8 simple macro concepts to understand the economy and financial market

The COVID-19 pandemic drove a boom in retail investor participation in the global equity market. Ultra-low central bank policy rates to combat the economic shock, cash handouts by governments as well as spare time at home encouraged neophytes to invest in the market for better returns. Retail investors represented 25% of total trading volume in the US in Q1 2021 compared to 11% in 2011! (Source: BNY Melon)

New and young investors can make better investment decisions by following and understanding the macroeconomic context. As an economist and investment strategist, I produced investment recommendations by taking cues from the economic environment.

As you join the investment band wagon, here are some macroeconomic concepts that can aid you in understanding the economic context and connecting it to finance and investment.

Gross domestic product (GDP) and GDP growth: GDP refers to the sum of the final price of all goods and services produced in a country in a year. Its growth rate determines the economic momentum of a country. High GDP growth lifts the average income of the population, boosts local businesses and attracts foreign investment.

Application in finance: Economists and investment strategists use GDP data to identify growth trends in economies and formulate investment recommendations. For instance, robust consumption growth may indicate scope for good investment opportunities in fast-moving consumer goods (FMCG) companies. Strong trade (exports-imports) data should nudge you to look into major exporting companies and their products. National statistics agencies publish GDP data by industry (agriculture, mining, manufacturing and IT, among others), which is helpful to spot growing industries.

High GDP growth, if unchecked, may over heat the economy and stoke inflation (think Turkey under President Erdogan’s leadership). The central bank will need to raise the policy rate to control prices, leading to higher yields and lower returns for bond investors (inverse relationship between bond price and yield).

Infrastructure projects including toll roads, data centers and renewable energy are financed from the cash flow of the project. Higher GDP growth boosts project cash flow as greater economic activity brings more business to existing infrastructure.

Higher economic growth benefits public equities (companies listed on the stock exchange) by creating a more exuberant and optimistic environment for equity and bond investors. It is easier for listed companies to obtain financing, grow revenue through high consumer demand and invest in ambitious ventures.

Inflation: Financial market experts study two inflation indicators— consumer price and producer price inflation. Consumer price inflation (CPI) is used more broadly and reflects the year over year increase in the price of a bundle of consumption items. Producer price inflation (PPI) refers to the growth in price of raw materials and other inputs used by businesses.

Application in finance: Higher CPI inflation indicates rising consumer prices and falling purchasing power of the local currency (known as currency depreciation). Higher producer prices (current environment is a good example) lead to narrower profit margins for firms if they are unable to pass on input prices to consumers.

CPI inflation affects the stock market through various channels. Some sectors thrive while others get depressed. Please check my article on macroeconomics for equity investing to understand how inflation affects stocks.

High frequency indicators: Financial market experts often cite high frequency data to follow the pulse of the economy. High frequency indicators are published monthly and cover different aspects of the economy such as manufacturing activity, consumer spending and factory production. The most common high frequency indicators published by most advanced and emerging markets include:

Purchasing managers’ index (PMI) manufacturing and PMI services: These indices reflect the monthly activity in manufacturing and services sectors in a country. An index value above 50 indicates that the sector is growing month over month, while a value below 50 shows contracting activity. These indicators are particularly useful for heavy manufacturing countries including Singapore, South Korea and Germany as well as services-driven economies such as the US, Hong Kong and India.

Retail sales: Indicates the consumer spending momentum in a country on a monthly basis. This is an important indicator for economic growth and is used by both equity and bond market investors. Retail sales is a good indicator for countries that derive a high contribution to economic activity from consumption, including US, China, India and Indonesia among others.

Bank lending: Or credit disbursal is an indicator to determine the liquidity in an economy and consumers’ and/ or businesses’ access to bank lending. Higher credit disbursal encourages consumer spending and business investment.

Capital flow: Foreign capital flow into or outside an economy influences stock prices, economic activity and local currency. Foreign capital flow can be studied through variables such as foreign direct investment (FDI) and foreign portfolio investment (FPI). FDI refers to foreign investment into setting up factories and acquisition of local companies. FPI is foreign investment into local stocks and bonds.

During high growth periods, countries are likely to attract foreign portfolio capital into stocks and bonds, which could inflate equity prices. This occured in several emerging markets in 2021 during economic recovery from the pandemic. Foreign capital inflow raises demand for local currency and induces local currency appreciation.

Fiscal policy: Refers to the government’s expenditure on the economy and its implication on government debt and deficit.

Application in finance: Government debt and deficit impact government as well as corporate bond yields. Additionally, these fiscal variables are factored into sovereign credit ratings that affect all debt instruments in the economy. High government debt or fiscal deficit worsen a government’s fiscal profile and lead to higher bond yields as debt investors seek higher interest payments to offset the risk of default.

