Is it time for neutral equity exposures?

We have become used to a fast-paced cycle after 2020. The pandemic compressed the entire business cycle into just a few quarters, but also produced a much slower and persistent phenomenon: an inflation wave that, to date, remains a vivid concern for central banks and markets.

 

Need to know: Our inflation nowcasting indicator has been on the move recently, signaling changes ahead The regime of ‘low and declining’ inflation surprises is switching to one of ‘low but rising’ inflation surprises If the former was supportive for equities, the latter is a call for neutrality

 

The inflation signal

At LOIM, we have tooled ourselves up with a set of macro indicators to enrich our All Roads franchise, in order to explicitly take into account the dynamics of growth, inflation and monetary policy. A set of nowcasting indicators help us date regimes in a point-in-time manner before turning these measures into a tactical overlay for our portfolios. When we focus specifically on the inflation signal, we find the current message of our inflation surprise nowcasting indicator interesting – something we unpack in this instalment of Simply put.

 

Inflation: declining at a slower pace?

Our inflation indicator combines different economic data points that have proved over time to be sources of a higher inflation than expected. Typically, in the case of the US, these data will cover economic concepts such as production costs, housing, employment and economic activity.  Embracing a variety of inflation sources helps us avoid the typical bias that arises from cherry picking.

Figure 1 shows the phase diagram of this indicator. The chart illustrates the joint evolution of our level indicator (the nowcaster itself) and its direction (diffusion index) indicator. The latter looks at the percentage of data points in our nowcaster that have been increasing over a one-month period. When the nowcaster is low, but the diffusion index is above 50%, then we class the regime as ’low but rising’. When it comes to inflation, we find ourselves in a period characterised by declining inflation surprises (the level) and fewer declines (direction).

Figure 1 shows how much ground has been covered in terms of inflationary pressures over the past 24 months, moving from high and rising inflation pressures to high but declining in 2021, mainly, and finally low and declining since mid-2022. Over the past 2 months, that situation has evolved again, to become a regime that our methodology would describe as ‘low and stable’ to ‘low but rising’. Next, we will examine the historical performance of assets during this type of regime.

 

Figure 1. Recent evolution of our inflation nowcasting indicator

Source: Bloomberg, LOIM

 

Low but rising

Figure 2 shows the Sharpe ratio of global and emerging market (EM) equities over each of the six regimes associated with our nowcaster and its diffusion index since 1991. The chart shows how much the Sharpe ratio exceeds its long-run trend in order to better measure the impact of regimes over performance.

All regimes for which inflation surprise risk is high are detrimental to equities, both developed market (DM) and EM. The impact looks more pronounced in the case of EM, given the impact of world inflation on the US dollar, since EM assets are known for their dependency on the greenback.

When inflation surprises are low, the situation seems to be the opposite, notably for EM equities. Across all cases, the asset class is expected to deliver a Sharpe ratio that is higher than its long-run value. For instance, in the current environment of low but rising inflation surprises, EM equities should be expected to add about 0.4 to their long run Sharpe ratio of 0.19 over the period – an overweight signal.

The case of DM equities is strikingly different: in the low and stable regime, DM equities have a tendency to display a Sharpe ratio in line with their history. In the case of a low but rising regime, that Sharpe ratio can even be slightly lower, without being meaningfully different from its long-run level. This is a neutral message for DM equities: when inflation surprises stabilise at low levels or start increasing again, in our view the time has probably come to neutralise DM equities exposure. This contrasts with a low and declining inflation-surprises regime – the situation we were in between September 2022 and March 2023 – which calls for an overweight.

From this vantage point, it is a sign that the current macro environment is becoming less supportive for an asset class that has done well over the first half of this year, in our view.

 

Figure 2. Sharpe ratio (in excess of trend) over various inflation regimes

Source: Bloomberg, LOIM

 

Simply put, inflation surprises are now less likely to be on the downside. This suggests investors should consider a neutral position on DM equities.

 

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Macro/nowcasting corner

This section gathers the most recent evolution of our proprietary nowcasting indicators for world growth, world inflation surprises and world monetary policy surprises. These indicators keep track of the most recent macro evolutions that make markets tick.

Our nowcasting indicators currently point to:

• Our growth indicator increased marginally over the week with slightly better macro figures in China. In the US, 57% of the data are now improving: with lower inflation, there is little wonder why markets are running after equities 
• Inflation surprises have stabilised at low levels now, but 60% of the data show an uptrend 
• Our monetary policy signal remains below its 45% threshold as its diffusion index is sinking fast: we expect less hawkishness now

World growth nowcaster: long-term (left) and recent evolution (right)

World inflation nowcaster: long-term (left) and recent evolution (right)

World monetary policy nowcaster: long-term (left) and recent evolution (right)

LOIM's nowcasting indicators gather economic indicators in a point-in-time fashion to measure the probability of a given macroeconomic risk - growth, inflation and monetary policy surprises. The Nowcaster ranges from 0% (low growth, low inflation and dovish monetary policy) to 100% (high growth, high inflation and hawkish monetary policy).

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