It is a well-recognized empirical observation that different asset classes respond differently to different economic drivers. For example, fixed-income assets tend to respond to anticipated movements in interest rates, among other factors; bond prices fall when interest rates rise. Commodities respond to, and sometimes drive, inflation expectations; commodity prices can rise fast when inflation expectations are rising, and they can fall quickly once inflation appears to have peaked.
It is also well-recognized that asset class behavior can vary significantly over shifting economic scenarios. For example, business cycles tend to affect cyclical and non-cyclical companies in markedly different ways, primarily because of sensitivities of consumers and producers to economic growth.
Yet, while asset class performance certainly varies with changing conditions, traditional asset allocation approaches make no effort to adapt to such shifts. Instead, traditional approaches seek to develop static “all-season” portfolios that optimize efficiency across a range of economic scenarios.
In this piece, we consider a compelling alternative. We define economic trends in their totality as a single complex system that changes over time to produce what we call economic “regimes.” And we investigate whether regime-based asset allocation can effectively respond to economic regimes at the portfolio level to provide better long-term results when compared against static benchmark-based approaches.
Regime-based investing is distinct from tactical asset allocation. While the latter is shorter-term, higher frequency (daily or monthly) and driven primarily by valuation considerations, regime-based investing targets a longer time horizon (a year or more), and is driven by changing economic fundamentals. It straddles a middle ground between strategic and tactical. A regime-based approach is designed to give investors the flexibility to adapt to changing economic conditions within a benchmark-based investment policy.
As a preface to our complete work on this topic, we offer the following preview of how regime analysis may be implemented to improve portfolio results. We also provide insights into the key benefits and challenges associated with implementing such an approach.
Step 1: Develop the relationship between economic factors and financial markets
In developing these relationships, we find that economic regimes can be broadly defined in terms of four key factors, which tend to dominate financial market performance. These factors are economic growth, inflation, monetary policy and labor market slack. Our research indicates that developing insight into near-term changes in these four factors — rather than their absolute levels — can provide an effective framework for executing a regime-based asset allocation policy.
We also find that regime-based investing requires understanding the state-dependent relationship between financial markets and the broader economy and devising a method of modeling the non-linear nature of such relationships. Modeling such relationships is quite complex for both conceptual and practical reasons. For example, a simple scatter plot of S&P 500 returns and U.S. real gross domestic product growth may not at first reveal much of a relationship, at least not a clearly linear one (Exhibit 1). But advanced non-linear statistical techniques can help in identifying and defining this relationship. While prospects for economic growth improve, equity prices tend to rally. Beyond a certain threshold, however, the relationship starts to break down.