A weak fiscal profile limits the government’s capacity to boost GDP growth through infrastructure spending. For instance, the Indian government was unable to drastically stimulate the economy over the past few years given its weak fiscal finances.

Monetary policy: Refers to the policy rate set by a country’s central bank. The central bank rate affects the yield on all debt instruments in an economy (loans, bonds).

Application in finance: Monetary policy tightening generally detrimentally impacts the equity market as firms face a challenging environment to service their debt servicing cost. Small cap stocks are disproportionately hit as smaller firms and startups with less robust balance sheet are more vulnerable to higher rates.

Higher policy rate, ceteris paribus, raises the return for lenders in the domestic economy relative to other countries. This brings foreign capital into the domestic economy in search of higher debt returns and leads to currency appreciation.

Readers can follow simple macroeconomic concepts such as GDP growth, inflation, high frequency data and fiscal and monetary policy announcements to gauge the pulse of the economy and use these indicators to understand the financial market.

Indian house price recovery...gone in a jiffy?

• Indian house prices grew sub-5% in 2021, amidst post COVID recovery, bucking the global boom in home prices
• Government policies, banking sector deleveraging and COVID had driven a decade long slump in the sector
• The nascent recovery in demand during the pandemic may now be threatened by rising input prices, property sector deleveraging and the eventual rollback of regulatory easing

Indian real estate has bucked the global trend of booming house prices during COVID. According to the Reserve Bank of India (RBI), house prices grew sub-5% y/y in 2021, much lower than the global house price increase of 10.3% as per Knight Frank research.

Prior to COVID, India’s real estate market had been undergoing a slowdown stoked by government policy decisions and banking and property sector deleveraging. After the Delta wave subsided in H1-2021, there were nascent signs of recovery in house prices given the demand for spacious homes. However, rising input prices and regulatory rollback may halt the nascent signs of recovery.

Government policies drove a slowdown in the real estate sector since 2013:

In the first tenure of the Narendra Modi government, policy measures were introduced to clamp down on property market speculation by diminishing the tax incentives on rental homes and curbing black money transactions. In December 2016, the government shocked the country by announcing the demonetization of 500- and 1000-rupee notes in order to curb corruption, counterfeit currency and terror funding. The real estate sector took a hit as cash is an important means of financing home buying. Housing sales plummeted and stressed balance sheets drove many developers to bankruptcy.

Since 2015, India’s banking sector has been undergoing a painful deleveraging process to identify and resolve non-performing assets. This clean-up, though necessary to resolve bad debt, detrimentally impacted bank lending and hit loans towards housing and commercial real estate.

India bank loan growth (y/y)

Thereafter, in September 2018, IL&FS, a systemically important shadow finance company defaulted and triggered a chain reaction. This episode stoked severe risk aversion in the banking sector and drove a growth slowdown in the country, affecting the real estate sector as well.

India quarterly GDP growth (y/y)

As the economy started recovering from these successive shocks at the beginning of 2020, the pandemic hit. The government announced a nationwide lockdown between 25 March and 31 May, that resulted in a 24.4% decline in the GDP in calendar Q2-2020! House prices, much like the rest of the economy, took a hit during this period as activity came to a stand-still.

These successive policy actions kept house prices depressed through the last decade. Following the delta wave, home prices were recovering with the rising demand for spacious homes and salary hikes enjoyed by service sector workers.

However, input cost inflation, property sector deleveraging and the rollback of regulatory measures may keep home prices depressed.

Elevated input prices may choke the nascent demand recovery:

The delicate recovery in housing demand after the second wave of COVID may be threatened by the broad-based rise in input prices such as oil, steel, cement, bricks and sand due to global commodity shortages. Several developers in New Delhi and Mumbai are now threatening to halt construction activity as higher input prices are turning projects unviable.

Surveys conducted by Housing.com suggest that home buyers are seeking flexible payments and discounts to pull the trigger on buying a house, indicating the price sensitivity of the home buyer.

Property developers are undergoing consolidation:

India’s property developer sector has undergone a significant consolidation, amidst a weak real estate market and distrust among home buyers. Instances of incomplete or delayed property construction and foul play by indebted developers drove this buyer distrust as well as a pileup in unsold inventory over the past few years. Weak demand and stressed balance sheets led many developers to close shop and shrank the number of participants in the sector. Developers are now focusing on volume growth rather than price appreciation, to maintain cash flow and continue deleveraging.

Regulatory measures will soon be rolled back:

Amidst the dismal economic performance during COVID, the government announced regulatory measures to boost consumer sentiment and demand for housing. These included stamp duty cuts and discounted registration fee to encourage home buying. Although these measures helped spur demand at the margin, the rollback of such policies in the coming months will likely dent the propensity to consume.

