One the key ways to gain portfolio returns is through exploiting the time-varying nature of market risk premia. Risk premia will change with income and wealth, so it is natural to use the business cycle as a means of dynamically adjusting allocations. Nevertheless, using the business cycle can be difficult in practice. An obscure working paper from Thomas Raffinot, "Time-varying risk premiums and economic cycles", uses a different approach to identifying and exploiting fundamental data through separating the classic business cycle from the economic growth cycle as measured through the output gap. This approach may have added value for macro investors and tactical asset allocation.
Using a very simple model for an equity asset allocation, and then a four-asset portfolio including, equities, Treasuries, investment grade bonds, and high yield bonds, the author finds that an indicator associated with the economic growth cycle (deviations for trend growth or output gap) will do a better for making asset allocation decisions than a model that is focused on the classic business cycle or levels of economic activity.
The idea behind looking at the economic cycle is simple and intuitive. The economic cycle looks at the economic growth deviations from trend. There can be an economic expansion, but growth below trend should impact risk premia. Similarly, a better economic environment is measured through growth above trend. The combination of looking at the economic and classic business cycle has been called the ABCD approach for detecting cyclical turning points and has been developed in "Detecting Cyclical Turning Points: the ABCD Approach and Two Probabilistic Indicators". It is practical and relatively easy to implement.
The peak in growth from trend will occur before any recession. The trough in growth from trend will occur slightly later than the trough in the business cycle, so it will cover a longer period but should give an early warning of economic declines. Additionally, since there can be a slowdown in growth without a recession, the economic cycle can provide signals for economic events that can impact risk premia unrelated to a recession.
The paper shows that there is a distinction between the economic growth cycle and business cycle. The conditional returns and risk are different from the full sample.
Of course, there are problems measuring the output gap and getting the timing correct, but overlaying growth slowdown periods will help with asset allocation between recessions. While this work has to be updated for more recent events, we think that it would have added value especially during the slow growth periods seen on 2015-16 and late 2018.
The idea behind looking at the economic cycle is simple and intuitive. The economic cycle looks at the economic growth deviations from trend. There can be an economic expansion, but growth below trend should impact risk premia. Similarly, a better economic environment is measured through growth above trend. The combination of looking at the economic and classic business cycle has been called the ABCD approach for detecting cyclical turning points and has been developed in "Detecting Cyclical Turning Points: the ABCD Approach and Two Probabilistic Indicators". It is practical and relatively easy to implement.
The peak in growth from trend will occur before any recession. The trough in growth from trend will occur slightly later than the trough in the business cycle, so it will cover a longer period but should give an early warning of economic declines. Additionally, since there can be a slowdown in growth without a recession, the economic cycle can provide signals for economic events that can impact risk premia unrelated to a recession.
The paper shows that there is a distinction between the economic growth cycle and business cycle. The conditional returns and risk are different from the full sample.
Employing a simple 120/80 rule of levering in good times and cutting exposure for bad times based on growth signals leads to improved returns and lower risk for the growth cycle signal.
The correlation matrix across assets will change with the growth and business cycle which will have an impact on asset allocation.
Of course, there are problems measuring the output gap and getting the timing correct, but overlaying growth slowdown periods will help with asset allocation between recessions. While this work has to be updated for more recent events, we think that it would have added value especially during the slow growth periods seen on 2015-16 and late 2018.
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