When in a slowdown, take sector beta risk off the table.

 Looking at the current beta for each major US market sector shows the relative risk across the market, (66-day moving average, current value). Given the current economic expectation of a slowdown to a recession, the portfolio structure is clear. Buy low beta consumer staples, utilities, and health care, (XLP, XLU, and XLV) and sell communication services, technology, and consumer durables, (XLC, XLK, and XLY). If the portfolio exposure is dollar neutral, it would have a short beta tilt. 

This long/short portfolio is consistent with what has been historically a defensive portfolio during a market slowdown, see:

 

Sector rotation based on the business cycle - It can work

Sector rotation across the business cycle - relative and absolute performance.

All these sectors have fallen since Chairman Powell's Jackson Hole comments, but the higher beta sectors have seen greater declines in return.

 

Sector rotation based on the business cycle - It can work

 

We are facing business cycle changes with the current slowdown and the policy switch to monetary tightening. Given the rise in inflation, bonds are not the same diversification solution, so other alternatives haver to be reviewed. Sector rotation is a viable alternative, but you need to know where you are at in the business cycle. However, using the concept of macro momentum is a helpful start.

The leading economic indicator index can be used to breakdown the economic environment into four regimes: expansion, slowdown, recession, and recovery. The LEI can be either above or below trend and be either expanding or contracting. If time is divided into these four regimes, market sector performance can be scored to provide conditional returns for different business cycle regimes. See "Sector business cycle analysis" from State Street Global Advisors.  Their research finds clear distinctions across the business cycle. 

In a recession, buy consumer staples, health care, and utilities and sell real estate, technology, and communication services. In a slowdown, hold consumer staples, health care, and industrials, and exit from consumer discretionary, materials, and real estate. The hit rate for excess returns in any month may be between 50-60% for buys but the overall excess performance can be significant.

The real work is forming a portfolio that will be workable and have controlled risk. The variation from portfolio construction may be high; however, the concept of trading against the trends in the business cycle is sound and offer a simple way of playing macro momentum. 

Asset class have common risk premia

Different asset classes will be driven by different risk premia, but asset classes will often have some commonality with these premia. Asset classes will differ by their weight to these premia.  

Diversification comes through mixing asset classes which then mixes the weight of premia. An expected change in risk premia will lead to a change in asset allocation. For macro traders, forecasting the macro factors that drive risk premia will drive relative value trades.

Nominal bonds will be comprised of an interest rate and inflation premium. There is also a term premium when comparing bonds with different durations. The inflation protection bonds will only be driven by the interest rate premium. Corporate bonds will have the risk premia for any nominal bond with an added credit risk premium. An emerging market bond will have the risk premium components of corporate bonds with the added EM premium that is unique to the bonds associated with developing economies.

Equity risks includes an interest rate and inflation premium, but most of the risk will be associated with the economic growth premium. Small cap stocks will have an added premium associated with liquidity.

The premia are associated with macro factors that can be measured:

• Economic growth premium - associated with surprises in GDP that will impact consumption risk.
• Interest rate premium - associated with surprises in real interest rates which affect present value calculations.
• Inflation premium - associated with surprise changes in inflation which will impact fixed cash flows.
• Credit premium - associated with the surprise risk of default which is associated with changes in firm valuation.
• Emerging market risk premium - associated with changing legal and political structure as well as changes in currencies. 
• Liquidity risk premium - associated with volatility and the spread between large and small cap equities.

There can be a deep narrative with any asset class but the story for why a given asset class should be held should start with describing how different macro factors affect risk premia.

 

 

Macro factors driving returns - Growth, Inflation, and commodity prices

 

What drives equity returns? A simple principal component analysis applied to large cap stocks finds that the top three components can explain 27% of the variation in daily stock returns. These factor components can be matched with macro factors which can tell us what key macro variables to watch. See "Three macroeconomic factors to watch in equity markets" from the Dallas Fed. The longer paper attached to the Fed posting looks at more localized drivers of stocks, but the macro story is very attractive. 

The first principal component is associated with economic growth and is similar to the market beta. It can explain about 22.5% of the variation There is a .54 correlation between growth and factor 1. The second principal component is associated with inflation, specifically PPI. The third principal component is associated with commodity prices, either the GS commodity index or Brent oil prices. The second and third components explain just over 2% each of the return variation. The data show that the variation explained by macro factors has increased significantly from 10% to 30% of the variation.

Having a sense of macro conditions are important when looking at equity return variation. Surprises in growth, inflation, and commodity prices will have a strong impact on any diversified portfolio.