Thursday, January 15, 2015

When macroeconomics relationships fail, simpler approaches may succeed

  • The Fed balance sheet has exploded, inflation is down and the deflation is a threat.
  • Unemployment is down, growth is up and inflation is down.
  • Budget deficits are down, austerity is up, and employment is up.
  • Growth is up and interest rates are down.
  • Growth is below trend but asset prices are significantly higher.
Perhaps an over-simplification or a set of straw men representing some false macroeconomic relationships but the failure of some key relationships gets at the heart of the problem for global macro investors. The simple relationships or rules of thumb of what should occur in the macro-economy are just not working. 

Most of the big macro trades are based on simple stories and those stories have proved to be false. For example, think about the big Great Rotation story that was all the rage a year ago. Long bonds performed well even though employment and growth were up. Looking at macroeconomic relationships has always been about subtlety, but this has especially been the case in the post-crisis period. Telling stories based on a simple relationship learned in some long ago economics class is dangerous.

There are alternatives to using these relationships which have not held up to closer review. The simple answer is to uses price-based systems to serve as the primary guide to decision-making. A price-based system would have held long bond positions for a good portion of the year. Decision rules based on  price would have cut exposure at some key times during the year but would have still held equities in key global markets. Following prices would have reduced or eliminated long oil exposure regardless of the musing of expert oil analysts. 

Price-based systems use the weighted average views of all market participants as measured by their dollar votes. It will not always be right but in an uncertain world it may be superior to placing bets on relationships which are in a state of flux.


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