These headwinds indicate that the nascent signs of recovery in the Indian housing market may be short lived.

The Fed's policy may just drive a recession

On 16 March, the US Federal Reserve (Fed) hiked its policy interest rate by 25 basis points and started the process of monetary policy tightening after slashing rates to 0% during COVID. This move along with its plans to hike at each of the subsequent six meetings this year was expected by the market. What surprised market participants was the Fed’s terminal policy rate expectation (the highest policy rate it expects out of this rate-hiking cycle) at 2.75% by 2023 versus the estimated long-run neutral rate (the rate supporting full employment while keeping inflation constant) of 2.35%. The Fed also plans to start shrinking its balance sheet earlier than expected and as soon as in May.

What prompted this degree of hawkishness? For one, US inflation at 7.9% in February is the highest since 1982! Second, the US labour market is pretty tight with the unemployment rate at 3.8% in February, close to the pre-pandemic rate. Additionally, job gains have been widespread across leisure and hospitality, professional services, healthcare and construction.

The Fed published its revised economic forecasts for 2022–24 after the policy meeting. It was striking to see the downward revision to its US growth forecast at 2.8% in 2022 compared to its December forecast of 4.0%. The significant increase in commodity prices and economic uncertainty are expected to drive this slowdown. Simultaneously, it projected personal consumption expenditure growth at 4.3% vs 2.6% in December. The epic level of policy stimulus undertaken during COVID both from the fiscal and monetary sides had driven inflation higher throughout 2021 in the US. 2022 added the extra layer of commodity price shock arising out of the Russia-Ukraine conflict.

Following the announcement, the 10Y-5Y US Treasury (UST) spread turned negative, in other words, the yield curve inverted, signaling that the market has started pricing in an economic recession. This was driven by expectations around a global growth slowdown from elevated commodity prices and the degree of monetary policy tightening projected by the most important central bank. Thanks to the 0% interest rate in the US over the last two years, corporate America issued copious amounts of debt to stay afloat. Non-financial corporate debt rose by USD 1.2 trillion during the pandemic. Corporates will now face higher interest rates and some are bound to go bankrupt in trying to meet their debt obligation. Although the Fed did not amend its unemployment forecast for 2023 (at 3.5%), I would assume job losses starting this year as corporates restructure to raise cash and service their debt.

Despite the degree of interest rate hikes forecasted, the Fed does not expect a recession. In fact, Fed chair Jerome Powell cited three historical instances in 1965, 1984 and 1994, where the Fed was successful in cooling the economy through interest rate hikes without causing a recession. The market disagrees and between you and me, the market usually pre-empts and forces the Fed’s actions.

In this stagflation scenario — with growth slowing and inflation remaining persistently high — how should an investor think about portfolio construction? Consumer staples are an obvious beneficiary as higher prices force buyers to cut back on discretionary spending. Utilities and healthcare are other defensive sectors that could protect the portfolio. Loading up on blue-chip names is another good move. You may have come across the argument that ESG investment is inflationary as it penalizes investment in fossil fuel and metals and thereby creates an uneven supply for important commodities. I would take this prompt and add green metals that are needed for renewable energy generation to my portfolio. These include lithium and cobalt (used in batteries), copper (wind, solar PV) and zinc (wind, solar, hydro, energy storage) among others.

Some regions such as Asia have relatively dovish monetary policies compared to the West as inflation is not out of control. Here, ASEAN stocks continue to benefit from their disproportionate exposure to financials, real estate, materials and construction sectors that outperform during inflation. Please check my piece on ASEAN as an inflation hedge for this topic.

Central banks globally are struggling to juggle high inflation and easing growth. At the moment, containing inflation appears to be the number one priority. However, as monetary policy tightening weakens growth, central banks may disappoint the market’s rate hike expectations in order to protect the economy. This would create a good environment for bond investments to thrive, particularly next year.

Conclusion:

The Fed’s aggressive interest rate projections coupled with elevated commodity prices suggest the rising probability of a recession in the US and global economy.

Portfolio construction during stagflation periods should tilt towards defensive sectors such as consumer staples, healthcare and utilities.

Green metals that are used in renewable energy generation and select sectors that benefit from inflation are a good fit in the current environment.

Please consider contributing to humanitarian efforts in Ukraine. Refer to this or this website for organizations undertaking humanitarian efforts.

Reforming corporate Korea out of stagnation

 

South Korea is the tenth largest economy by gross domestic product and has a per capita income of USD 31,360 (2020), qualifying it as an advanced economy. Korea was given the title of the ‘Miracle on the Han River’ for its spectacular rise from an agrarian economy in the 50s to an industrial power house in the latter half of the 20th century.

