MACRO MECHANICS: GROWTH
1/ Macro investors spend a great deal of time & effort trying to understand the trajectory of future economic growth to understand the path for asset prices. However, it is often unlcear how growth mechanically flows to assets. We share our framework.
1/ Macro investors spend a great deal of time & effort trying to understand the trajectory of future economic growth to understand the path for asset prices. However, it is often unlcear how growth mechanically flows to assets. We share our framework.
2/ Economic growth is best reflected in GDP, which is the total amount of spending in the real economy. This includes all types of consumption & investment activity, which results in income & savings activity. However, this measures excludes financial asset activity...
3/ Financial activity includes the increase in leverage, and the purchase of financial assets. While not directly dependant on GDP, aggregate financial activity stems from either current GDP, or expected GDP....
4/ Putting together income activity & financial activity- we have the cumulative sources of potential demand for assets. Taking the example of a household: Households generate income from employment & output, which they then spend on consumption & investment (spending)....
5/ When their income is greater than spending (includes investment), they have positive savings. These savings can be deployed to the purchase of a financial asset- i.e. a checking account, a savings account, treasuries or stocks etc...
6/ The greater the spike to savings, the greater the potential for spending into different types of financial assets. It is important to recognize that these spikes typically occur during periods of accelerations in incomes, i.e. when GDP is accelerates...
7/ However, these savings, which come from the real economy, are not the only source of potential asset demand- they can also be augmented by borrowing, i.e. leverage. Increases in leverage are in part driven by current conditions, & in part by expectations of future conditions..
8/ In choosing to lever, economic entities take in consideration their ability to finance interest burden, during periods of economic acclerations (i.e. GDP accelerations) this ability rises significantly. Furthermore, at the economy-wide level, most increases in leverage....
9/ Facilitate more GDP, creating a virtuous cycle. Therefore, a significant portion of leverage stems from ongoing GDP conditions. Combining our two drivers, i.e. savings and leverage, we get the total potential sources of asset demand....
10/ The price of an asset is determined simply by how much money is chasing the existing supply of that asset. So far, we have discussed the drivers that potentiate this demand (strongly linked to GDP), but not what catalyses it (the chasing part)....
12/ This is where the relative attractiveness of an asset becomes much more important, i.e. in the current environment will a given asset outperform others, i.e. should more of the potential demand flow to this asset than others....
13/ By and large, there are two types of assets, procyclcial (equitie, credit etc) and countercyclical (bonds, cash etc). Where this potential demand flows will depend largely on the state of the economy (once again tying back to GDP). In the US , the private sector plays.....
14/ ....an extremely large role in determining the state of affairs in the economy, with private active accounting for the bulk of economic activity. Thus, as the economy expands, procyclical assets with variable rate payments have generally benefitted at the expense....
15/ of countercyclial fixed-rate payments (cash, bonds etc). Countercylical assets typically look better when private conditions are bad, and and look poor when private sector conditions are good. They also have the benefit of being backed by the govt, which doesn't need income..
16/ As mentioned before, these dynamics are once again strongly linked to GDP conditions. Therefore, both the cumulative sources of demand for financial assets, and the relative distribution of returns can be broadly understood by assessing growth conditions
17/ Overall, GDP is an extremely comprehensive measure, which is mechanically linked to the sources of asset demand and their distribution. The relationship between GDP & asset prices is not as simple as a linear regression......
18/ But by understanding the nuances & details of how GDP links to the potential demand for assets & catalyses it can deliver edge over time. Macro moves are the most important driver of asset class returns, and understanding these mechanics will always help manage risk.
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