Macro Regimes and Asset Returns

Macro regimes and their impact on assets
The economy can be in various regimes characterized by different combinations of growth and inflation. Each regime creates specific conditions for different asset classes. Identifying the current regime and forecasting its change is a key task for the macro investor.

Classification of macro regimes
Growth + low inflation (Goldilocks): an ideal regime for financial assets. Equities grow on profits. Bonds are stable with moderate rates. Central bank is neutral. Credit spreads are narrow. Volatility is low.

Growth + high inflation (Overheating): a risky regime. Equities can rise but face the threat of tightening. Bonds are under pressure due to rates. Commodities and real assets benefit. Volatility increases.

Recession + high inflation (Stagflation): the most challenging regime. Equities fall (recession of profits). Bonds are under pressure (inflation). Commodities may serve as a hedge. High quality defensive assets are valued.

Recession + low inflation/deflation (Deflation): bonds are the best asset (falling rates, flight to quality). Equities fall. Cash and quality are attractive.

Historical examples of regimes
1990s in the USA — Goldilocks: technological growth, low inflation, moderate rates. Equities delivered excellent returns.

1970s — stagflation: oil shocks, high inflation, weak growth. Equities and bonds delivered negative real returns. Commodities, gold, real assets benefited.

2008-2009 — deflationary crisis: demand fell, threat of deflation. Government bonds served as a safe haven, equities plummeted, credit was under stress.

2021-2022 — inflation shock: post-pandemic demand growth, supply chain disruptions, rising prices. Bonds saw their worst year in decades, equities were volatile, commodities rose.

Mapping regimes to assets
Each regime has a typical ranking of asset classes by expected returns.
Goldilocks: equities > credit > bonds > commodities.
Stagflation: commodities > bonds ≈ 0 > equities (negative).
Deflation: bonds > cash > equities (negative).

Sector positioning also depends on the regime. Cyclical sectors — in Goldilocks and early overheating. Defensive — in recessions. Commodity sectors — during inflation.

Transitions between regimes
Markets react more to regime changes than to their continuation. Transition from growth to recession causes sharp repricing of assets. Transition from low to high inflation — similarly. Forecasting transitions is the key to superior returns. Leading indicators, yield curve, credit conditions help identify an impending transition.

Application for investors

• Assessment of current regime: based on growth, inflation, policy data, determine which regime the economy is in.
• Positioning for the regime: choose allocation corresponding to typical asset returns in the given regime.
• Monitoring transitions: track signals of regime change for timely rebalancing.
• Scenario analysis: evaluate the portfolio in various regimes to understand vulnerabilities.