Did You Know?
- By Sam van de Schootbrugge
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- 10 min read
Summary
- We explore our most-read Deep Dives on the vanguard ideas that led markets this year.
- We cover inflation, recessions, machine learning, crypto, stocks, FX and more.
Introduction
Did you know that every week we summarise an academic paper on a topic that is featuring heavily in market conversations? Our ‘Academic Deep Dives’ present the findings of leading academics and practitioners from the best institutions worldwide to provide a perspective that investors may otherwise miss.
For those new to the series, we want to bring you up to speed with some of the most insightful findings over the last few years. Much of the content is evergreen, and so a trip into the archives is well worth it. For those more familiar with our Deep Dives, perhaps this will prove a welcome reminder of our most-read content.
Inflation – Did you know…
…most firms (65%) have no idea what the Fed’s inflation target is, according to an NBER working paper. The majority they surveyed thought it was 3%, and firms’ expectations of short-term inflation appear unanchored. The research provided a good rationale for persistently higher inflation in 2022.
Other evidence of higher inflation in 2022 came from prominent economist Larry Summers. He looked at Zillow’s Home Value Index, which is a good predictor of OER inflation, and job vacancy rates, which capture labour market tightness well. Summers showed how labour supply and housing shortages will keep inflation higher for longer.
And so, with inflation here to stay, investors may look to alter their asset allocations. According to seasoned practitioners at Man Group, commodities and collectables have historically offered the best returns during high inflationary periods. Equities may not be a bad bet either, as the latest research shows they have become less sensitive to inflationary news since the policy rates have moved to zero.
Recessions – Did You Know…
…according to former Bank of England MPC member David Blanchflower, the best way of predicting a recession is through tracking consumer and business surveys. In his words, ‘the thoughts of the ordinary man or woman will give more insights into the state of the economy than any quantitative data’. He, alongside fellow UCL Professor Alex Bryson, explained why in a series of three working papers.
Academics at the University of Cambridge, however, may disagree. They identify equity volatility, credit-to-GDP growth and global financial conditions as the key macroeconomic factors that drive movements in the left tail of domestic growth. The Bank of England finds that the yield curve slope and global credit conditions are the best predictors of recessions.
Meanwhile, a paper in the Journal of Financial Economics finds that the implied volatility from options on five-year Treasury note futures can predict real GDP growth and macroeconomic volatility. Specifically, a 1.15% increase in implied volatility leads to a 1.12% decline in annual GDP growth in the subsequent year.
Perhaps a prelude to recessions, much literature agrees banking and financial crises can be predicted. The debt-to-service ratio, credit market sentiment measures, asset price inflation and household credit growth are all key predictors of these events 1-5 years ahead. A Journal of International Economics paper finds that commodity price volatility is also a significant predictor.
Machine Learning – Did You Know…
…the OECD has a weekly growth tracker that was constructed using a neural network algo that has been trained on 263 Google Trends search topics over 15 years. The US’s latest figure is 4.5% as of 27 February 2022, down from its year-high of 6%. Russia’s dropped 2.5pp in one week following its invasion of Ukraine.
The OECD growth tracker analyses textual data. The ECB has also shown how researchers can use texts from European newspapers to predict GDP growth. Interestingly for quants, analysing texts in their native language, or translating those texts into English and then analysing, yields the same results. They use the VADAR and AFINN dictionaries.
Researchers from Stanford and Colombia Universities have shown, using a feedforward network, how mutual fund performance can be predicted by their fund flows and fund return momentum. These two variables are the best predictors of a mutual fund’s performance over the next month. And by going long in the top 10% and short in the bottom 10%, investors could obtain abnormal returns of 6% per year with a Sharpe ratio of 1.5.
Meanwhile, an IMF paper is a good reference point on the risks of adopting AI/ML systems. Interpretability is a key issue. It is why many macro researchers will augment ML with traditional econometric models. One such example uses Wall Street Journal texts to create a measure of ‘news attention’, which the authors then combine with more familiar macroeconomic variables.
Lastly, a Journal of Financial Economics paper uses audio from FOMC press conferences to come up with profitable trading strategies. Aligning the audio with a transcript, they use end-to-end deep learning algorithms to show that price changes around the statement are highly correlated to price changes during the subsequent press conference.
Crypto – Did You Know…
…that bitcoin is now responsible for 17% of the daily volatility in US equity prices? The findings, published in an IMF working paper, show just how closely connected crypto and equity markets have become in recent years. This may be related to the type of cryptocurrency investors. A BIS working paper finds that most are young, educated and digital native males whose motivation, contrary to early beliefs, are not linked to distrust in fiat currencies.
Valuing bitcoin has always proven difficult. However, a paper published in 2020, proposes using Fisher’s Quantity Theory of Money equation to value the crypto. According to the authors, valuing bitcoin requires a good estimate of the number of outstanding tokens, knowledge of its penetration within its addressable markets, and a good handle on the ratio of users to speculators.