Despite its notable economic achievements, the Korean equity and currency markets are hindered by governance challenges and investment hurdles. These have kept Korea in the emerging market (EM) bucket by equity index provider MSCI since 1992. Weak corporate governance in large conglomerates, restricted access to the currency market and onerous onboarding hurdles for foreign investors among other factors, have prevented Korea’s upgrade to developed market (DM) status.

Why is corporate governance a big issue in Korea?

Korea’s benchmark Composite Stock Price Index (KOSPI) is dominated by family-run conglomerates called Chaebols (wealth clique in Korean) such as Samsung, LG, SK Hynix and Lotte among others. Chaebols constitute over 50% of the KOSPI’s market cap and the top 10 own over 27% of all business assets in the country. Chaebol families were praised for their role in industrializing Korea during the 60s and 70s and turning the nation into a manufacturing powerhouse from an agrarian economy. Today, Korea’s economy is the 10th largest in size, in a large part thanks to Chaebols.

Notwithstanding their massive contribution to the economy, Chaebols are notorious for their opaque corporate governance policies to retain power with founding family members. These conglomerates have often used circular shareholding structures, made decisions to favour family members and generally disregarded minority shareholder returns. To provide context — the gap in the dividend payout ratio of MSCI World (comprising developed market stocks) and MSCI Korea stood at 21.72 ppt in 2000, 28.01 in 2010 and 29.85 in 2020. The persistent weakness in dividend payout — as Chaebol managements prefer to hoard cash rather than invest — drive Korean stocks’ valuation discount to peer indices as well.

Activist hedge funds are trying to force policy changes

An activist hedge fund invests in companies and plays an active role in changing policies and / or management to unlock business improvement and value. Several activist funds have endeavoured to implement governance reforms in Korean corporates. Local fund KCGI attempted to remove Korean Air / Hanjin Group CEO and establish an independent board of directors to improve decision-making. Samsung’s Lee family is notorious for retaining power with family members. In 2015, activist hedge fund Elliott Management failed to prevent the merger of Samsung C&T and Cheil Industries as the Korean government intervened and backed the Chaebol. This was despite Samsung heir Lee Jae-yong’s blatant attempt to consolidate power in the corporation. These examples highlight the difficulties faced by minority shareholders to unlock value from the biggest Korean firms.

Korean stocks have stagnated over the past decade

Aside from corporate governance challenges, Korean stock prices are held back by the cyclical nature of businesses. For instance, the KOSPI is dominated by cyclical stocks such as semiconductors (Samsung, SK Hynix), shipbuilding (Hyundai), construction (Hyundai Engineering and Construction) and steel (Hyundai Steel, POSCO) that are sensitive to the economic cycle. Korea is an important producer of memory chips that go into manufacturing electronics. The memory chip sector is highly cyclical and correlated to global economic cycle and firm inventory. The KOSPI is often vulnerable to shifting sentiments of the memory chip sector. This generates earnings volatility for corporates and prevents steady flow of capital from foreign investors.

An upgrade to developed market status to the rescue?

If Korea were to achieve an upgrade from emerging to developed market (DM), its stocks would be added to the MSCI World indices which have greater capital invested in them. Against the USD 960 billion tracking MSCI EM, MSCI World Indices benefit from approximately USD 3.6 trillion in assets under management. Research houses estimate USD 20–50 billion capital inflow into Korean stocks upon inclusion into MSCI World indices. These flows may finally help the KOSPI reach the aspired 4000 level and exit the prolonged period of stagnation.

Public officials may be keen for reforms

Korea elected conservative People Power Party’s Yoon Seok-youl as its next president on 9 March. As a former high-profile prosecutor general, Yoon took corrective action against large corporations, suggesting the potential for corporate governance improvements under his leadership.

Democratic Party (DP)’s candidate Lee Jae-myung called for reforms to facilitate Korea’s upgrade to DM during his election rally. In response to MSCI’s wish list, the Korean finance minister spoke about implementing currency reforms this year. It is too early to tell, but these developments paint an optimistic picture for Korean stocks.

Conclusion

Given the stagnation in Korean stock prices and the very low expectation of an upgrade to DM (following numerous failed attempts), the realization of an upgrade and entry into MSCI World indices could be very positive for Korean stocks. From an investor’s perspective, any seriousness from policymakers and Chaebols for corporate reforms is positive. In recent years, Korea’s Fair Trade Commission (FTC) banned new circular shareholdings in 2013, facilitating a reduction in business owners holding key board posts. Companies with independent audit committees rose and the KOSPI’s dividend payout ratio has been inching higher. This momentum needs to continue to see any evident impact on share prices.

