Using simple macro signals for investing in the equity market
Equity market investing is not just for finance professionals. Anyone can build smart investment strategies based on the evolving economic scenario and by following the news!
Investing in the equity market can seem daunting, particularly to those of us who are risk averse and worried over a (supposed) lack of finance knowledge. However, history tells us that market performance can be anticipated by following macroeconomic signals and paying attention to the political and geopolitical changes taking place in the economy.
Following the financial crisis in 2007–08, the global economy witnessed a recession where growth collapsed, interest rates were slashed and inflation was subdued. Despite the gloomy atmosphere, some stocks performed better than others given their defensive quality. Think discount stores and medical services providers that benefit from demand inelasticity. You need these goods, recession or not. Or recall India between 2010–11, when consumer price inflation rose to double digits. With input prices shooting up and hurting profit margins, commodity, industrial and bank stocks did reasonably well. These examples suggest that you can (and should) pick stocks or investment themes based on the macro environment.
Hard core finance professionals rely on bottom-up company analysis to select companies with good balance sheets, cash flow and rising profitability. However, bottom-up stock analysis is time-consuming and arcane for individuals outside the field of finance. On the other hand, keeping track of economic changes through the news and the power of observation is more relatable and efficient. Macroeconomics can help you pick and choose investment themes and the companies that fit them. Exchange-Traded Funds (ETFs) are widely available in the market and investors can access the companies within the ETF index, its investment style and historical performance. Finding the right ETF suitable to the current economic environment is relatively simple given the information available today at your fingertips.
In addition to macroeconomics, geopolitical and regulatory changes also influence stock prices. Think US-China trade war that disproportionately hurt US automakers, chipmakers and electronics manufacturers. Or the regulatory crackdown in China in 2021 which hammered Chinese tech companies. Following these economic and political developments could have guided you on where NOT to invest!
Let’s take a look at the different macroeconomic and political scenarios and the sectors that outperform and underperform in them, to assist you in your investment journey.
High growth: Periods of economic boom are ripe for equity investing given strong consumer spending, corporate optimism and credit disbursal to fund unique business ideas. In order to select the sector or company that can generate high returns, turn to the details of GDP growth in that country. What is driving growth? Is it the consumption boom? If so, what are consumers spending on? Is it a corporate investment into R&D, machinery or factories? Export boom led by specific products? Think semiconductors in Korea and Taiwan, electronics in Singapore and automobiles in Japan. The details help spot the growth-generating sectors and investment themes that could give you your next big investment. GDP data is released by national statistics agencies and is freely accessible.
A study conducted by Morgan Stanley Capital International (MSCI, provider of equity indices such as MSCI World, MSCI Emerging Markets among others) showed that industrials, consumer discretionary, financials and information technology are the most cyclical sectors. This implies that companies within these sectors closely follow the business cycle. On the other hand, consumer staples, healthcare and utilities are the most defensive i.e., least correlated with growth and the economy. Thus, cyclical stocks tend to outperform during growth boom while defensive stocks protect the investment portfolio during a recession.
High inflation: MSCI’s research shows that high inflation lowers future growth and adversely impacts small cap companies in the medium term. Higher inflation could also take away from sectors that depend on stable cash flow over the long term such as utilities. On the other hand, sectors that act as effective inflation hedges including energy (through rising commodity prices), financials (through higher central bank policy rates that lift banks’ interest income) and real estate investment trusts (REITs own real estate assets which benefit from rising rent and property prices during periods of inflation), outperform.
Emerging market equities have historically performed well during inflationary periods given the dominance of the commodity sector in their economies and/or export baskets. Examples include oil and gas in the Middle East, soybean and crude oil in Brazil, copper in Peru, petroleum, coal and coffee in Colombia and oil and gas in Indonesia.
MSCI Emerging Market Index (MXEF) vs Commodity Research Bureau Index (CRB RIND)
High-interest rates: A high-interest rate environment usually arises during periods of growth and/or inflation boom, when the central bank tightens liquidity conditions to prevent excesses. The central bank hikes the policy rate, thereby raising borrowing cost and in the process slowing economic activity. This is the environment we find ourselves in today with global central banks raising rates and tightening liquidity conditions.
Financial stocks thrive in a rising rates environment as banks and brokerage firms can charge higher interest on loans and earn a higher income. Insurance firms’ profit margin improves in this environment as insurers reinvest premiums in long-term instruments like bonds, which earn higher interest income when rates are hiked. An analysis conducted by CI Global Asset Management showed that Canadian and US life insurers generated on average 19.36% and 27.27% return respectively during periods of interest rate hikes over the past twenty years.
Rising rates have also benefited real estate stocks such as REITs as interest rate hikes are led by robust growth and inflation which are positive for real estate prices. An analysis conducted by S&P Dow Jones research concluded that between 1970 and 2006, there were six periods with rising bond yields in the US, of which four saw US REITs produce a positive total return. In two instances, REITs outperformed the S&P 500 index.
In 2021, several emerging market central banks including Bank of Russia, Banco Central do Brasil and the Hungarian National Bank among others raised their policy rate to combat inflation. Latin American central banks were among the most aggressive in hiking rates last year. Amidst rising rates, the Latam sectors that produced positive returns on average were communication services, consumer staples, energy and materials. Communication services such as telecom as well as materials (required in construction) benefit from the growth boom.
Political uncertainty: Numerous examples come to mind when contemplating the impact of political developments on equities. Taking a current example — the military standoff between Russia and Ukraine sent stocks crashing in Europe and US while also elevating commodity prices. Back in 2018, diminishing confidence in Spanish Prime Minister Mariano Rajoy’s government sent Spanish and Italian stocks tumbling.
Amidst ever-changing political dynamics, investors should pay attention to the sectors tied to these economic and political developments. Particularly during the election period, having a quick read through candidates’ election manifestos is a great tool to anticipate stock market winners and losers.
Catalyzed by the potential sanctions against Russia, oil, wheat, aluminum and palladium (key Russian exports) prices rallied. Markets fear a hit to the supply of these commodities if Western economies slap sanctions on Russia. Blue chip stocks, US treasuries, Japanese Yen (JPY) and Swiss Franc (CHF) tend to perform better in such scenarios, as they are considered safe haven assets, whereas companies and /or assets linked to sanctions or sanctioned entities underperform. Given the adverse supply shock on Russian natural gas, Dutch natural gas stocks rallied.
During the political uncertainty in Spain, market sentiments were tied to Spain’s relations with the EU. Strong relations would signal policy continuity and boost investor sentiment. When PM Pedro Sanchez formed the government, the market rallied and bond yields fell given his commitment to standing by the Euro as well as following sound government policies. In this case, the persona of the potential prime minister, signaled by his/her comments and election mandate determined market reaction.
Stock market investing can seem daunting. However, simple tools such as tracking the economic changes, reading through government budget documents and election manifestos go a long way in determining equity market winners and losers. You don’t need a finance degree to grow your money. Just some good observation and daily reading.
If you have any questions or comments, reach out to me via the comments section. I would be happy to help!
I write blog articles on applying macroeconomics to the market. You will find additional resources on this theme.