Speculation aside, prominent macroeconomics Kenneth Rogoff and Carmen Reinhard estimated that 7.4% of all bitcoin trades are used for (cross-border) wealth transfers and payments. Domestic bitcoin payments are most popular in China and Russia, while international payments occur most in Nigeria and Argentina.
Beyond bitcoin, did you know that the word ‘NFT’ was Collins Dictionary 2021 Word of the Year? Also, more than 50 central banks have publicly communicated their research and development efforts in CBDCs. Lastly, the best method for measuring cryptocurrency market liquidity is the Amihud illiquidity ratio, according to a Journal of Banking and Finance paper.
Stocks – Did You Know…
…that ‘noise’ is the cause of roughly 31% of the variation in daily returns on stocks listed on the NYSE, AMEX and the NASDAQ. That is information not captured by market or firm conditions. However, this percentage has dropped and, according to the authors, is consistent with increasing market efficiency.
Did you also know that the best S&P 500 returns are achieved when the VIX was below 20? According to Thorsten Wegener, only holding the S&P when the VIX is below 20 delivers average returns of 16% over the last 30 years.
Meanwhile, if you are an investor with a time horizon of 15 years or more, recent research shows the dominant asset allocation strategy is to have a stocks-bonds ratio of at least 60:40. But, beware of inflation. Almost a fifth of diversified global investors will lose relative to inflation over a 30-year investment period. That proportion shrinks for US-based investors.
FX – Did You Know…
…the S&P 500 is the best predictor of the nominal exchange rate over one, 12, 36 and 60 month horizon. Surprisingly, global risk factors have very little additional forecasting power. However, if you are looking to value a currency, then the PPP model appears to be the best bet, especially for GBP and NOK. For AUD, CAD, EUR, JPY, NZD, SEK and USD, you may prefer to choose the BEER model.
Regardless, valuing G3 currencies over the long term has become easier over the last decade, explains macroeconomist Kenneth Rogoff. He documents the secular decline in FX volatility in the dollar, yen and euro. Driving the decline are smaller interest and inflation rate differentials, giving perhaps the clearest empirical indication that monetary policy is at the heart of exchange rate variability.
Despite the drop in volatility, there is still money to be made in FX volatility markets, according to a Journal of Financial Economics paper. A long-short strategy that buys implied volatility at a discount and sells implied volatility at a premium generates a significant Sharpe ratio.
On EM FX, we found that Asia FX futures – INR/USD, USD/CNH, USD/SGD, TWD/USD and KRW/USD – provide important and distinctive differences from G10 currencies and other asset classes. They therefore deliver diversification benefits to investors should these currencies be added to developed market portfolios.
ESG – Did You Know…
…decarbonising portfolios has a significant impact on high-emitting firms. It not only reduces their stock prices; it reduces their carbon emissions over the next 48 months. Even better, by excluding only the most-polluting firms from a portfolio, investors can significantly decarbonise without sacrificing expected returns.
Did you also know that a country’s ESG ratings can help price an IPO? That is, IPOs issued in countries with more transparent accounting disclosures, greater liability standards, and stronger shareholder protections are less likely to be priced below their real value.
Creating a sustainable economy is also on the minds of governments. According to an NBER working paper, to get 35% of American’s to have an electric vehicle by 2035 will cost the US government an estimated $1tn. Any more widespread adoption hinges on the availability of a light truck alternative.
Another costly government venture would be a carbon tax. In the EU, a $75 carbon tax could affect up to 150,000 manufacturing jobs in the largest EU countries, according to a new ECB paper. But an IMF paper shows it may be worthwhile in the long term. For every dollar spent on carbon-neutral or carbon-sink activities, it adds over one dollar’s worth of economic activity.
China – Did You Know…
…the BIS has created a measure for estimating Chinese GDP growth using provincial macroeconomic data. Their results show that coastal and central regions of China are contributing most to national GDP growth. Their model is just one of various alternative China growth measures, which include the C-CAT, energy consumption, business sentiment indicators, and satellite-recorded night-time lights.
There is also evidence that big tech lenders in China are disrupting credit markets and weakening the transmission of monetary policy. These lenders react differently to market conditions and house prices than traditional banks, breaking down the ‘financial accelerator’ on which central banks focus.
On China-US relations, a BIS working paper identified which equity markets to avoid when sentiment worsens. Specifically, the stock prices of IT-related firms in China are most responsive to any trade sentiment deterioration. US tech firms are also not immune to greater tensions.
And Finally…
Several interesting Deep Dives did not make the cut. These are ‘When Can You Trust a Forecaster?’, ‘What Determines How Wealthy You Become?’, ‘Beware of Trading on Your Smartphone’, ‘The End of Financial Districts?’, and ‘How Retail Investors Stack Up Against the Professionals’. Keep tabs on our Deep Dives every Wednesday for new and exciting content!
Sam van de Schootbrugge is a Macro Research Analyst at Macro Hive, currently completing his PhD in international finance. He has a master’s degree in economic research from the University of Cambridge and has worked in research roles for over 3 years in both the public and private sector.
Awesome collection of Macro hive’s deep dives…. one of my favorite things to look forward to every week!