By Raghu Suryanarayanan
Six years after the global financial markets crisis, economic growth and inflation rates in the US have not reverted to their pre-crisis trend. Consequently, the uncertainty about the continuation of below-trend growth and inflation has become a central question facing institutional investors.
The resolution of this uncertainty is important for the timing and scale of future interest rate increases and factor allocations. A rise in interest rates could be driven by faster growth or significantly higher inflation. Relative to bonds, both scenarios could be positive for equities according to our research[1]. Uncertainty-tolerant institutional investors could decrease their allocation to bonds relative to equities, and remain tilted towards equity factor-based strategies.
Factor investing has attracted significant interest from institutional investors searching for higher long-term returns. This interest has been driven, in part, by well-established academic research and historical evidence showing that factor-based strategies such as value, size, and momentum have tended to outperform the market on a risk-adjusted basis over the long-term. It is also driven by the more recent availability of lower-cost index-based solutions that implement factor-based strategies through passive management or exchange traded funds.
The continuation of macroeconomic uncertainty since 2008 and the simultaneous growth of factor index investing provide two important questions for investors. First, how to rationalise the existence of factor return premia and factor allocations? Second, how do macroeconomic scenarios impact factor allocations?
MSCI’s research[2] on incorporating macroeconomic scenarios into asset returns and allocations suggests that institutional investors can approach macro-sensitive factor allocation in a structured way.
To begin, investors must define the source of macroeconomic risk and then apply that definition in a rigorous way, via quantitative models, to each factor strategy. Building on recent advances in macro finance, our research suggests that macroeconomic uncertainty is about persistent shocks to trend. Investors should care about quarter-to-quarter shocks to macro variables (such as real GDP growth or inflation) only because they may carry signals about persistently higher (or lower) growth in the future.
Our macroeconomic risk model indicates that systematic factor return premia reflect compensation for macroeconomic uncertainty. In turn, allocations to factor-based strategies could depend on investors’ macroeconomic views and tolerance for macroeconomic uncertainty.
A by-product of continued below-trend growth is slower long-term dividend growth for factor-based strategies, relative to market. As a result, slower real dividend growth is manifested in lower realized returns.
The persistence of below-trend growth is also consistent with low real bond yields. If investors believe that real growth will take longer to revert to the pre-crisis average trend, then they will demand insurance in the form of real bonds, thus bidding real yields lower. As nominal bonds are priced in nominal terms, the persistence of below-trend inflation also implies low levels of nominal yields.
Since the Federal Reserve’s decision to increase rates will likely depend on improvements in growth and inflation, an imminent hike is unlikely under our model’s baseline scenario. According to our model, slow growth and low inflation are likely to persist, consistent with low 10-year treasury yields (1.8%), and annualised equity market and factor returns remaining stable at 7.6% and 9.7%. Under this scenario, our model indicates that uncertainty-tolerant institutional investors could favour equities (65%) over bonds (35%), and within equities, factor-based strategies (38%) over the market (27%).
However, a decision by the Fed to raise interest rates could be triggered by faster growth or significantly higher inflation. While the growth scenario could be positive for the equity market and factor-based strategies, the inflation scenario could have an adverse impact. A faster recovery to pre-2008 crisis trend growth in the US could spur the Fed to hike interest rates sooner, increasing bond yields to 2.2% according to our model, and both equity market and factor annualised returns to 8.7% and 11.5%.
If the Fed delays its move to raise interest rates for too long, significantly higher inflation cannot be ruled out. In turn, economic growth could falter. As an example, our model indicates that, if inflation were to mount to 3.2% – a two-standard deviation event – pushing bond yields to 3%, then real GDP growth could fall by 80bps, decreasing annualised equity market and factor returns to 6.5% and 7.2%.
Relative to bonds, however, both scenarios could be positive for equities. In turn, uncertainty-tolerant investors could decrease their allocation to bonds (26%), and within equities, remain tilted towards factor-based strategies (about 40%).
Asset allocation is meant to reflect forward-looking views. In that context, macro-sensitive factor allocation begins to make sense.
Raghu Suryanarayanan is executive director, macroeconomic risk and asset allocation research, MSCI
[1] See “Interest Rate Uncertainty in the US Has Implications for Factor Allocations”, by Raghu Suryanarayanan, Jahiz Barlas, Andras Urban and Katalin Varga, MSCI Insights, April 2015.
[2] See “Macro Risk and Strategic Asset Allocation”, by Kurt Winkelmann, Raghu Suryanarayanan, Ludger Hentschel and Katalin Varga, MSCI Research Insights, June 2013.
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