- Geopolitical news and analysis has become a common investment thesis.
- Unusual circumstances exist, but if the economy is not vulnerable to a recession, geopolitical shocks are usually "shrugged off".
- If the economy decelerates to the point in which a recession becomes an active risk, geopolitical shocks can be a trigger.
- Currently, the economy continues to slow, and employment is the factor that will either push the economy into a vulnerable recessionary window or save the economy from the fourth slowdown this decade.
- The analysis favors a portfolio that is balanced based on risk and tilted in the direction of assets that are slightly more defensive, to respect the trajectory of leading indicators.
- I do much more than just articles at EPB Macro Research: Members get access to model portfolios, regular updates, a chat room, and more. Get started today »
The past several days have come with an influx of geopolitical headlines, algorithmic trading against questionably accurate information, and a panic among media pundits, analysts, and strategists alike, all seeking to answer the same nonsensical question.
Headlines break, only to be retracted moments later or revised with more accurate information. Yet, investors hang on every headline and try and answer what it may mean for their portfolio of stocks.
If President Trump retaliates, what happens to the price of oil? If Iran strikes back, will that trigger a risk-off environment? The hypothetical scenarios one can dream up are endless, and in the end, are extremely unhelpful to a long-term investment strategy.
Uncertain times challenge investors.
Many investors do not have a strong investment process that is repeatable and consistent through turbulent times. The lack of an investment process will cause narrative drift and a lack of conviction in your portfolio during choppy markets. This leads to watching media pundits for the answers and, more often than not, being led down a dangerous and unprofitable path.
Too often, a strategy is deployed only to be forgotten as soon as the overnight futures trade lower by 2%, a scenario that has become very familiar in the past several days.
The events that have kickstarted 2020 with a bang, literally and figuratively, are a humbling reminder that your investment strategy and your portfolio construction are the single most important factors responsible for long-term success.
If you are a buy-and-hold investor and have no plans to sell stocks when the economy turns lower, don't let geopolitical events deter you from your long-run plan.
As an analyst of economic cycles, I always maintain a balanced portfolio of stocks, bonds, commodities, and gold. I simply "tilt" my portfolio in the direction of the assets that are strongly suited to have the best risk-reward potential for the upcoming 6-12 months, based on our leading economic indicators.
When Iran retaliated and the overnight futures traded lower by over 1.5%, gold, Treasury bonds, and oil traded higher, allowing those with a risk-balanced portfolio to assess the situation with a clear mind. Are these events going to impact the direction of economic growth or inflation? If the answer to these questions is "no," then there is no reason to alter the investment strategy that was initially based on economic cycle research, not a geopolitical strategy.
Later, as fears of a more substantial escalation subsided and the stock market traded higher, those with a balanced portfolio benefited from the rise in risk assets.
The larger point here is that if you were not a geopolitical expert before the latest events hit the front page, you should not allow your opinions to influence your investment strategy that was likely based upon more sound investment principles, to begin with.
Everyone is entitled to an opinion and a trading/investment strategy. Still, we should make sure we keep our investment strategy focused on data, facts, and objective analysis rather than opinion and likely less than qualified geopolitical speculation.
Turbulent times are often an abrupt reminder that a portfolio balanced based on "risk" or, as Ray Dalio famously marketed, a portfolio that can survive "all-weather" is a fantastic starting point for investors who are focused on wealth preservation, capital appreciation, and risk mitigation.
At EPB Macro Research, there are two distinct parts to our investment process, the economic cycle analysis and the portfolio construction.
Firstly, through the lens of secular economic trends and recession risk, we use a process of leading economic indicators to have the most accurate and reliable forecast regarding the future direction of growth and inflation.
After formulating a view on the secular economic trends, the current level of recession risk, and the future direction of economic growth, we overlay long-term valuation measures as an added layer of protection.
We then move into the portfolio construction process, fully equipped with a data-driven and objective measurement of the economic cycle.
Using a portfolio that is balanced based on risk as a starting point, we use the economic cycle analysis to tilt an otherwise balanced portfolio towards more aggressive assets or more defensive assets.
This strategy allows us to keep portfolio volatility low and drawdowns minimal (as the portfolio is diversified across uncorrelated assets). It still gives us the ability to generate alpha by making the correct pivots.
Gambling on an asset class or trading frequently may be a fine strategy for a slice of your investable assets but is unlikely to be a winning formula over multiple years and both bull and bear markets.
Building a portfolio that is focused on risk, volatility, and then capital appreciation always wins over the long-run - and there is still a lot less stress in the process.
Has the Iran conflict impacted global economic data? Is the future direction of growth or inflation meaningfully altered by the constant rise and fall of Middle East tensions?
The beautiful part about having a process of leading economic indicators, separated into long leading, short leading, and coincident economic data, is that we do not have to guess about the future impact of any conflict.
If there is a lasting change to the economic cycle sparked by war, conflict, or an unforeseen event, it will flow through the sequence of leading indicators in an objective and empirically observable fashion. Some indicators that incorporate market-based data will respond quickly should a significant change occur.
Short-term price movements or economic shocks that do not flow through the leading indicators are just that - short-term movements that can likely be chalked up as "noise" in the long run.
When economic indicators decelerate to the point in which the economy becomes susceptible to a recession, economic shocks become more impactful as any shock can become recessionary when the economy walks into a vulnerable window.
Given the current shape of leading indicators, the economy remains in a trend of deceleration, walking closer to a recessionary window with each passing day. Today, however, while reasonably close, we are not in the highly vulnerable window. That window swings wide open when the economy starts to lose jobs, and the unemployment rate starts to rise.
The most significant risk in 2020 is not the Middle East conflict; it is the slowdown in cyclical jobs growth that CAN push the economy into a highly vulnerable position; a situation in which the economy would become more exposed to unpredictable shocks.
Most recently, we have been analyzing the employment situation carefully, watching our indicators of employment for a signal to shift our portfolio more defensive or get more aggressive within the context of a risk-balanced portfolio.
Let's take a quick moment to understand a more important trend for the economy and for the performance of financial assets: employment.
Geopolitical shocks can be mostly offset through a balanced portfolio. Unique situations require special measures, but more often than not, a portfolio that has a share of "risk" in many uncorrelated assets can usually "weather" just about any storm.
Major economic trends that have recessionary implications are often far more impactful to the stock market, the bond market, and financial assets in general over a longer time horizon.
When employment growth falls below population growth, the unemployment rate tends to rise quickly as the economy is adding jobs at a slower pace relative to the growth in the labor force.
Currently, total employment growth is running at 1.5% year over year. This represents a decline from a growth rate of 1.9% earlier in 2019.
Cyclical employment growth, however, (right-hand pane) defined as durable goods manufacturing, construction, and trade/transportation services have slowed to 0.6%, the rate of population growth.
The top-left pane in the chart below shows the spread between cyclical employment growth and population growth. Periods in which the spread is below 0 are highlighted in red and tend to correspond to sharp rises in the unemployment rate.
The Unemployment Rate May Be At Risk:
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