Dr. Brian Jacobsen, CFA, CFP, is a Senior Investment Strategist with the Wells Fargo Asset Management Multi-Asset Solutions Team.
People love good stock stories. I’m not talking about pre-canned stories you can pull out at any dinner gathering. I’m talking about stories about companies whose equities performed in ways that captured the imagination. But, for most investors, when you have a well-diversified portfolio, the point is to reduce the risk of a good stock story turning into a bad one. That’s why macro makes a difference: When investors diversify away the idiosyncratic risks of individual securities, macroeconomics can drive returns.
One of the great macro stories of the past few years has been how the economic data—globally—has been exceeding expectations. That’s important because surprises cause stock prices to react. The primary drivers of asset class returns are expectations and surprises around growth, inflation, real yields, and sentiment. Structural considerations are also important, like starting points for valuations, and the regulatory environment.
Historically, different asset classes have responded differently to expectations and surprises. To quantify this, I looked at the quarterly year-on-year returns from the second quarter of 1982 through the first quarter of 2017 of stocks, bonds, and commodities using the following benchmarks:
- Oil (West Texas Intermediate)
- Stocks (S&P 500 and Russell 2000 indexes)
- The Bloomberg Barclays U.S. Aggregate Index (for bonds)
My goal was to see how their returns—by way of asset price changes—responded to quarterly expectations, and then surprises, pertaining to three economic variables tracked by the Survey of Professional Forecasters:
- Short-term Treasury bill yields
- One-year gross domestic product (GDP) growth
- Inflation, as measured by the year-over-year change in the Consumer Price Index
The charts’ bars represent the assets’ t-values, or their estimated sensitivity to the three macroeconomic variables divided by the degree of uncertainty around those estimates.
Insights for investors
So what do the above charts tell us? Surprises are more important than expectations, though expectations do matter.
If people are expecting inflation, they tend to demand higher yields on fixed income investments, which is why fixed income (the Bloomberg Barclays US Aggregate Index) has responded positively to higher expected inflation. Stocks have also tended to react favorably to increases in expected inflation.
However, a surprise increase in inflation is not good, in my view. An unexpected rise in inflation is typically bad for fixed income, and less so for stocks.
For oil, the relationship is the exact opposite: Higher expected inflation has tended to result in lower oil prices—probably because yields have tended to go up, and the opportunity cost of storing oil (instead of investing) goes up. But an unexpected increase in inflation tends to send oil prices higher. This is partially due to oil being part of the many things people buy, from gasoline prices to the transportation costs of goods. Mathematically, if oil prices rise, inflation also rises, so part of the causation runs from oil prices moving higher to inflation moving higher.
Gold prices have tended to rise with a surprise increase in inflation, but gold has been more sensitive to surprise declines in Treasury bill yields. This relationship could reflect a “flight to safety” tendency among investors, in which—right or wrong—people view gold as a safe-haven during risky times, which also tends to push Treasury bill yields lower.
The only surprise that stocks have tended to respond favorably to is surprisingly good growth. In today’s environment, where most people still seem to think growth must slow down, corporate profits have kept surprising to the upside. This resiliency is probably the main reason stocks have continued to hit new highs. When those surprises stop, then maybe the bull market will, too. With earnings season near, it’s important to monitor what happens as companies begin issuing their results.
Risk management with an eye on macro
For investors, considering macro drivers, and how different asset classes tend to respond to changes in expectations and surprises, is important in managing portfolio risk. Many investors take a “check the box” approach to diversifying, meaning they just make sure they have representation in their portfolio across a checklist of assets. But, in my view, it’s better to try to balance the risks of a portfolio according to these important macro drivers.
This is especially true when an investor might have liabilities, or future spending needs, that could suddenly go up in the event of a surprise increase in inflation. In that case, to offset some of that inflation risk, a person may want to consider building more exposure to assets whose prices have tended to go up with surprises to inflation. Conversely, if an investor has income that tends to go up with a surprise increase in inflation, it may make sense to underweight those assets, helping to balance the macroeconomic asset and liability exposures.
While good stock stories may be fun for dinner parties, balancing macroeconomic risks may help investors build good portfolios. It would be nice if investors could successfully anticipate changes in macro expectations and surprises, bringing to mind the famous economist and investor John Maynard Keynes’ quote: “Successful investing is anticipating the anticipations of others.” That may be overstating it, though, as few people actually have that gift. In the end, I think that successful investing is achieving a financial goal. Analyzing macro risks and trying to strike a balance in one’s portfolio is one way to help investors reach that outcome.