Please consider contributing towards humanitarian efforts in Ukraine. Refer to this or this website for organizations that are assisting Ukraine.

ASEAN as an inflation hedge

The epic proportion of fiscal stimulus in advanced economies, pent-up demand post COVID and supply-chain shortages had together raised inflation in the global economy since 2021. As the pandemic subsided in 2022, the expectation of many had been for raw material shortages to ebb and inflation worries to gradually subside.

Enter Russia’s invasion of Ukraine and its grave implication on the commodity market. Russia is an important exporter of crude oil, natural gas, aluminium, palladium and wheat among other commodities. As Western governments slap sanctions against Russia, commodity prices including Brent Crude have rallied. Higher commodity prices are likely to elevate inflation, particularly in net oil and commodity importing nations.

ASEAN stocks thrive during inflation:

Investors can prepare themselves for the equity-market volatility by investing in stocks and sectors that benefit from higher inflation. In an earlier post, I had identified sectors such as banks, insurance, energy and real estate, where companies see higher revenue during inflationary periods.

One way to play the inflation theme is by investing in ASEAN equities. If we take a look at the MSCI ASEAN index — financials constitute 38% of the index, followed by consumer staples at 8.31%, real estate at 8.19%, materials at 6.04% and energy at 4.49%. Over 60% of the index contains stocks that thrive during inflation!

Extracted from MSCI ASEAN Factsheet, January 2022

How certain sectors react to inflation:

• Financial stocks thrive during rising inflation as central banks hike their policy rate to manage price pressures. This increase in the policy rate allows banks to charge higher interest on their loans.
• Consumer staples are products that are essential for daily living such as food, clothing and personal products. Rising prices drive consumers to cut back on discretionary spending (on new gadgets, vehicles) and concentrate spending on essential items.
• Real estate benefits from higher rent and property investment to hedge against falling purchasing power of currency.
• The materials’ sector comprises companies producing chemicals, construction materials, containers and packaging goods and metals and mining products. You may have been reading about the rally in gold, silver, aluminium and copper among other metals since 2021, given the economic reopening, surge in demand and constrained supply in these items.

MSCI ASEAN constitutes countries rated investment grade:

By country, the MSCI ASEAN index is dominated by Singapore, a AAA rated credit (highest credit rating) by S&P, Moody’s and Fitch ratings. Thailand, Indonesia, Malaysia and Philippines, the other countries in the index, are all rated investment grade by the agencies. While ASEAN countries are mostly classified as emerging markets, consider them to be better quality EMs given their historical growth profile, government indebtedness, central bank policymaking and business environment.

The top 10 constituents of the index are all large cap stocks (where market capitalization exceeds USD 10 billion), indicating that the index benefits from quality companies that offer stability during periods of geopolitical unrest and risk-off.

ASEAN’s macro outlook is likely to improve in 2022:

Barring Singapore which profited from 7.6% y/y growth in 2021, all other ASEAN economies underperformed growth expectation set at the start of last year. This was led by the spread of the highly infectious Delta variant, low vaccination rates and intermittent imposition of movement restrictions in these nations. This suggests the scope for strong recovery in 2022, led by better vaccine coverage, milder impact of the Omicron variant and with pent-up demand being unleashed.

As per the IMF, the average growth rate of Thailand, Indonesia, Malaysia and Philippines is forecasted at 5.67% y/y in 2022 compared to 2.72% in 2021. This improvement in growth, led by consumer spending and business revival is likely to support companies and stocks. Consumer price inflation is also forecasted to maintain steadiness at 2.29% in 2022 compared to 2.3% in 2021, much higher than the 0.67% seen in 2020. Higher inflation will support the MSCI ASEAN index.

Good growth outlook, attracts foreign capital. The capital flow tracker prepared by the Institute of International Finance (IIF) corroborates this statement for the ASEAN region. The graph below shows foreign capital returning to EM ASEAN countries in late 2021.

Data extracted from The Institute of International Finance (IIF) capital flow tracker

Note: Please click on the chart to zoom in

Conclusion:

• Inflation pressures are likely to persist in 2022 given geopolitical developments and economic recovery.
• Investors should modify their portfolio by adding stocks that benefit from higher inflation.
• One solution is by investing in the MSCI ASEAN index. Over 70% of the index is composed of sectors that thrive during inflation.
• MSCI ASEAN’s country exposure is dominated by Singapore, a country rated AAA by the rating agencies. The index is exposed to quality large cap names that are likely to protect the portfolio from equity market volatility.

