep investing in stocks because they couldn’t count on stock price appreciation in that environment. For example, during the 54-year period between 1871 and 1925, the stock market index only increased from four to ten, an average annual pace of less than 2 percent. In the persistently positive inflation, post–World War II world, more of the return came from price appreciation as earnings tend to grow roughly in line with nominal GDP.