Remember "the Great Moderation" phenomenon? A Harvard economist coined the phrase in a 2002 research paper to refer to the persistent decline in output and inflation variability since the mid-1980s. The slogan attracted a much wider audience when Ben Bernanke entitled a 2004 speech with the same words. Numerous economists took the concept and projected it well into the future. In retrospect, was macroeconomic volatility really a thing of the past?
Enter the Global Financial Crisis (GFC). Since 2008 volatility has returned with a vengeance, and credit markets have continued to contract. Not surprisingly, the validity of a permanent period of moderation is now seriously being called into question. In fact, the relatively benign financial backdrop of the last 25 years has morphed into a different animal altogether ... leaving many investors dazed and confused. Many had never witnessed a world where financial markets could collectively rise and fall so dramatically or where economic data could swing so wildly.
While we are not predicting a sustained rise in global volatility, the GFC has radically transformed the macroeconomic landscape. How so and how best to respond? Most important for this new period, is that a thematic top-down, global macroeconomic investment approach will become mandatory (often referred to as "global macro"). This style of investing surveys "big picture" conditions around the world, analyzing investment classes in order to select those that are forecasted to outperform on a risk-adjusted basis. Fortunately, ETFs are tools that lend themselves well to this approach, providing exposure to a wide variety of theme-based asset classes.
Make no mistake -- we are not arguing for the abolishment of traditional bottom-up security selection. Benjamin Grahamstyle value investing remains a fundamentally valid investment process. And, this bottom-up methodology can also be applied to ETFs where aggregate index valuation levels can be analyzed, (using the same measures employed with individual company analysis). However, given ongoing structural re-alignments, it is clear that macro dynamics will play a more significant role in influencing the direction of global capital markets in the coming years. Of course, many questions are left unanswered. Which particular macro factors will shape the investment topography in the coming years? And, importantly for investors, what portfolio strategies will be appropriate in this new, post-GFC environment?
Why Top-Down, Global Macro? Renowned global macro investor George Soros once remarked that his investment style did not play according to a set of rules, but rather continually looked for changes in the rules of the game. So it is today: some accepted investing rules having been tossed out the window and replaced with a challenging new game to navigate. Below, we list key reasons for incorporating a top-down, global macro methodology in the investment decision-making process:
1. Thematic Investing and the New Normal. The GFC has unleashed a number of important macro shifts that will influence trends in global capital markets in the coming years. While the global economic free-fall has likely passed, the United States and other consumption-driven appendages are likely to settle at a new, lower level of economic activity ... experiencing more subdued nominal growth than witnessed since the mid-1980s (where the tailwind of US household debt expansion existed -- soaring from 64% of GDP in 1995 to over 100% today). The lingering problems caused by deflating asset bubbles, radical capital misallocations and government debts will constrain overall growth in the wider economy.
How should investors position themselves in this type of lowgrowth environment in the cash world? Low inflation and economic growth combined make a difficult environment for general profit growth. A broad-based approach, therefore, is unlikely to be a successful strategy. In fact, a high-probability scenario is a secular period of range-bound stock indices in Occidental markets. As such, an opportunistic theme-driven approach to portfolio management will be essential. Rather than allocating investments according to country or region, investors should search for supply-demand mismatches of capital in various sectors, industries and themes ... analyzing global macro factors for guidance.
While certain regional economies and financial markets may fare better over this period (primarily in the non-Occidental world), shifting portfolio allocations among developed country investors ensure that these markets will remain highly cyclical. Consider that emerging markets still only account for just over 10% of the all-country MSCI World market capitalization. Therefore, capital re-allocations from developed country investors can create large waves in the smaller capital markets of emerging countries. Macro factors such as market sentiment and fund flow dynamics will be key considerations for calibrating portfolio exposures here.
2. Expanded Measures of Risk. Risk is perhaps the most misunderstood concept in finance. It certainly cannot be distilled into a single number (standard deviation or VaR measures for the quants out there). But recent large portfolio declines have challenged traditionally held assumptions about risk. During the recent financial market meltdown, many bottom-up forecasting models -- that have worked well in the last 25 years -- failed to deliver positive results.
What went wrong? To begin, it's instructive to recognize that many investment decision-making models used on Wall Street rely on historical data inputs. But can backward-looking data really chart the future? One of our colleagues compares this approach to driving a car while looking solely through the rearview mirror ... believing that the road ahead will be a continuation of the curves and straight-aways just experienced. While the rear-view mirror can provide valuable information, it cannot provide many important signals about the pathahead.