 

Using macro signals for equity investing

Investing in the equity market can seem daunting, particularly to those of us who are risk averse and worried over a lack of finance knowledge. However, history tells us that market performance can be anticipated by following macroeconomic signals and paying attention to the political and geopolitical changes in the economy.

Following the financial crisis in 2007-08, the global economy witnessed a recession where growth collapsed, interest rates were slashed and inflation was subdued. Despite the gloomy atmosphere, some stocks performed better than others given their defensive quality. Think discount stores and medical services providers that benefit from demand inelasticity. You need these goods, recession or not. Or recall India between 2010-11, when consumer price inflation rose to double digits. With input prices shooting up and hurting profit margins, commodity, industrial and bank stocks did reasonably well. These examples suggest that you can (and should) pick stocks or themes based on the macro environment.

Hard core finance professionals rely on bottom-up company analysis to select companies with good balance sheets, cash flow and rising profitability. However, bottom-up stock analysis is time consuming and arcane for individuals outside the field of finance. On the other hand, keeping track of economic changes through the news and the power of observation is more relatable. Macroeconomics can help you pick and choose investment themes and the companies that fit them. Exchange Traded Funds (ETFs) are widely available in the market and investors can access the companies within the ETF index, its investment style and historical performance. Finding the right ETF suitable to the current economic environment is relatively simple given the information available today at your fingertips.

In addition to macroeconomics, geopolitical and regulatory changes also influence stock prices. Think US-China trade war that disproportionately hurt US automakers, chip makers and electronics manufacturers. Or the regulatory crackdown in China in 2021 which hammered Chinese tech companies. Following these developments and their impact could have guided you on where NOT to invest!

Let's take a look at the different macroeconomic scenarios and the sectors that outperform and underperform in them, to assist you in your investment journey.

High growth: Periods of economic boom are ripe for equity investing given strong consumer spending, corporate optimism and credit disbursal to fund unique business ideas. In order to select the sector or company that can generate high returns, turn to the details of GDP growth in that country. What is driving growth? Is it the consumption boom? If so, what are consumers spending on? Is it corporate investment into R&D, machinery or factories? Export boom led by specific products? Think semiconductors in Korea and Taiwan, electronics in Singapore and automobiles in Japan. The details help spot the growth generating sectors and investment themes that could give you your next big investment.

A study conducted by Morgan Stanley Capital International (MSCI, provider of equity indices such as MSCI World, MSCI Emerging Markets among others) showed that industrials, consumer discretionary, financials and informational technology are the most cyclical sectors. This implies that companies within these sectors closely follow the business cycle. On the other hand, consumer staples, healthcare and utilities are the most defensive i.e., least correlated with growth and the economy.

High inflation: MSCI's research shows that high inflation lowers future growth and adversely impacts small cap companies in the medium term. Higher inflation could also take away from sectors that depend on stable cash flow over the long term such as utilities. On the other hand, sectors that act as effective inflation hedges including energy (through rising commodity prices), financials (through higher central bank policy rates that lift banks' interest income) and real estate investment trusts (REITs own real estate assets which benefit from rising rent and property prices during periods of inflation), outperform.

Emerging market equities have historically performed well during inflationary periods given the dominance of the commodity sector in their economies and / or export baskets. Examples include oil and gas in the Middle East, soybean, crude oil in Brazil, copper in Peru, petroleum, coal and coffee in Colombia and oil and gas in Indonesia.

MSCI Emerging Market Index (MXEF) vs Commodity Research Bureau Index (CRB RIND)

Extracted from 'Emerging market equities in an inflationary environment', Man Institute, August 2021

High interest rates: A high interest rate environment usually arises during periods of growth and / or inflation boom, when the central bank tightens liquidity conditions to prevent excesses. The central bank hikes the policy rate, thereby raising borrowing cost and in the process slowing economic activity. This is the environment we find ourselves in today with global central banks raising rates and tightening liquidity conditions.

Financial stocks thrive in a rising rates environment as banks and brokerage firms can charge higher interest on loans and earn higher income. Insurance firms' profit margin improves in this environment as insurers reinvest premium in long-term instruments like bonds, which earn higher interest income when rates are hiked. An analysis conducted by CI Global Asset Management showed that Canadian and US life insurers generated on average 19.36% and 27.27% return respectively during periods of interest rate hikes over the past twenty years.

Rising rates have also benefited real estate stocks such as REITs as interest rate hikes are led by robust growth and inflation which are positive for real estate prices. An analysis conducted by S&P Dow Jones research concluded that between 1970 and 2006, there were six periods with rising bond yields in the US, of which four saw US REITs produce positive total return. In two instances, REITs outperformed the S&P 500 index.

