In our previous post on market narratives we talked about what narratives are, why they’re important and how they can help investors make better decisions in their portfolios. Our successive posts will focus more squarely on developing a system that helps us develop a market narrative. As a reminder, a market narrative is a story that we tell that helps frame why we’re making an investment decision today given what we know and expect to happen in the economy and markets tomorrow.
“A market narrative is the story we tell explaining where we believe the market is headed and why.”
Market narrative: establishing a framework
To get started we need a framework that can help support our market narrative. A macroeconomic-based approach takes a top-down view on the markets, uses the economy as our guide and focuses our narrative on an understanding of how the business cycle may affect investment performance. In other words, the story we’re telling happens to be our belief about how the markets may favor certain assets given where we expect the economy to be headed in the future.
As we craft a narrative our framework walks us through four key steps that leads us toward investment action. Within each step of the process our aim is to answer the following questions:
- Current economic environment: where are we in the business cycle? Are individual components of the economy expanding or contracting and why?
- Expected economic environment: given a set of expectations that we have about the components of economic growth, how do we see the business cycle evolving over the near- and long-term?
- Favorable investments: which broad asset classes or sectors are likely to perform well given what we know about the current and future expectations about the business cycle?
- Market valuations: is the broader market already clued into where we expect the economy (and potentially earnings) to go and is this reflected in asset prices?
Current economic environment: where are we in the business cycle?
The first step in crafting our market narrative is to assess where we are in the business cycle. The business cycle tends to ebb and flow over time. This is important because as it does, performance in cyclical investments tend to vary as market participants “price in” future expectations about the health of the economy.
So, what is a business cycle? Simply put, a business cycle represents the variation through time of investment and spending activity within the economy. We break down this cycle into four periods:
- Expansion: the economy is steadily growing, businesses and consumers feel more confident; households increase discretionary spending as labor market conditions improve and corporate earnings rise.
- Peak: the economy is doing very well; business and consumers are extremely optimistic; household spending and business investment activity accelerate while unemployment rates head toward cycle lows.
- Recession: the economy is no longer doing well; confidence has faded precipitously; household spending is exhausted; businesses are increasingly reluctant to engage in capital investment activity.; the unemployment rate moves higher.
- Recovery: the economy is finding its footing; unemployment continues to move higher before leveling off; households and business confidence moderate leading to a modest spending and investment rebound.
Components tell the GDP story
To understand what drives the business cycle is to understand what drives the economy. Consumer expenditures, business investment, government spending and trade are the four broad components that drive GDP growth. Within these components exists economic activity consisting of retail spending, home sales, construction, business expansions, government defense spending, U.S. auto exports and imports of consumer goods.
An assessment of the current economic environment gives us an idea of where we are in the business cycle. Given our work as of this posting, we believe that the economy is in the peak phase of the business cycle. Given this baseline we can make assumptions about the potential future direction of the economy.
Expected economic environment: which factors are likely to affect the business cycle?
Now that we have crafted the first part of our market narrative (where are we in the business cycle) our next step is to determine where the business cycle may be headed. We do this by developing forward looking forecasts of activity for the 4 key components of GDP growth.
We begin by developing a set of assumptions about how we believe activity in these components will unfold in the future. This can be approached in several ways, whether by econometric methods or by simply using qualitative assumptions. Nevertheless, at the heart of the process is a set of questions that we ask that help guide our narrative about the trajectory of these key economic components, including the following:
- Is the trend in the component expanding or contracting?
- What about the past data suggest this trend could continue into the future?
- What could cause these trends to change?
- What is the expected magnitude of change?
- What are other people in the industry saying about these trends and where they’re headed?
Risks to the economic outlook
Next, we evaluate risks that are likely to materially alter the assumptions underpinning our forecasts for component level GDP growth. Here again we make another set of assumptions about risks, the likelihood of their occurrence and potential magnitude impact on the trends underpinning our component level growth forecast. These risk factors include:
- Monetary policy: will monetary policy choke off growth if it is expected to be restrictive in the coming year or if too easy, stoke rampant inflation?
- Fiscal policy: does the Federal Government plan to increase or cut discretionary spending in the current or future fiscal year budget?
- Foreign Policy: will changes in trade policies help or hinder the business environment and/or business and consumer confidence?
- Domestic policy: how will changes in bank regulation or certain industrial policies affect lending or hiring activity?
- External environment: could an economic slowdown among key trading partners hinder exports or are there other geopolitical concerns that may otherwise alter sentiment?
Now that we have component level estimates and have identified key risks, the final step in determining how the business cycle may unfold is to formulate point estimates of GDP growth into the future. This can be a highly technical process and a discussion we’ll save for another time. For now, let’s assume the US economy grows by 2.2% in 2019.
Tying it all together
With this forecast in hand we can close the circle on our expectations of the economic environment and answer where the business cycle may be headed. Based on our component level forecasts and assumptions about risks, we believe that the business cycle could be headed for a recession by late 2020 assuming GDP growth comes in at 2.2% in 2019 and 1.5% in 2020.
Again, our narrative is dependent on how actual activity in the GDP components unfolds in the months ahead which means that our current estimate of the business cycle could change depending on how a host of factors underpinning our assumptions about GDP components unfold through time. Which is why it is important to remain attuned to the economic Broadview and pay attention to headlines and watch for evidence that our assumptions may be undermined.
Favorable Investments: sectors sensitive to the business cycle
Now that we’ve identified where the business cycle is headed, the next step in crafting our market narrative is to identify assets that tend to perform well in the projected economic environment.
