There are reason and evidence for financial markets failing to be efficient with respect to macro trends. The main reason is cost: “tradable” economic research is expensive and investment firms will only invest in such research if their fees on expected incremental portfolio returns exceed their expenses. This requires them to concentrate scarce research budgets on areas where they see apparent inefficiency and where they can trade their information advantage in size; professional macro research and macro information efficiency are mutually exclusive. Macro inefficiency is evident in the simplicity of dominant investment rules, such as trend and carry, the conspicuous absence of economic data in most strategies, and the bias of financial economics towards marketing rather than trading. Academic papers claim ample evidence of herding and sequential dissemination of information. Hence, the great incremental value of “tradable” macro research is that it turns informed macro traders into trendsetters as opposed to trend followers and enhances the social benefit of the investment industry overall.
Financial markets are not information efficient with respect to macroeconomic information because data are notoriously ‘dirty’, relevant economic research is expensive, and establishing stable relations between macro data and market performance is challenging. However, statistical programming and packages have prepared the ground for great advances in macro information efficiency. The quantitative path to macro information efficiency leads over three stages. The first is elaborate in-depth data wrangling that turns raw macro data (and even textual information) into clean and meaningful time series whose frequency and time stamps accord with market prices. The second stage is statistical learning, be it supervised (to validate logical hypotheses), or unsupervised (to detect patterns). The third stage is realistic backtesting to verify the value of the learning process and to assess the commercial viability of a macro trading strategy.
The difference between market price and fundamental value estimate is one type of “valuation gap” indicator. It is arguably the most challenging approach, since it must encompass all important relevant information simultaneously and requires both financial and macroeconomic modelling skills. Popular valuation ratios, such as equity earnings yields or real effective exchange rates, can form the basis of a valuation gap, but what is critical is their relation to a plausible theoretical value that accords with the economic environment.
Macroeconomic trends are price factors for virtually all traded securities. Hence, changes to expectations of these trends are classic market movers, in particular if their long-term prospects are not “anchored”. Importantly, the influence of unanticipated economic changes is more dominant over longer horizons than is visible in day-to-day fluctuations. In many cases the direction of the impact of medium-term economic change is straightforward and intuitive enough for non-economists. Even information on the state of economic uncertainty can provide valuable information for macro trading strategies, as it affects both volatility and direction of market prices and helps to detect periods of complacency and panic.
As a consequence, applying best practices to create macro trend indicators has great value. There are three major sources of information: economic data, financial market data and expert judgment. Since the range of available indicators is vast one must condense them into a manageable set through plausible theoretical models and statistical estimation methods.
We define implicit subsidy as a premium that is paid to financial investors by other market participants through significant transactions or commitments for reasons other than conventional risk-return optimization. Implicit subsidies are more like fees for services than compensation for standard financial risk. Detecting and receiving such subsidies creates risk-adjusted value. Implicit subsidies are paid in all major markets. Receiving them often comes with risks of crowded positioning and recurrent setbacks.
We define setback risk as a gap between downside and upside risk of an asset or a trade that is unrelated to its fundamental value proposition. It arises from the market’s “internal dynamics” – as opposed to changes in fundamental value – and is a handicap for valid but popular trading strategies. Setback risk consists of two components: positioning and exit probability. Positioning refers to the “crowdedness” of a trade and indicates the potential size of a setback. Exit probability refers to the vulnerability of positions and indicates the likelihood of liquidations.
Price distortions are apparent price-value gaps. Trading strategies that are based on such distortions rely less on information advantage than on consistent price monitoring, flexibility of trading, privileged market access, superior financial product knowledge and – most of all – a rational attitude in turbulent times. Price distortions arise from inefficient flows and prevail as long as a sizable share of market participants is either unwilling or unable to respond to obvious dislocations. There are many causes of such inefficiencies, including risk management rules, liquidity disruptions, mechanical re balancing rules and government interventions.
Systemic crises are rare. But they are make-or-break events for long-term performance and social relevance of investment managers. In systemic crises conventional investment strategies lose big. The rules of efficient positioning are turned upside down. Trends follow distressed flows away from best value and institutions abandon return optimization for the sake of preserving capital and liquidity. It is hard to predict systemic events, but through consistent research it is possible to improve judgment on systemic vulnerabilities. When crisis-like dynamics get underway this is crucial for liquidating early, following the right trends and avoiding trades in extreme illiquidity. Crisis opportunities favor the prepared, who has set up emergency protocols, a realistic calibration of tail risk and an active exchange of market risk information with other managers and institutions.
