Investment Strategy

Economics: it's not only the bubbles that count

Originally published in the December 2007/January 2008 issue

Warren Buffet once said that he spends around 5 minutes a year looking at economics and that is probably about 4 minutes too long. Harsh words, but a view probably shared by a large number of fund managers who regard themselves as being almost entirely ‘bottom-up stock pickers’. I would venture to disagree, however; economics and the top-down should be a key element of investment strategy, particularly at the global level.

Indeed, I would go as far as to say that I believe that you can only manage global equity portfolios successfully if you have a clear view about how global economies and global markets operate. Combining this view with a repeatable framework for translating such top-down inputs into bottom-up portfolio construction should allow the investors to maximise their opportunity set for potential returns. The macro view is not only for the return side of the equation however, but also to generate an awareness of the tail risks to which your portfolio is exposed. I suspect the real problem with the perception of macro inputs is that the majority of them are at best irrelevant, at worst downright misleading to most equity investors.

This is not to attack economists, rather to highlight that the vast majority of economics used in financial markets is commissioned, and paid for, by people trying to sell you or trade FX, money markets and (particularly) bonds. It is not that economics isn’t useful, it’s just that for equity investors the economics they are being given isn’t really relevant or useful.

The FX and money markets in particular are largely noise driven, short term, momentum markets, the economics generated by them largely ex-post and ready to flip over at a moment’s notice. And so, believe it or not, are bond markets – 30 year instruments traded on a 30 minute viewpoint. Keynes who became rich far less by investing than by speculating, described market speculation as “bubbles on a stream of enterprise.” The majority of financial market economics should be recognised as being aimed at the bubble, not the enterprise; at speculators, not investors.

Gaining a deeper understanding

I believe economics can provide a framework for investing, for understanding the factors affecting the enterprise, not just the bubbles. At the most basic level of demand and supply we can use a macro viewpoint to assess which areas are likely to benefit from economic headwinds or tailwinds before focussing on whether the companies exposed to these winds are actually generating a return from them and building our portfolios. I suspect this is where economic inputs tend to come unstuck; an obsession with big numbers such as inflation and GDP is all very well if you are trying to forecast the reaction functions of central banks but is pretty useless in deciding the micro economic climate for companies.

This focus on official reaction functions is one of the key problems; if you believe your economic model is the same as that of the Fed or the Bank of England or the ECB, then it doesn’t actually matter if it is right or not. You aren’t being paid to forecast GDP, you are being paid to forecast what the central bank thinks GDP will be. Very different. This is why the consensus can give you ‘Armageddon’ in 1998, followed by a wealth-effect driven Y2K boom in 1999 and a view on a ‘jobless recovery’ in 2003 /4 that would have kept investors out of the first leg of the equity bull market and a 75% rise in the S&P. All completely wrong, and rightly derided by equity investors, but the economists’ job isn’t to forecast the real world, but to forecast financial market economics. The second big problem is econometrics.

“What I am really looking for is the headwinds and tailwinds affecting the enterprises we are investing in”

Financial market economics suffers from the same problem that has been exposed in finance theory by recent market movements. The key and necessary simplifying assumptions required to make the models work, essentially normal distribution and stationarity of variables, are at fault. The irony of course is that the very financial markets we operate in are a key factor behind the instability of the world the economic models are trying to describe and predict. If we see a relationship we throw capital at it until it changes!

The most obvious example of this is actually the key ingredient in the way I view the macro world. The impact of changes in interest rates on the US economy is a central part of most models and the yield curve is a major factor in most GDP forecasts. But these assume that the relationship between interest rates and consumption is stable over time, something we know isn’t true. In the early 1990s, the US developed the fixed rate, re-financeable mortgage and within a decade 75% of US mortgages were fixed for between 15 and 30 years. Changing short term interest rates no longer had any impact on disposable income of most US households. Models forecasting the imminent collapse of the US consumer essentially missed this simple point. By contrast, the sensitivity of household cashflow in the UK, Ireland, Italy and Spain increased dramatically over the last 5 years as balance sheets ballooned, all at floating rates.

Looking at the macro economy in this ‘balance sheet’ fashion helps us to get a better feel not only for aggregate demand response to changes in monetary policy, but also at the microlevel. Companies exposed to the rapid expansion of the European household balance sheet – mortgage companies, housebuilders, financial services, durable goods companies, all had a strong tailwind from 2002 through 2006. Not only has that wind faded, it has now reversed and is strongest where the interest rate sensitivity is highest. The balance sheet expansion is now happening in Asia – mortgages are only around 3% of GDP in India for example – providing a tailwind for companies exposed there rather than here.

Another way traditional economics lets equity investors down is the obsession with places where data is strongest and easiest to model – US and manufacturing – rather than where the investment opportunities mostly are – emerging markets and services. Here we need to use data from companies themselves as our inputs, deriving a bottom-up view of the top-down. This is particularly important in terms of supply rather than demand. In my experience, the majority of profit surprises come from supply shocks rather than demand shocks.

Watching inventory data is extremely useful, while capacity utilisation gives a strong indication as to the potential for operational gearing and cyclical profitability. This supply side approach helped pick the turn in profitability in 2002 as inventories were worked off and industrial production (and hence profitability) soared while the macro consensus fretted over a jobless recovery required by their traditional models. The same framework now has me looking at the end of operational gearing and the start of a cap-ex cycle.

Respect for economics
When I say that I invest thematically and start from a macro viewpoint, most people assume I take a big picture stand on the US consumer or inflation or the dollar. I don’t. I respect those factors – the consensus as well as my own view, but what I am really looking for is the headwinds and tailwinds affecting the enterprises we are investing in. The data is there if you care to look for it. Economics can be useful to investors. Honestly.