Equity sectors and the business cycle
Equity sectors are typically divided into two categories: cyclicals and non-cyclicals (or defensives). During an economic downturn companies within certain sectors may see outsized declines in profit. On the other hand, when the economy is on the rebound, revenues and profits may soar. We refer to these such sectors as cyclicals because their earnings are dependent on the business cycle. Defensive sectors on the other hand tend to see relatively stable earnings growth over the course of the business cycle. Knowing where the business cycle is headed as part of our market narrative can assist us in selecting sectors that may outperform over time.
- Consumer discretionary
- Real estate
- Information technology
- Communications services
- Consumer staples
- Health care
Bonds and the business cycle
The interplay between monetary policy, inflation and other risks related to debt service are factors that tend to affect bond investors’ decision making processes beyond those of simply preserving capital.
A bond investor typically functions as a lender to the government or private sector, exchanging their money for cash flow to be paid at some time in the future. While price appreciation is a main concern for an equity investor, preservation of capital and yield is typically what matters most to those participating in the bond market.
What drives bond market prices?
Interest rates are an important contributor to price fluctuations in the bond market. When government and private firms issue bonds, the interest they pay is typically determined by prevailing market rates. These rates are influenced by central bank policy rates and other market and economic forces. When interest rates rise, the price of a bond traded in the market tends to go down (and yields go up) because there is an expectation that an investor will sell a lower coupon bond and use that money to purchase a higher coupon bond coming on to the market.
There are other risk factors that drive bond prices which are influenced by the business cycle:
- Duration Risk: a bond’s sensitivity to interest rate changes. Bonds with higher duration (measured in the number of years that it takes to pay back principal) are more sensitive to the mid and late cycle of the economy when a central bank is adjusting policy rates to either slow down or speed up the economy.
- Inflation Risk: rising inflation can reduce the purchasing power of a bond’s interest payments over time. Therefore, when inflation is accelerating, the market price of a bond will go down (and yields rise) to compensate investors for reduced purchasing power. This typically happens during the expansion and late stage of the business cycle.
- Credit Risk: when the economy is in recession or early phase of a recovery, the ability of a firm to make interest payments and repay its debts can come under pressure. Therefore, the value of a bond or market segment can go down as investors price in credit risks.
How does this fit into the decision making process?
These risk factors play into our investment decision of how to position portfolios according to developments within the business cycle. Periods where central bank policy entails raising interest rates may prompt an investor to reduce duration risk within their portfolios by moving down the yield curve. Expectations of rising inflation as the economy heats up may similarly drive up yields up on higher duration bonds. Government bonds may appear to be more favorable over private sector corporate bonds when the economy is headed for tougher times as lower rated bonds may face challenges in servicing debt.
The point here for developing our market narrative is that certain equity and bond market characteristics lend themselves to fluctuations in the business cycle. Therefore, given our view that the economy is currently in the late stage of the business cycle, cyclical sectors and lower duration corporates are favorable positions to hold in the market. We would become more defensive over the course of the year as we approach the recessionary phase of the business cycle.
Market valuations: buying assets on sale
Am I paying too much for this investment? This is a fundamental question that prudent investors attempt to answer as they consider entering the market and buying or selling an asset. How do we know whether the price of an asset is cheap, expensive or fairly-valued and more importantly, will it remain that way over the next 12 months?
When considering the attractiveness of an asset we tend to think in terms of absolute and relative valuations. Absolute valuations include such metrics as price to earnings (P/E), price to book (P/B), price to cash flow (P/CF) and dividend yield (E/P) for a given asset. These ratios are important because they help put into context the price assigned to an asset by market forces relative to the intrinsic value, or company specific factors of an asset. These include things like a firms’ ability to generate earnings or cash flow, the underlying value of the company or the earnings paid out in dividends. Equities are thought to be cheap when these multiples are low relative to recent or long-term historical trends and expensive when they rise above those levels.
Absolute valuations for bonds focus on the par value and coupon component that leads to a yield calculation. The yield on a vanilla (or simple) bond equals the rate of its coupon if the bond is trading at par value (what will be paid back to the investor at maturity). For bonds that trade with coupons, rates are typically fixed therefore what drives bond yield is fluctuation in its market price. When the price of the bond rises above par, we say that it is trading at a premium, and at a discount when price falls below par.
Relative valuations are metrics that we use to determine whether the value of an asset is cheap or expensive compared to market peers. For stocks, we’ll consider the ratio of price multiples of a given sector versus one more sectors over time. A cyclical stock may be cheap on an absolute basis yet appear to be expensive if its relative measure is running higher compared to peers historical trend.
For bonds, relative measures typically focus on spread measures of yield in a historical context. For example, spread widening or the difference between the yield on a low rated corporate bond versus the yield on a similar maturity government bond may suggest that the price of the lower quality bond is falling. Assuming that the factors affecting the spread widening are not related to the perceived ability of the corporate to repay its debt, this widening may suggest cheaper bond valuations.
How do valuations fit into our market narrative? The story we’re telling is that we believe the business cycle is likely headed for a recession in about a year or so, therefore we would want to position our portfolios more defensively. Our work suggests that we would decide to position ourselves towards defensive sectors as valuations become more favorable in the current market environment.
Finalizing the market narrative
In future posts we’ll take a deeper dive into the questions outlined in our economic environment, sector selection and valuation techniques. This post is intended to serve as a primer to how we develop our market narrative framework.
A market narrative is the story we tell explaining where we believe the market is headed and why. Having a process to help frame the narrative is helpful because it enables an investor to make decisions in their portfolio using a systematic approach rather than simply responding to the whims of headlines and day-to-day market fluctuations.