How much attention should you pay to economics when deciding on asset allocation?

If you take economic figures into account you need to decide which ones to pay attention to, interpret them perfectly and decide on the right asset allocation for the right time. But interpreting economic data is not easy.

For example, a recent International Monetary Fund (IMF) study found that gross domestic product (GDP) forecasts for 63 countries made between 1992 and 2014 largely didn’t predict recessionary years. The report looked at 153 calendar years where GDP fell, and found only five occurrences of an accurate prediction.

Jim Wood-Smith, chief investment officer at Hawksmoor Investment Management, says you should begin by deciding what you want to get out of looking at macroeconomic figures.

“When deciding how much to put into risky [assets] and how much into assets with safer returns, it helps to know whether the economy is speeding up or slowing down, and from what speed,” he says. “The shape and direction of the economy [domestic and global] affects different asset classes in different ways. But stock-pickers would say that that’s all rubbish and economics is never more than unintelligent guess work. Economists would say data proves stock-pickers on average are rubbish and that 90 per cent of portfolio returns come from asset allocation.”

Key metrics

Fund managers often inform investors of any changes in asset allocation, whether they are bullish or bearish, but go into less detail about why and which factors led them to these decisions. This comes down to the way they interpret data, and more importantly, what they are looking at.

There are a few key data points investors should keep a look out for, and understand how they are interlinked and what their movement means. Rob Gleeson, head of research at data provider FE, suggests central bank interest rates as a place to start. Changes and expected changes to the bank base rate are one of the biggest drivers of markets. The bank base rate – which is currently 0.5 per cent in the UK – and its effect on government bond yields, could be very useful.

The base interest rate affects the market the most by changing the yield on government bonds. The base rate of interest is exactly what it says and it’s set by the Bank of England’s Monetary Policy Committee. If this rises, the yield on government debt will also rise to ensure that investors continue to hold bonds even though cash has become more attractive. And it makes assets such as low-risk corporate bonds and lower-risk income stocks less attractive thus reducing their prices. This is because the yield on government bonds is now higher and more secure, so you don’t need to take a lot of risk for a low yield.

A rise in the base rate might however be associated with higher prices of riskier equities. This is because an increase in the base interest rate tends to be because the economy is doing well and a stronger economy raises profit expectations and investors appetite for risk. This drives up the yield on bonds, which are affected by higher base rates and lose value in an inflationary environment. A positive economic environment is good for businesses, so investors sell bonds and instead buy equities. Stocks are also seen as a hedge against inflation and so become more popular.

Not much use

Some data points are not helpful when it comes to asset allocation. For example, GDP growth is published every quarter, and tells you how much an economy has expanded in the previous three and 12 months. But it is published with too much of a lag to be useful for asset allocation, argues Frances Hudson, market strategist at asset manager Aberdeen Standard Investments.

“The first estimate is based on 40 per cent of the data and it can be revised up to a year later,” she explains. “It’s not a great signal.”

Inflation figures, which are published once a month in the UK, eurozone and US, are more timely. But the headline figures tell us very little about the underlying economic fundamentals. A more helpful but less well-known figure is core inflation, which strips out volatile items, such as oil or currency effects, that have a significant but short-term impact on prices.

The Purchasing Managers’ Index (PMI) and consumer confidence indices are known as soft economic data as they are generally based on surveys or sentiment studies. PMI is based on surveys of procurement managers in businesses and questions their immediate spending plans to give an impression of business confidence.

Data points such as these are of little use to investors as standalone figures. PMI is a survey based on yes or no questions, so when the PMI is at 50 it implies as many managers are as positive as negative. It is also volatile, so if investors were to rely on this to gauge business confidence and whether to allocate to equities they would need to look at its trend or one country’s PMI compared with another’s.

Ms Hudson says: “At the middling level they do not tell you very much, but if they are far away from the middle level they are more informative. If you can spot a trend, where the PMI is rising in one place and falling in another, that gives you a relative call. In Europe, PMIs have been weaker but in the US they have been quite strong. That may lead you to favour Europe over the US, for example.”

Central bank rate setters – the Monetary Policy Committee in the case of the UK – use both hard economic data, such as GDP, inflation and unemployment figures, and soft data when coming to a decision. They also publish their thinking and which statistics have led them to form their opinion, giving investors insight into what is deemed useful and what is not. Forecasts of inflation and economic growth are published every quarter.

So investors can pay attention to the underlying soft and hard macroeconomic statistics, as these feed into central bank decision making, which affects the base interest rate. This changes the yield on a government bond, which affects the level of risk investors are willing to take, driving markets.

A nuanced appreciation

However, in the current environment in areas such as the UK, US and the eurozone, yields and interest rates have been so low for so long that even a small rise in rates might come as a shock to investors who have become accustomed to ultra-cheap money. Yields have been so manipulated by central banks via quantitative easing that it will take some time for this to unwind.

Investors should also question the logic of equity valuations only increasing when yields rise, as over the past few years equity markets have risen significantly while yields have been low. There are always quirks, whether a demand for income or economies not having the right kind of inflation. So investors may need a more nuanced appreciation of how macroeconomics work.

“It’s not that macro figures are not useful but they are impossible to interpret,” says Mr Gleeson. “There are an infinite number of variables that determine economic and market performance. All the macro data is interesting but you’re only ever looking at a tiny bit of the puzzle so it is very easy to misinterpret what that might mean. The big story at the moment is inflation and interest rates. You look at the data and it suggests a negative outlook for bonds, a positive outlook for equities and that you should allocate your portfolio accordingly. 

“But then you have all the counterfactuals. Macro indicators tell us something that might happen but there are a lot more possible outcomes. We have forgotten the random factor. What happens in a year’s time when data comes out showing inflation and employment is weakening? The Bank of England will revise down its interest rate forecasts and all of those equities we went in on 12 months ago will get slaughtered.”

Mr Gleeson is not necessarily advocating a static asset allocation that relies solely on diversification, but suggests more scenario planning and creating a flexible portfolio that can work in several circumstances. So he suggests you angle a portfolio towards the most likely outcome based on the macro data but remain cognisant this is only one outcome, and plan for others, too.

For example, when there are gradual interest rate rises as in the US, and expected soon in the UK and the eurozone – equities start doing better. So you would want funds with exposure to value stocks – companies whose share prices do better when there is a good economic foundation. And you wouldn’t want safe-haven bonds – especially those with a long maturity.

“You would have a value-type equity fund with a lot of financials,” says Mr Gleeson. “High-yield debt could also do well.” However, if rate increases slow or go into reverse the opposite would be true and you’d want something defensive.

Ms Hudson, meanwhile, says investors would benefit more from looking at the data and thinking about what comes next in terms of the business cycle, and going against the grain.

“When a central bank starts raising interest rates it is closer to the end of the cycle, when economic growth starts to slow,” she explains. “In that situation, you would hold onto equities but start looking for more safety. When confidence is at a maximum, that is the time you should consider selling. And vice versa. It’s hard to do because you are going against what you are reading, but that contrarian approach is the more sensible one to take.”

Investors have an array of data points to choose from. Hard is more in-depth than soft, but soft is more current than hard. Ultimately, macroeconomic data can help investors understand the direction of interest rates, and what this might mean for an economy, how much risk to take, and where to take it. But scenario planning is vital.

Mr Wood-Smith says: “The data provides you with a view of the likely direction of the economy and policy over the next 10 years. That gives simple clues about what to hold: inflation up, bonds down, for example. You then have to factor in a degree of confidence – how likely is it that I am wrong? That gives you an indication of risk that you should apply to your expected return.”