The operational frameworks of central banks have changed fundamentally in the wake of the great financial crisis. Non-conventional monetary policies have become the new normal in all large developed economies. Their main forms have been balance sheet expansion and risk premium compression through asset purchases and targeted lending, forward guidance in respect to future monetary policy, and changes to collateral rules. Future non-conventional policies could team up with fiscal expansion to create versions of “helicopter money”. Non-conventional policies have created new systemic risks, arising from [i] prolonged sedation of financial markets through containment of asset price volatility, [ii] exhaustion of scope for further monetary stimulus in future crises and [iii] addiction of economies to cheap funding.
The European Central Bank runs one of the most complex monetary policy regimes in the world. Since the euro area sovereign crisis its operating framework has extended well beyond regular liquidity supply and now includes [i] long-term full-allotment and targeted lending operations, [ii] large-scale asset purchases, [iii] active and comprehensive collateral policies, [iv] flexible forward guidance on policy operations and [v] a contingent facility to intervene in government bond markets in case of sovereign debt crises.
The Federal Reserve relied heavily on non-conventional monetary policy after the great financial crisis, purchasing treasuries and mortgage-backed securities in excess of a quarter of concurrent GDP. In conjunction with various forms of forward guidance it compressed both term and credit risk premiums by unprecedented margins. The Federal Reserve has also been the first large central bank to begin reversing ultra-easy monetary policy. The initial focus is on a normalization of interest rates, while any reduction of the Fed’s huge balance sheet is more uncertain and a matter for the further future. The prime focus remains on downside or deflationary risks for the economy, while considering the inconvenient side effects for the global economy. The latter include growing addiction to cheap funding and challenges to the business model of financial institutions.
The Bank of Japan has walked furthest on the path of non-conventional policies. It introduced quantitative easing as early as 2001 for the purpose of expanding its monetary base. After a first attempt of exiting non-conventional policies, the Bank had to revert to broader and larger asset purchases in the “Comprehensive Monetary Easing” from 2010. In 2013 it took a big step up through its “Quantitative and Qualitative Monetary Easing”, a massive expansion of the monetary base and compression of risk premia, mainly through purchases of government securities and maturity extension. The program has picked up pace since then and is being supported by novel features, such as “yield curve control” and “inflation overshooting commitment”.
Public debt ratios in the developed world remain stuck at 200-year record highs, even with a mature global expansion and negative real interest rates. This poses a lingering systemic threat to the global financial system for at least three reasons. First, governments’ capacity to stabilize financial and economic cycles has been compromised, which matters greatly in a highly leveraged world that has grown used to public backstops. Second, many countries have taken recourse to mild forms of “financial repression”, which puts pressure on the financial position of savers and related institutions, such as pension funds. Third, future political changes in the direction of populist fiscal expansion can raise the spectres of old-fashioned inflationary monetization or even forms of debt restructuring.
The great financial crisis revealed vulnerabilities of the regulated banking system’s capital structure, liquidity reserves and resolution regimes. This has given rise to an unprecedented expansion and tightening of regulatory rules that include a massive increase in minimum capital ratios, mandatory minimum leverage ratios, new compulsory liquidity ratios and new resolution regimes. The new rules may have unintended consequences, however, including tighter bank lending conditions and more regulatory arbitrage.
Shadow banking means financial intermediation outside the reach of standard regulation. Shadow banks engage in term, credit and liquidity transformation similar to regulated banks and function principally to channel institutional cash pools to the funding of asset holdings. This makes them an essential part of financial markets. Often this intermediation takes place in a complex multi-institutional setting. The special vulnerability of the shadow banking system arises from its dependence on collateral (asset) value and the absence of a safety net in form of central bank backstops.
Institutional asset management seems to be in structural ascent, due mainly to demographic developments. The importance of asset managers for global financial conditions is now comparable in importance to the regulated banking system. Asset managers bear much less leverage than banks, but the sheer size of their asset holdings and their vital role for market liquidity and leverage in the shadow banking system has created substantial vulnerabilities. There is evidence that institutional asset managers and their clients can be the source of self-reinforcing market momentum.
Emerging markets have greatly increased in importance since the 1990s. In particular, local-currency bonds and foreign-currency corporate debt have expanded rapidly. Emerging economies and political systems are now highly dependent on global financial conditions and their feedback onto developed markets is powerful. A particular concern is China, due to its size and aggressive use of financial repression to sustain high levels of leverage and investment. The expected decline in China’s medium-term growth will put the sustainability of private debt, corporate earnings and property prices to a test.
