LO 63.2: Explain how different macroeconomic risk factors, including economic growth, inflation, and volatility affect risk premiums and asset returns.
Macroeconomic factors, such as increasing inflation or slowing economic growth, affect all investors to varying degrees. Most, though not all, investors are hurt by rising inflation, slowing economic growth, or both. But it is not the level of the factor that matters, it is the shock (i.e., unanticipated changes) to a factor. For example, asset prices generally fall when inflation unexpectedly increases. Economic growth, inflation, and volatility are the three most important macro factors that affect asset prices.
Economic Growth
Risky assets like equities generally perform poorly during periods of low economic growth. Less-risky assets like bonds, and especially government bonds, tend to perform well during periods of slow growth. For the investor who can weather a downturn easily, she should invest in equities because returns will be greater over the long run. Periods of stronger growth generally last longer than downturns. For the investor who cannot bear large losses during a period of slow growth, she should invest in bonds. Fler portfolio will likely perform better during the downturn but worse in the long run.
Figure 1 reports the returns of large and small stocks, as well as government, investment grade, and junk (high-yield) bonds during expansions and retractions as defined by the National Bureau of Economic Research (NBER). Returns are from Ibbotson Morningstar and cover the period 1932 through 2011. During periods of recession, government and investment grade bonds outperform equities and high-yield bonds, yielding 12.3% and 12.6%, respectively. During expansion periods, equities outperform bonds with large stocks yielding 12.4% and small stocks yielding 16.8%. Fligh-yield bond returns appear indifferent to changes in economic growth, yielding 7.4% in recessions and 7.7% in expansions.
Figure 1 also reports returns based on quarter-on-quarter real GDP growth and quarter-on- quarter consumption growth (i.e., real personal consumption expenditures). The patterns are similar to those exhibited by NBER expansion/recession data. Equities outperform in periods of high real GDP growth and high consumption growth, while bonds outperform in periods of low real GDP growth and low consumption growth. High-yield bonds perform slightly better in high-growth periods.
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Topic 63 Cross Reference to GARP Assigned Reading – Ang, Chapter 7
Figure 1: Investment Returns During Expansions and Recessions
Large Stocks
Small Stocks
Government
Bonds
Investment
Grade
High Yield
Corporate Bonds
Returns
Full Sample Business Cycles
Recessions Expansions
Real GDP
Low High
Consumption
Low High Lnflation
Low High
11.3%
5.6% 12.4%
8.8% 13.8%
5.6% 17.1%
14.7% 8.0%
15.3%
7.8% 16.8%
12.2% 18.4%
5.6% 25.0%
17.6% 13.0%
7.0%
12.3% 5.9%
10.0% 3.9%
9.6% 4.4%
8.6% 5.4%
7.0%
12.6% 6.0%
9.7% 4.4%
9.1% 5.0%
8.8% 5.3%
7.6%
7.4% 7.7%
7.0% 8.2%
7.1% 8.2%
9.2% 6.0%
In terms of volatility, both stocks and bonds are more volatile during downturns and periods of low growth. For example, large stock return volatility was 23.7% during recessions and 14.0% during expansions. Government bonds perform best during recessions but are also more volatile during these periods (13.3% volatility during recessions and 9.3% volatility during expansions).
Inflation
High inflation is generally bad for both stock and bond prices and returns. Figure 1 indicates that all categories perform better in low inflation versus high inflation periods. Volatilities are also higher in high inflation periods. Large and small stocks return 14.7% and 17.6%, respectively, during low inflation periods, and 8.0% and 13.0% during high inflation periods. Bond yields of 8.6%, 8.8%, and 9.2% (government, investment grade, and high-yield bonds, respectively) during low inflation periods exceeded returns during high inflation periods by approximately 3.0%. Bonds are fixed payment securities. As such, it is clear that bonds should perform poorly in high inflation times. Inflation lowers real bond returns. It is less clear that stocks perform poorly in high inflation times since they represent ownership of real, productive companies, not a claim to a stream of fixed cash flows.
Volatility
Volatility is an important risk factor for many asset classes. The CBOE Volatility Index (VIX) represents equity market volatility. The correlation between the VIX and stock returns has historically indicated a negative relationship (correlation coefficient of 0.39 between 1986 and 2011). This means that stock returns tend to drop when the VIX (equity volatility) increases.
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Topic 63 Cross Reference to GARP Assigned Reading – Ang, Chapter 7
The financial leverage of companies increases during periods of increased volatility because debt stays approximately the same while the market value of equity falls. The negative relationship between stock returns and volatility is called the leverage effect. As financial leverage increases, equities become riskier and volatility increases. Additionally, higher volatility increases the required rates of return on equities, pushing stock prices down. Thus, there are two paths to lower stock returns resulting from higher volatility: 1. When market volatility increases, the leverage effect suggests a negative relationship
between stock returns and volatility.
2. When market volatility increases, discount rates increase and stock prices decline so that future stock returns can be higher (to compensate for the higher volatility). The capital asset pricing model (CAPM) supports this second path.
Other Macroeconomic Factors
Other macroeconomic factors, including productivity risk, demographic risk, and political risk, also affect asset returns. Productivity shocks affect firm output. In periods of falling productivity, stock prices fall (like in the 1960s and 1970s). In periods of improving productivity (like the 1980s and 1990s computer revolution) productivity shocks are positive and stock prices generally increase. The correlation between productivity shocks and stock returns is relatively high (approximately 30%).
New models, called dynamic stochastic general equilibrium (DSGE) macro models, indicate that economic variables change over time due to the actions of agents (i.e., consumers, firms, governments, and central banks), technologies (and their impact on how firms produce goods and services), and the way that agents interact (i.e., markets). A benchmark model created by Smets and Wouters (2007)1 specifies seven shocks that impact the business cycle. They are: (1) productivity, (2) investment, (3) preferences, (4) inflation, (3) monetary policy, (6) government spending, and (7) labor supply.
Like productivity shocks, demographic risk, which can be interpreted as a shock to labor output, is a shock to firm production. Economic overlapping generation (OLG) models include demographic risk as a factor affecting investor returns. In these models, generations overlap. Young, middle-age, and retired workers exist in a system. Workers earn income and save during the young and middle-age stages. Retired workers disinvest. As a cohort progresses through life, they join others already in the cohort but born at an earlier time. According to several OLG models, events that shock the composition of the cohort, like World Wars I and II, infectious diseases, like the Spanish Flu of 1918, and the baby boom, which followed World War II, impact returns. For example, one model predicts that stock prices will fall when baby boomers retire as they liquidate assets to fund consumption. This would occur if there are relatively fewer young and middle-age investors to offset the asset liquidation of retirees. If there are a greater number of young and middle-age workers, relative to retirees, the impact will be lessened (or even overcome). Another study shows that risk aversion increases with age and that as the average age of the population increases, the equity risk premium should also increase. Note that it is important to use cross-country data in demographic studies. 1
1. Frank Smets and Rafael Wouters, Shocks and Frictions in US Business Cycles: A Bayesian Dynamic Stochastic General Equilibrium Approach, American Economic Review 97, no. 3 (2007): 586-606.
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Topic 63 Cross Reference to GARP Assigned Reading – Ang, Chapter 7
Political (or sovereign) risk, once thought only important in emerging markets, increases risk premiums. The financial crisis of 20072009 made clear that political risk affects both developed and undeveloped countries.
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