28 April 2020
Our investment framework, ERAA®, analyses the economy and the markets to make asset allocation decisions for our clients’ portfolios. Given the complexity of the times, we wanted to share and detail how we’ve navigated the unprecedented economic and market disruption that COVID-19 has triggered. You’ll find that there are points where we offer some more technical explanations than we usually do, and we wanted to share this level of detail because we know that many of you have been interested to know more about the intelligence behind our investment framework particularly in times of such uncertainty.
Under relatively normal economic conditions, ERAA® uses leading (i.e. forward-looking) economic indicators, to gauge underlying economic conditions. For instance, in normal economic circumstances, we’d look at the Conference Board Leading Economic Index (LEI) to predict the US growth rate for the coming months. Though, it’s fair to say that economic conditions over the last few months have been far from normal.
Due to the widespread shutdown in economic activities, there was a 2-month data blackout between February and April because leading indicators were unable to capture the full impact of the economic shutdowns. Continuing with the US-based example, as seen in Figure 1, the LEI (blue line) flatlined for 2 months, proving to be useless in helping anyone understand what was truly going on in the economy.
When a leading economic indicator is in a blackout period, we can’t just sit and wait indefinitely for data to come in eventually. We also can’t make investment decisions based on historical data in hopes that the future could coincidentally mimic the past.
Source: StashAway. Note: LEI YoY stands for the year-on-year percent change in the Conference Board Leading Economic Index for the US economy
So, for the US, instead of waiting for signs of life from the LEI to understand the state of the economy, ERAA® looked to the broader stock market, as represented by the S&P 500, to assess what economic scenario the markets have priced in by looking for valuation gaps in various asset classes (i.e. whether particular asset classes are under- or over-valued).
What did we see during the LEI blackout? The S&P 500 had declined by 34.5% between 19 February and 23 March. With this information, ERAA® inferred that, given both the severity and rate of decline, by 23 March, the broader market, proxied by the S&P 500, had already priced in an approximately 11% decline in the US growth rate YoY (orange line in Figure 1).
Based on the valuation gaps we identified, we could see that the markets were pricing in a deep recession up until 23 March. Then, the slew of economic stimuli that governments and central banks around the world swiftly introduced to counteract the economic fallout from COVID-19 on 23 March convinced the stock markets to price in an average recession instead.
From 23 March onwards, the S&P 500 priced in these economic stimuli, or as we're enjoying calling them, “policy bazookas”. As seen in Figure 1, we estimated that the LEI would have risen from -11% on 23 March to around -6% YoY by 17 April1. The LEI, the leading economic indicator of US growth, finally reported economic data on 17 April, and our estimation of the state of the economy was in line with the LEI.
We applied this analysis to other indices we’d track, such as the Li Keqiang Index for China. The outcome of this analysis is similar.
Growth-oriented assets have significantly rebounded from their 23 March lows, but market volatility continues to be more severe compared to pre-crash levels, and we wouldn’t be surprised if that market volatility continues.
Though the world seems to feel uncertain about the state of the economy, we have measures in place to understand the state of the economy even without the guidance of indicators on which most people rely.
Embedded in our investment framework, ERAA®, is a mechanism that assesses valuation gaps of particular asset classes to infer information about economic factors that relate to growth, inflation, and interest rate expectations. One of the applications of this valuation gap assessment is that it can serve as a stopgap in rare data blackout periods, such as this one, so that we can continue to make forward-looking assessments about the economy.
The next paragraph explains how we derived the state of the economy from market prices. For those who aren’t interested in the assumptions and calculations we used to derive the estimated LEI, you can skip this next paragraph:
At the risk of oversimplifying the problem, the equation can be expressed as: Yt = 𝛼 + 𝛽1X1t + 𝛽2X2t + 𝛽3X3t +... + 𝛽NXNt + 𝜀t where Yt is the price of the S&P 500 at time t. X1t, X2t, X3t to XNt are the various economic factors and 𝛽1 𝛽2.𝛽3 to 𝛽N are the sensitivity of the S&P 500 to factors X1t, X2t, X3t to XNt. First, we assume that the market (Yt) was cheap for a good reason. Hence, there is no distortion to market valuation, which means 𝜀t is set to zero. Next, we hold all the other economic factors other than X3t (which is the Conference Board LEI) constant. Finally, we can solve for the values of X3t (expected LEI) by solving for X3t= (Yt - 𝛼 - 𝛽1X1t - 𝛽2X2t - ... -𝛽NXNt ) / 𝛽3.
Market expectations for the COVID-19’s impact on the LEI shifted from -11% YoY to -6% LEI YoY. By our estimates, this means that the market’s expected impact on real GDP has been revised up from -4.6% YoY to -2.5% YoY. A decline in real GDP is often associated with an impending recession, which could be a reason to adjust a target asset allocation. However, in principle, if the markets have already priced in a recession, it’s unnecessary, and counterproductive, to additionally make reactive and belated changes to a portfolio’s asset allocation.
So far, we’ve seen that the markets have already priced in a recession, and then they positively responded to the Fed’s policy bazookas. Though we may likely see numbers that technically indicate a recession, the markets are demonstrating that they are able to persevere through the doom and gloom of the real economy: Not only have the markets already priced in a recession, but they also confidently expect the central banks’ economic stimuli (or “policy bazookas”) to have a multiplier effect on the financial markets, as we saw happen during the 2008 Financial Crisis.
