One of the questions that clients often ask is how we distil macro information into our thinking and ultimately your portfolio. To do this, we take what’s commonly known as a top down, bottom up approach.
The top down perspective involves identifying some of the key drivers in the macro environment. For example, these may be related to geopolitics, the direction of interest rates and bond, broad equity market & sector valuations, GDP growth and consumer & business confidence that we see across particular markets. Once we identify and gain an understanding of these key drivers we then think about the impact on our asset allocation strategy (i.e. are the current circumstances likely to be more favourable to equities, bonds, property, cash or a range of other asset types), and what changes should we be considering.
Once we get this framework in place, we then think about how we build up positions in each particular asset class. This is the bottom up approach. In this instance we look to identify particular securities, external investment managers or investment opportunities that can take advantage of the broader external macro environment. This can be either via additional return opportunities or a better way to manage portfolio risk.
This is a constant process because you can never get it right 100% of the time. We’re operating in a dynamic and changing environment, so we need to continually reconsider and reaffirm our decisions as things come out of left field to challenge us.
Two good examples of how macro factors feed into portfolio decisions are the US/China trade dispute and the increase of cash rates in the US through the course of 2018. From a top down perspective, the US/China trade dispute has led to lower growth and lower earnings in China because they’re exporting less into the US and those exports are now more expensive. China is the second largest global economy, but it’s also an emerging market so the impact is significant.
China is Australia’s biggest market for iron ore, coal and gas. So the slowdown in China has implications on the potential earnings outlook for companies like BHP, Rio and Fortescue. From a bottom up perspective, we then have to think about what the trade dispute means for these companies future earnings and therefore what exposure we think is appropriate.
The other example, is the move in cash rates. When we look to higher interest rates in the US, this has led to higher bond yields. As a result, investors are investing into US bonds – which means they are buying US dollars and driving up their value. As emerging markets tend to have a lot of debt in US dollars, their currencies are weakening as a result and they now have to find more local dollars to pay down their US dollar debt. This means they either have to draw from their own foreign currency reserves or try to increase capital into their markets by increasing their own cash or bond rates. These activities slow down economic activity in their own internal markets and economies. This impacts on our asset allocation decision in how much exposure we would have to emerging markets.
So, when we look at these top-down factors we the have to think about what exposure we have to US dollar investments. In a portfolio context, we might think about investing in companies who are more exposed to the US market. In doing this we consider both their business performance and whether we can get an advantage when their returns are translated back into Australian dollars.
So, all up, global investment markets and economies cannot be viewed in isolation and the need to think about the interlinkages is an important determinant in how we manage portfolio asset allocation as well as underlying security/investment decisions.
Piers Bolger is Chief Investment Officer at Viridian Advisory
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