In 2021, several emerging market central banks including Bank of Russia, Banco Central do Brasil and the Hungarian National Bank among others raised their policy rate to combat inflation. Latin American central banks were among the most aggressive last year. Amidst rising rates, the LATAM sectors that produced positive returns on average were communication services, consumer staples, energy and materials. Communication services firms such as telecom as well as materials firms benefit from growth boom.

Political uncertainty: Numerous examples come to mind when contemplating the impact of political developments on equities. Taking a current example - the military standoff between Russia and Ukraine sent stocks crashing in Europe and US while also elevating commodity prices. Back in 2018, diminishing confidence in Spanish Prime Minister Mariano Rajoy's government sent Spanish and Italian stocks tumbling.

Amidst ever changing political dynamics, investors should pay attention to the sectors tied to these economic and political developments. Particularly during election period, having a quick read through candidates' election manifestos is a great tool to anticipate stock market winners and losers.

Catalyzed by the potential sanctions against Russia, oil, wheat, aluminium and palladium (key Russian exports) prices rallied. Markets fear a hit to the supply of these commodities if Western economies slap sanctions on Russia. Blue chip stocks, US treasuries, Japanese Yen (JPY) and Swiss Franc (CHF) tend to perform better in such scenarios, as they are considered safe haven, whereas companies and /or assets linked to sanctions or sanctioned entities underperform. Given the adverse supply shock on Russian natural gas, Dutch natural gas stocks rallied.

During the political uncertainty in Spain, market sentiments were tied to Spain's relations with the EU. Strong relations would signal policy continuity and boost investor sentiment. When PM Pedro Sanchez formed the government, the market rallied and bond yields fell given his commitment to standing by the Euro as well as follow sound government policies. In this case, the persona of the potential prime minister, signalled by his/her comments and election mandate determined market reaction.

Stock market investing can seem daunting. However, simple tools such as tracking the economic changes, reading through government budget documents and election manifestos go a long way in determining equity market winners and losers. You don't need a finance degree to grow your money. Just some good observation and daily reading.

Economics for bond investment

Good investors understand the importance of diversifying their portfolio by balancing risky and safe investments. Government bonds are generally considered to be among the safest investment assets as governments are less prone to default than corporates. Given the lower risk profile, government bonds offer lower interest payments compared to corporate bonds. However, adding government bonds to one's portfolio is a good hedge against investment volatility.

In this note, I will discuss the various macroeconomic variables to assess when considering investment into government bonds. One formula to familiarize yourself with is the opposite relationship between bond yields and prices. When bond yields go up, bond prices go down and vice versa. Rising bond yields therefore, lower the investment return of bonds.

Are we in a high growth and high inflation phase?

Periods of strong economic growth are generally driven by consumer spending, corporate investment, government spending and/or strong trade performance. Strong economic activity may generate inflationary pressures that force the central bank to hike interest rates and raise bond yields. Moreover, during economic boom, equity investments tend to outperform bond investments as investors are generally optimistic about the business outlook.

As economies are emerging out of the COVID-induced lockdowns, economic growth and inflation have been rising since late 2020. In such an environment, investors would wait until interest rates have peaked (and bond prices have troughed) before re-entering the debt market.

Debt market capital flows in Asia turned negative earlier this year as bond yields and inflation rose. In several economies such as India and Philippines, negative real yields (nominal yields less inflation) dimmed the attractiveness of government bonds.

Quarterly growth and monthly inflation data can be accessed through local statistics agency websites, central bank websites or the International Monetary Fund (IMF).

How is the fiscal profile likely to evolve?

A country's fiscal profile refers to the government's debt and budget deficit to GDP. A highly indebted government may face difficulties in servicing its debt as investors require higher interest payments to hold that debt. A poor fiscal profile deteriorates a country's sovereign credit rating and raises the investment risk of holding government bonds. During the pandemic, India, Malaysia and Philippines among other Asian countries found their sovereign credit rating or outlook downgraded by the rating agencies. This raised concerns among investors and weakened capital inflows into their debt markets.

Having said that, bond investors should concentrate on the trend of fiscal profile rather than absolute levels. For instance, several governments announced medium term fiscal consolidation plans post COVID, to bring their debt under control. Examples include India, Indonesia and Malaysia, where ministries of finance announced medium-term debt and deficit targets to soothe concerns. Fiscal improvements, ceteris paribus, lead to lower yields and better bond returns over the medium term.

Investors should also study the average debt maturity and currency denomination of government debt. Longer maturity profiles reduce the exigency of debt repayments and give governments the time to bring finances in order.

Foreign currency denominated debt is more vulnerable to exchange rate volatility during crisis periods. Indonesia and Philippines have higher proportion of foreign currency denominated debt. During periods of risk-off, these markets are more vulnerable to capital outflow driven by exchange rate depreciation. In this regard, although India's debt and deficit levels are generally higher than Asian peers, long average debt maturity (exceeding 10 years) and largely local currency denominated debt provides important cushion to investors.