Why are the markets optimistic about the Fed’s policy bazookas? The Fed’s quantitative easing program can have a multiplier effect on the economy: For every dollar the Fed injects into the financial system, more money will circulate in the economy.
So, how does this money multiplier effect work?
Imagine there is a total of $100 in the banking system. Let’s suppose banks have a 10% reserve requirement. (Banks in the system are required by the banking regulator to hold a certain percentage of deposits in reserves, and typically that percentage is set somewhere between 3% and 10%2, depending on the size of the financial institution.) In this 10% reserve case, with $100 in the system, the bank will keep just $10 as reserve, and loan out the remaining 90%, or $90. Now, suppose an individual borrows that $90, then deposits the $90 into her bank account. This deposit results in an increase of $90 of deposits into the banking system. So now there is $100 + $90 = $190 of value available in the banking system. Simultaneously, this individual’s bank is required to hold only 10% in reserves. This means that this bank can loan the other 90%, or $81. Now, there is $100 + $90 + $81 = $271 in the banking system because of the original $100 input. The process can repeat itself until we see the total deposits in the banking system compound up to 10x.
Because banks aren’t required to hold 100% of their deposits in reserves, banks can lend more to consumers and businesses as they receive more liquidity. Naturally, we will not see the actual money multiplier reach as high as the theoretical construct of 10x. As it currently stands with the current policy bazookas in place, the velocity of M1 money in the US is approximately 5.6x3.
The velocity of the M1 money multiplier gives us an idea of how the Fed’s stimulus could compound over time. The measure of the M1 money supply is particularly relevant for payments and transactions, and indicates the trends in consumer activities. A decreasing velocity of M1 would indicate that fewer short-term consumption transactions are taking place, and vice versa.
As the velocity of M1 in the US has been on a persistent decline since 2010, the Fed recently reduced the required reserve ratio for deposit-taking institutions to 0%. In other words, banks don’t have to maintain any reserves, and can loan out as much as they want. This is clearly an effort by the central bank to quicken the velocity of M1 once again, which, in turn, could further increase the impact of the Fed’s quantitative easing programs.
With that said, at StashAway, we’ll maintain a conservative approach, and continue to use current figures for the velocity of M1 to estimate the impact of Fed’s stimuli, instead of reading too much into the Fed’s efforts to increase the velocity. So a conservative estimate is that the Fed’s $2.3 trillion USD quantitative easing program could compound 5.6x to generate a cumulative impact of $12.8 trillion USD over time. This would make up for approximately 8.2 months of GDP that the US economy could lose because of the COVID-19 crisis4. As of writing, governments around the world are planning more aid and we are looking at another $2 trillion to $3 trillion USD stimulus in the US alone, as the Fed has only used 40% of its seed capital to date.
This stimuli and associate money multiplier effect could keep the markets relatively disconnected from the full extent of the recession.
At StashAway, our fundamental principle has always been to keep our clients’ investments prepared for market and economic adversities. First, ERAA® estimates and budgets for extreme risk based on top stress scenarios in history, such as the 2008 Financial Crisis. Then, rather than predicting and reacting to future events, ERAA® builds into your portfolio mechanisms to manage your risk. Mechanisms include allocating a portion of your portfolio to funding currencies, such as the US Dollar and Japanese Yen. These risk measures, amongst others embedded in our investment strategy, have helped reduce the impact of the 2020 black swans on your portfolio.
In addition to managing your risk, our asset allocation strategy determined by our investment framework, ERAA®, ultimately enables your investments to capture opportunities in any economic environment.
Back in mid-August 2019, ERAA® switched to an “All-Weather” strategy for assets exposed to global non-US economies and increased USD exposure in the global portfolios. While our US exposure is still tilted towards growth, using data-driven analysis, ERAA® has been optimised to stay invested as the markets have already priced in the economic impact of COVID-19, the oil crash, and the policy bazookas. What drives the overall stock market is how aggregate economic stimuli stack up against aggregate output. ERAA® continues to analyse new data as they come in, looking at both how the economy shapes up as the COVID-19 crisis unfolds, as well as how the markets react, and what they do price in.
1By our calculations, this is equivalent to a 4.6% contraction in real GDP YoY. Real GDP measures the annual output of the economy adjusted for inflation. The data we used is indexed to the purchasing power of a dollar earned in 2012. In our first estimation, we use a very long-dated historical regression which converted the -11% impact on LEI to a -3.3% impact on real GDP. We also use another method that is more forward-looking and accounts for mean reversion. The latter yielded a -5.8% impact on real GDP. Taking the average of -3.3% and -5.8%, we arrived at an expected impact of -4.55%.
2As announced on March 15, 2020, the Board reduced reserve requirement ratios to zero percent effective March 26, 2020. This action eliminated reserve requirements for all depository institutions. https://www.federalreserve.gov/monetarypolicy/reservereq.htm
3The M1 money supply refers to currency in circulation, namely notes, coins and traveller’s cheques.
4As of the end of 2019, the US economy produces output worth $21.73 trillion USD per year.