These insights merely scratch the surface of the macro-market connections that have been identified. Useful as they are, there's nothing particularly surprising here. It's widely known that economic risk explains some of the better-known sources of excess return, such as the small-cap and value stock premiums. The celebrated research by professors Eugene Fama and Ken French in the 1990s theorized as much, and plenty of follow-up analysis strengthens that view. For example, one study quantitatively profiles the extent of the link between small-cap and value factors and the business cycle ("Can Book-to-Market, Size and Momentum Be Risk Factors That Predict Economic Growth?" by Jimmy Liew and Maria Vassalou, Journal of Financial Economics, August 2000).
As researchers keep digging, the details on the interaction of markets and macro continue to yield informative results. Consider "The Cyclical Component of U.S. Asset Returns," a working paper in which David Backus and his co-authors outline "the common tendency for excess returns to lead the business cycle." The evidence "suggests a macroeconomic factor in the cyclical behavior of asset returns and the equity premium in particular." The study analyzes the correlation between U.S. equity returns and industrial production over the past 50 years and finds that relatively high equity premiums tend to be followed by stronger growth in industrial production within a year.
The relationship over the past half century is illustrated in Figure 1, which summarizes the correlation profile between annual changes in the equity market and subsequent annual changes in industrial production, a proxy for the broad economy. Note the tendency for correlations to rise ahead of increases in industrial production. The process generally reverses itself after industrial production rises. The basic message: High equity returns imply high economic growth in the near future and vice versa.
A similar relationship holds with yield spreads and industrial production. "Roughly speaking, the evidence suggests that several months before an increase in economic growth, returns on equity rise and the return on the short bond falls," the study advises. "If we put the two together, we see that changes in economic growth are preceded (on average) by an increase in the expected excess return on equity; that is an increase in the equity premium."
What's the economic logic? Backus (a finance professor at New York University and a research associate at the National Bureau of Economic Research) provides one possible scenario. In an interview with Financial Advisor, he explained using an approaching cyclical downturn as the setup.
"You can imagine there being two types of agents in the economy," he said. "You have people who are very risk averse and people who are not so risk averse. If something happens that [diminishes the influence of] the not-so-risk averse people, it's going to be the more risk-averse people who are pricing the assets and the price of risk is going to go up. You can think of that as being a streamlined metaphor for the financial system that suddenly gets squeezed, and so those are the people bearing a lot of risk. Now all of a sudden they bear the risk because they basically run out of money. That means some other sectors of the economy have to bear this risk. That's going to widen spreads. If you feed that into a macro model, all of a sudden people are going to stop investing. Why? Because the cost of financing investment just went up a lot. Investment is inherently risky, and we're going to price that in a way that's a lot less attractive."
It's no secret that markets offer clues about future turning points in the economic cycle, although the flow of intelligence can be thought of as a two-way street to a degree. Forecasting equity returns, for instance, is a function of the current state of the economic cycle, according to "Business Cycle Variation in the Risk-Return Trade-off," a working paper by professors Hanno Lustig and Adrien Verdelhan, both of whom are also NBER researchers. "Average equity excess returns are higher during recessions than during expansions," they write.
Crunching the numbers on more than a half century through 2009, Lustig and Verdelhan show that risk-adjusted equity returns (based on one-year holding periods) generally rise for a period of up to roughly seven months after the economy peaks, based on official NBER cycle dates. The pattern holds in reverse during expansions: Excess returns fall for about half a year once the economy starts growing again in the wake of recessions. Comparable patterns are found in other large economies.
Regime Change
Monitoring the economic cycle and risk premiums simultaneously provides one level of strategic analysis, but some researchers assert that there's another level of macro-market connectivity to consider. The regime, as economists say, matters too.
Fluctuations in risk premiums seem to coexist within longer-term periods of macroeconomic volatility. Risk premiums rise and fall in the short term based on the economic cycle. At the same time, the magnitude of those changes appears to be dependent on the prevailing state of economic risk-the regime.