Understanding the ‘What’s Priced?’ framework

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An important aspect of being a multi-asset investor is the ability to interpret macroeconomic developments, assess how they impact one’s investment views, and as a result, determine whether to make changes in portfolio positioning. But when is the market pricing macroeconomic fundamentals differently than us? That question is the genesis of our What’s Priced framework. This paper will introduce the tool and showcase its value through three case studies.

The relationship between macroeconomics and market pricing

An important aspect of being a multi-asset investor is the ability to interpret macroeconomic developments, assess how they impact one’s investment views, and as a result, determine whether to make changes in portfolio positioning. Doing this well requires monitoring and interpreting a wide array of data that reflects the status of the global economy in areas such as growth, inflation and monetary policy. However, given the varying frequencies with which data releases can occur and the different levels of importance one can attach to them, there is a natural behavioral risk that investors who are analyzing the data will emphasize data that confirms their biases. If one has a thesis that the economy is moving in a certain direction, it is plausible that one would favor any data release that confirms that view and discount any release that is to the contrary.

In recent years, our multi-asset platform built a series of structured tools that drive a rigorous approach towards analyzing economic data and help mitigate any potential confirmation biases. In other words, we let the tools tell us what the economy is doing instead of superimposing what we think the economy is doing on the data. The most important thing while seeking to generate returns from tactical macro views is to correctly interpret both the macro view as well as the associated market pricing. When is the market pricing macroeconomic fundamentals differently than us? That question is the genesis of our What’s Priced framework. This paper will introduce the tool and showcase its value through three case studies.

Understanding the ‘What’s Priced?’ framework

What’s Priced is a structured effort to measure the macroeconomic environment as priced by the market, and then compare it with our own read on the macroeconomy. We measure the disconnect between market pricing and our own view of the fundamentals
to construct a “score,” estimating how disconnected pricing has become from the fundamentals. When the score is extreme, markets are trading in an abnormal range relative to the fundamentals. This could present a trading opportunity–for example, the market’s outlook on growth may be too pessimistic vis-à-vis our own views and therefore we may consider investing in equities.

There are a few reasons why market pricing of the macroeconomic environment can become disconnected relative to our read on the fundamentals in the short term:

• The market is pricing those macroeconomic fundamentals differently to how we have forecasted them. For example, our growth forecast is inconsistent with others, or we have missed something.
• The market is pricing other things as well as macro fundamentals. For example, rising uncertainty due to increasing geopolitical tensions leads to an equity market sell-off.
• The market is driven by technical factors, such as flash crashes or forced sellers fueling price declines.

What’s Priced: How are the scores generated?

We use the same approach to generate scores in the What’s Priced framework across Growth, Inflation, and Policy. In each case, we estimate the relationship between our macroeconomic indicator and the pricing factor using an exponentially weighted least squares regression. This approach places a higher weight on new information and thus relies more on recent data. It can learn and adapt more quickly to changing environmental conditions (whether it be pricing innovations or new macroeconomic data releases). Importantly, extreme scores do not always equate to trading opportunities. Understanding what might be driving that extreme score is crucial as evolving market conditions may warrant these distortions. In the following three case studies however, we illustrate the What’s Priced framework by focusing on instances where extreme scores did lead to such trading opportunities.

Three case studies illustrate periods when extreme scores led to trading opportunities

Key takeaways

• The What’s Priced framework is the result of our multi-asset platform’s focus on innovation and represents a rigorous way to measure the disconnect between market pricing and macroeconomic fundamentals.
• There is no guarantee that the What’s Priced framework will always point to trading opportunities, as there may be times where the disconnects are warranted or are reflecting something not in our own estimates. As such, the use of tool needs to be married with an understanding of what may be driving market pricing.
• This paper illustrates the power of the What’s Priced tool using three case studies across Growth, Inflation and Policy. In all these cases, the framework allowed us to take a more balanced view of what was happening in markets and make more informed decisions in our portfolios.
• As multi-asset investors, the need to monitor an ever-expanding opportunity set is of paramount importance in order to improve the chances of success. Incorporating new insights into the What’s Priced tool will allow us to develop even more robust views in the future.