The role of macro-economics in asset allocation

Allocation of the portfolio to different asset classes is one of the most important roles that take up a significant chunk of our research, with economics, valuation and sentiment the three key drivers behind any final decisions. Each of those three topics has an intricate relationship to allocation decisions, but this article will focus on just one: economics.

In basic terms, the two main economic measures to consider are growth and inflation.

A period of economic growth and expectations of future growth is normally supportive of investment in equity markets. That’s because a positive economic background should bring improved profitability and higher company valuations.

The reverse of that process is also true. When an economy is contracting and the outlook is for a continued decline going forward, then equity market investments become less attractive, as company profits will likely be under pressure due to weaker levels of expected business when employment and earnings aren’t growing.

The pace of price inflation is another important determinant when considering your investment options, and can have a significant impact on fixed income markets.

If price inflation is rising, the present value of an annual coupon from a bond will be eroded. So, even though at the end of the agreed period you will receive back your initial nominal investment, the purchasing power of that sum will be affected by inflation, and not allow you to purchase as much as it previously could, making bonds a less attractive investment option in an environment of higher or rising inflation.

When considering inflation and your investment options, the rule of 72 is useful when calculating how quickly the purchasing power of your returns will diminish. If you invest in fixed income when the rate of inflation is around 6%, you simply divide 72 by 6 which gives you 12, that calculation means the purchasing power of your money will halve in 12 years. But if the inflation rate is lower, say 4, then 72 divided by 4 is 18, so the purchasing power of your coupon, will lose value at a slower rate.

Outside of the pure economic environment, politics and central banks are also key considerations when making asset allocation decisions, as they too have a direct impact on the economic environment – and therefore the financial markets.

Some government decisions can have a major impact on the economy and financial markets. For instance, raising or cutting taxes and business rates or changing laws can affect the valuation of various asset classes.

Recent examples of a significant market impact from Government decisions came earlier this year. The 2014 Budget changes included an announcement on pensions which was considered positive to individual investors and those who would appreciate the flexibility to have greater control of their pension pot post retirement. But, to specialist pension annuity providers it was negative news as it meant that an annuity was no longer a requirement for pensions so shares of firms in that sector fell sharply on the news.

And it’s not just the government that can affect financial markets.

The opposition Labour party earlier this year announced it was considering a policy which would freeze energy prices in order to help consumers who were being financially squeezed by the increasing cost of energy to heat their homes and cook their food. While consumers may have welcomed this news, energy companies didn’t, with the share prices of the big energy firms falling by between 6-10% on the news.

Central banks are another potential avenue of influence on the economy, equity markets and asset allocation decisions.

Interest rate policy and more recently Quantitative Easing (QE) have both pushed investors to take more risk in the search for yield. The reasons for this are two-fold.

The first relates to interest rates. Prior to the 2008 global financial crisis savers could get around a 5% interest rate on their savings account so they didn’t have to look elsewhere for an acceptable return on their money. Now, however, with interest rates at a record low 0.5% - where they have been for roughly 5 years – savings account rates are equally low, meaning investors need to take more risks in order to get an attractive (above inflation) yield.

Secondly, QE, or at least any non-traditional Central Bank measure, is relatively new world-wide phenomenon and has led to bouts of currency weakness in the US, UK and Japan and more recently in the euro. For sterling based investors, the concern is, if your overseas investments are denominated in a currency that is getting weaker, amid Central Bank measures to provide support for the domestic economy, the value of those investments could fall in sterling terms.

When considering investment decisions, it may be useful to bear in mind a popular quote made by Benjamin Graham – considered the father of value investing: in the short-term, the stock market is a voting machine, while in the long-term it’s a weighing machine. Or, put another way – a stock price can rise or fall on any given day due to news and developments making a particular firm more or less popular. But, if you look at the performance of that same stock over a longer period of time, you will glean a true reflection of that certain company’s value and whether that value has increased or diminished.

Caspar Rock is Chief Investment Officer at Architas