Weathering the Storm: Navigating Elevated Macroeconomic Uncertainty

Over the past three years, the macroeconomic landscape has been remarkably volatile. A non-exhaustive list of events includes a pandemic, a war in Ukraine, skyrocketing inflation, and a regional banking crisis in the United States.  These macroeconomic surprises have translated into heightened volatility in financial markets, and how to allocate capital in an increasingly uncertain environment has become a conundrum for investors.

Although it may be tempting to postulate that there is always uncertainty in financial markets and the recent history is no different than the past, Jordan Brooks at AQR recently released a paper to quantify the current state of macroeconomic uncertainty and found that it is in fact high relative to historical norms.  The paper aims to answer whether this elevated level of uncertainty is likely to persist in the future or if it’s mean-reverting, and what the implications are for asset allocation decisions.  Brooks finds that elevated macro uncertainty is not only associated with both high equity market volatility and negative equity performance, but that the half-life of shocks to macro uncertainty is approximately four years (i.e., shocks are sticky). Much like volatility in financial markets is persistent and more predictable than returns over short periods of time, macro uncertainty also appears to be extremely persistent with a monthly beta of 0.98.  We would agree with Brooks that the underlying macro backdrop is not conducive to a swift reversion to the calm levels of the 2010s, as the trade-offs between keeping inflation under control and a tight labour market increase the probability that macro uncertainty will remain elevated.  Furthermore, market expectations for the future path of interest rates relative to the Fed’s own projections continue to meaningfully diverge, and this divergence will need to be resolved at some point, which is unlikely to be done in a smooth or calm fashion.

In the face of persistent macroeconomic uncertainty, investors would be wise to diversify their portfolios away from simple equity market risk.  By broadening out an investor’s opportunity set to include stocks, bonds, currencies, and commodities, an investor can reduce their reliance on a concentration of specific factors that drive the performance of a portfolio.  For example, broad exposure to a variety of commodities has a much different factor exposure than global equity markets, which are generally driven by changes to the discount rate and earnings growth.  Brooks highlights that you can take this asset class diversification a step further and use a risk parity approach to portfolio construction, where each asset class contributes the same amount of risk to the overall portfolio, as this “delivers much more consistent performance across macroeconomic environments than equities (or any single asset class).”  At Viewpoint, we would agree. In the face of heightened macroeconomic uncertainty, and in the absence of having a view on how markets will resolve directionally, the most defensible asset allocation position is to utilize a risk parity portfolio construction to efficiently balance a portfolio of beta exposures across a wide variety of macroeconomic scenarios.