Data on fiscal metrics is available on the websites of the ministry of finance, budget office and the IMF.

What are the demand and supply dynamics?

In Econ 101 we learnt that the price of a good is a function of its demand and supply. Similarly, bond prices depend on demand and supply. If demand for bonds is higher than supply, bond price would increase and improve the investment return.

I admit that gaining this information is slightly tedious, but not impossible. You simply need to know where to look.

Bond supply is easier to determine as the budget office or ministry of finance provides this data while promulgating the annual budget. Governments often discuss budget financing through surplus cash reserves and/or additional bond issuance.

Bond demand is onerous to determine as each country differs in its bond holders. Common sources of demand include 1) local insurance firms, 2) local pension funds, 3) local banks, 4) foreigners and 5) the central bank. For instance, in South Korea, the local pension fund called National Pension Service (NPS) is an important investor in Korea Treasury Bonds (KTBs). NPS often discusses its allocation into KTBs and its medium-term plans, which can be accessed on its website. In recent years, NPS announced its intention to raise overseas allocation in search of higher yields. With the Korean population rapidly ageing, NPS has been seeking more lucrative investment opportunities for its depositors. Greater allocation overseas implies lower allocation towards domestic assets such as KTBs. This is long term negative for KTB returns.

Similarly, the Employees Provident Fund (EPF) in Malaysia is a key sources of demand for Malaysian Government Securities (MGS). Amidst the COVID pandemic, the Malaysian government allowed citizens facing economic hardships to withdraw their EPF contributions. These withdrawals reduced EPF's assets under management and affected its MGS investment.

As the pandemic shuttered businesses across nations, banks became risk averse to lending. Rather, they preferred increasing their allocations towards the safety of government bonds. This created additional demand for government bonds and boosted prices. Banks provide data on their government bond investments during quarterly results filing.

For information into government bond holders, I would also recommend going through central bank publications. Central banks often produce deep dives on country bond markets and major bond holders.

Is the central bank assisting the bond market through QE?

Prior to COVID, quantitative easing or QE as a policy tool was used mostly in developed economies facing prolonged periods of low growth and inflation. For further information on QE please refer to this article. The Bank of Japan (BoJ) and European Central Bank (ECB) implemented QE measures to revive growth and inflation amidst demographic decline. Post the global financial crisis in 2008, the US Federal Reserve (Fed) performed QE to stimulate the economy and bank lending.

QE opens up an additional source of demand for bonds in the form of central bank bond purchases. The COVID pandemic forced several developing economy central banks to implement QE measures. These were aimed at 1) easing liquidity conditions for consumers and businesses affected by the pandemic and 2) financing governments' stimulus measures by lowering bond yields.

Several Asian central banks undertook QE measures including the Reserve Bank of India, Bank Indonesia, Bangko Sentral ng Pilipinas and Bank of Thailand among others. Central banks publish data on asset purchases on their websites.

As fiscal stimulus deteriorated government' fiscal profile, central banks mollified bond investors by purchasing government bonds and assisting government finances.

How is the currency outlook?

In a previous post, I touched upon the importance of currency return in the overall return of an asset. Foreign investors must incorporate the currency outlook when investing overseas. Suppose you are a US based investor and have invested in Indian government bonds. Over a period of time, the investment returned 15% through capital gains. However, over the same period, the Indian Rupee depreciated 10% against the US Dollar. In that case, your total return would be 15-10 = 5% from this investment.

Therefore, having some idea about where the currency is headed will add to the thoroughness of your investment analysis. Please refer to this post for case studies on currencies.

Conclusion

Government bonds are safe investment bets and considered to be good portfolio diversifiers. In order to assess the pros and cons of investing in this asset class, you can examine readily available economic variables. These include

1) Economic growth and inflation - higher growth and inflation raise government bond yields and lower bond prices.

2) The country's fiscal policy - improving fiscal outlook through lower fiscal deficit and debt over the medium term, ceteris paribus lower government bond yields.

3) Demand and supply dynamics - knowing the major holders of government bonds by country is a great first step in comparing demand and supply for bonds. Information on bond demand and supply can be found on central bank or ministry of finance websites.

4) Central bank asset purchases or QE - Another source of bond demand is the country's central bank. In Japan, the BoJ holds over 40% of outstanding Japanese Government Bonds (JGBs). This policy is aimed at lowering interest rates to boost bank lending, growth and inflation.

5) Currency outlook - investors should incorporate currency views into their investment analysis when investing overseas. Refer to my previous posts on currency discussions.