Free | Global Macro & Strategy

Macro Strategy: Trends have changed + economic regime change?

There is no getting around it at the moment – whether you are a professional money manager, or a DIY investor, its just a really difficult environment to be navigating right now. Quite apart from the obvious overhang of the COVID-19 virus, and the laundry list of risks that are still facing markets (such as listed in our Big Picture Summary) we’ve all of a sudden got some new landmines to cross over, and investors need to at least be aware of them – plus some real uncertainty on which economic “regime” the markets are pricing in.

Some trends have changed

There are a number of trend changes that warrant attention. We cover these in the Asset Class Dashboard (with charts), but to highlight a few:

  • First and foremost, share market momentum has changed. From the March lows to late August, it was all one way traffic with strong upward momentum. Sure, the markets were going through their usual zig zags, but there was a clear uptrend in place and the path of least resistance was up as markets looked through the problems and focussed on COVID winners and the effects of massive stimulus measures. Over the past month however, momentum has clearly faded as some of those stimulus impulses have faded, and the overall market looks to have peaked and rolled over, at least in the short term. The ASX 200 has been putting in a series of lower highs in a clear short term downtrend, and the US markets are in a similar position so far this month. It’s not panic stations, as these sorts of pullbacks are not uncommon after such a strong rise over the past few months, however investors will be wanting to see this short term downtrend start to lose traction and to at least find a bottom in the not too distant future. As can be seen in our ASX Sector Summary, there are not too many sectors looking strong at the moment, with recent leaders either pausing or retracing.
  • Gold has been on a tear for almost two years now, going through a series of strong price rises that are then followed by a period of consolidation (with prices either drifting down or sideways). Gold appears to be in one of those consolidation periods now, with the price down 9% from its recent peak at the time of writing. Whilst Gold still has appeal given the outlook for “real yields” (and in fact, inflows into Gold ETFs has remained strong), short term negative technical factors appear to have taken hold just for now.
  • The US dollar: most investors are blissfully unaware of how much an effect the US dollar can have on global markets. For a number of months now, there has been a very high inverse correlation between the US dollar and risk assets such as equites and commodities, with the later being beneficiaries of a weaker US dollar. Since bottoming at the end of August, the US dollar has started trending up again and this has coincided with the weakness described above in shares, along with commodities. If this uptrend in the US dollar continues and becomes anything more than just a short term counter-trend bounce, then expect volatility in risk assets to increase.

Whilst these trend changes may seem random, there is another overarching, and very logical reason for them that has got nothing to do with the daily news events linked to financial markets. It’s got to do with what economic regime the markets think we are heading towards. Lets see if we can explain.

An economic regime change ?

Many years ago, a framework was devised by Ray Dalio (founder of Bridgewater, arguably the world’s most successful hedge fund) that enables investors to see through the fog of the mountain of economic data points and news items that are produced on a daily basis.

In a nutshell, Dalio’s research led him to describe how there are only two things you need to solve for to get a handle on what is going on in markets right now, and how to be positioned. That is:

  • Is economic growth accelerating or decelerating, and
  • Is inflation accelerating or decelerating

By combining these two elements, you get 4 different “regimes” that an economy can be in at any one time. They are:

  • Goldilocks: this is where growth is accelerating, and inflation is decelerating.
  • Reflation: where growth is accelerating and inflation is accelerating
  • Stagflation: where growth is decelerating and inflation is accelerating, and
  • Deflation: where growth is decelerating and inflation is decelerating

Each one of those “regimes” will have certain expected outcomes for each asset class, based on history.

Here’s the thing though – by the time all the lagged economic data comes out that can confirm these regimes, the markets have already moved. The markets front run the data, which is why its important to have a framework that combines both fundamental outlooks that are based on these growth and inflation factors with market based trend and momentum observations that can be used to confirm or deny what your outlook is on growth and inflation.

For some time now, global markets have been trading in line with the Stagflation regime (mostly driven by the US). That is, bullish for growth shares (e.g. technology), commodities, and gold. Its generally OK for bonds, especially inflation protected bonds, and its bearish for the US dollar.

However, so far in September the markets are behaving like they are pricing in a future Deflation regime. That is, bearish for stocks overall and commodities, and bullish for bonds and the US dollar. Gold can be OK, but can also suffer sell offs due to the fact that the Deflation regime is where market meltdowns occur and panic selling of everything to cover margin loans can happen.

From an economic data perspective, forward models that try and predict which regime is coming up next are showing its on a knife edge between Stagflation continuing and Deflation over the coming quarter. Its really close – which is 100% consistent with how the markets have been trading of late. One day it trades just like Stagflation, the next like Deflation. Its very uncertain, and the market doesn’t quite know which way to signal right now. It needs more time.

The US Election

As if we didn’t have enough to worry about, in The Big Picture Summary this week the new addition to the Risk list is the upcoming US election, along with US politics in general. Whilst we have of course known the election date for quite some time, the speculation in the markets about the possibility of utter chaos in the event that the election is contested is gaining traction and is starting to have some effect. Markets hate uncertainty. Add to that the drama around the upcoming deal needed to avoid another Government shutdown, the impasse over further Government stimulus, and the partisan battle over Ruth Bader’s replacement on the Supreme Court, and you’ve got a powder keg of political risk brewing.

The bottom line

This is one of those times where the overall global markets across asset classes are wrestling with what regime it wants to price in for the future and it is unclear at this point in time which is entirely consistent with the macro modelling outlook. Of course, a policy response or sudden COVID vaccine could change this very quickly, but for now investors need to be prudent in their approach to risk taking whilst this resolves one way or the other.

Author: Graham Parkes