So it is with financial markets. Yes, investors should be avid students of financial history (particularly as it pertains to the cyclical nature of markets and underlying causality... oscillating regularly from risk to recoil). But, relationships among financial and economic variables are continually changing, often experiencing structural shocks that significantly alter their correlations. What's more, since many risk models use historical volatility assumptions (often from a benign period), they seduce their users into a false complacency, leading to a vast underestimation of risk. A top-down framework can help identify risks that would not be readily available from past data.
For example, prior to the GFC, many of our top-down models were signaling unsustainable developments tied to the banking sector. Profit margins had risen to unrealistically high levels, with a large portion of earnings driven by the packaging and sale of mortgage-backed securities. This profit machine could continue as long as house prices continued their multi-year climb. Optimists pointed out that there was no historical precedent for falling US home prices ... and continuing healthy profits should be expected from the banking sector. A top-down approach provided a different view. The supply of unsold homes started exploding higher as early as January 2005 ... and serious cracks started appearing in affordability measures. A number of other alarming developments surfaced in the housing sector ... portending a challenging environment ahead. With the benefit of that top-down view, we were able to reduce risk accordingly and mitigate portfolio losses.
3. Globalization of Finance. Globalization is not a new phenomenon. For example, consider the expansion of trade links between the Roman Empire and the Han Dynasty over 2000 years ago. Today's globalization is spreading most pervasively in the financial sphere ... aligning monetary authorities, accelerating cross-border capital flows and lowering trade barriers. Increasingly, these forces are influencing investments.
A number of issues emerge from this progressively synchronized and interconnected financial system. Perhaps the most important point relates to the concept of well-diversified portfolio. During the latest market decline of 2008 and early 2009, classic portfolio diversification did not pass the test. What portfolio malfunction happened here?
It's vital to understand that cross-asset correlations among traditional developed stock and bond markets have been rising for several years now. Research Affiliates has recently shown that the classic 60% stocks/40% bonds asset mix has a 0.97 correlation with the S&P 500 index. This high correlation can be partly attributed to investors taking on too much risk in the stock component (thus overwhelming the positive benefits of bonds as shock absorbers within the balanced construct).
However, the main point is that portfolios should depart from long-accepted balanced portfolio definitions. Two concepts should be noted here. Firstly, diversification is achieved more successfully by allocating investments by risk instead of conventionally allocating investments by asset-class categorizations (the latter are often too highly correlated as seen in ETF Chart 1). Consider that during 2008, out of 397 longonly US listed equity ETFs, all of them experienced substantial negative returns. Secondly, an expanded set of global investments should be used. Both these objectives will rely on macro factors and themes to guide the portfolio construction process.
4. The Advent of ETFs. We remain steadfast advocates of the portfolio-building conveniences and benefits of ETFs -- transparent, low-cost, tax-efficient, and flexible trading. Who can argue with that? But these are favorable features of just the the wrapper itself -- the ETF vehicle. The primary benefit of ETFs has caused a paradigm shift for global asset allocators -- that is, ETFs have granted access to a multitude of global investment classes in a single security ... the perfect macro tool for top-down, global approaches to investing. According to Barclays Global Investors, there are now 1,768 ETFs with 3,129 listings on 42 exchanges around the world (global ETF assets hit a record high of USD 861.57 billion as of the end of July 2009). And, there are plans to launch 780 more ETFs. Only five years ago, this macro toolbox was not available for the top-down, global investor.
Conclusions and Current Environment. The same economist who coined "the Great Moderation" also issued a stern warning at the end of his 2002 paper: "we are left with the unsettling conclusion that the quiescence of the past fifteen years could well be a hiatus before a return to more turbulent economic times." It was a prescient forecast. Today's private sector deleveraging is being fought at an enormous cost -- escalating government liabilities (and, in many cases, the further misallocation of capital). But an important lesson from the GFC is that sustained debt growth in excess of underlying economic growth rates is not a sustainable model. The resulting symptoms -- asset bubbles, monetary inflation and imbalances of both excess capital formation and consumption -- are ultimately destabilizing forces. It is precisely in these types of unstable macroeconomic environments that the top-down, global macro approach can add substantial value to an investment process. In the post-GFC environment, portfolio policy benchmarks need to adapt ... forward-looking, unconstrained mandates with a global perspective will be optimal approaches to investing.