If you only consult social media accounts or influencer advice about personal finance topics, you will often notice that the predominant suggestion is “Ignore everything macro” or “Macro does not matter if you are a long-term investor”. This is, unfortunately, a fallacy. Global macroeconomic developments can have a quite significant impact on individual investors’ portfolios and as such, they must be at least understood and there must be at least a basic level of awareness so that you don’t overexpose yourself to unwanted risks or be surprised by shocks that impact asset values, even over the long term.

The content of this post does not constitute financial advice. It is intended for educational purposes only.

What do we mean by macro?

In simple terms, looking at how an individual company performs, for instance, and what is driving its performance (earnings and revenue growth, the strength of its balance sheet, leverage, risk of default, etc.) is a micro perspective. Analyzing the economy at the aggregate level – its growth, rate of inflation and overall price levels, unemployment rates and job creation, policy rates and money supply, etc. – means taking a macro perspective. The state of the economy and its dynamics over time are deeply interconnected with financial market activity and therefore influence each other. For example, changes in the levels of activity can influence employment and consumer behavior – i.e., spending and saving – which, in turn, has implications for the movements of prices of financial instruments.

Financial instruments themselves are basically claims on something that exists in the underlying economy. This creates a fundamental link between the choices and decisions made by economic agents, private and public, and the performance of investment instruments, such as stocks and bonds. Unfortunately, these choices and decisions are not always driven by sound economic logic (i.e., they are not always rational), as much as economic theory likes to assume that they are. And government policies are not always driven by a proper understanding of what is happening in the economy and what needs to change, but rather by fixed ideologies that may do more harm than good. Which also what makes the macroeconomy such a complex system, very hard to predict with any precision and very difficult to always understand in its entirety, especially given the fact that it is always evolving.

The purpose of this article is not to convince individual investors that they should attempt to analyze and understand every single aspect of the macroeconomy or that they should only act based on what happens in the macroeconomy. Neither is it that individual investors should try to trade macroeconomic news and data releases to try to earn easy returns. Rather, the idea is that the macro aspects should not be ignored, they should be factored into investment decisions. Macro and policy changes can define whole decades in an economy’s development, as new economic regimes start and old ones end, which is exactly why they are so key for long-term investors.

Lately, one can hear from many influencers how it is not worth looking at anything else but the US markets (and in particular, the stock market) for investments – because the US has ‘always’ outperformed foreign markets. This statement is of course factually incorrect, as is visible in the two charts I’ve added from Goldman Sachs. The US stock market has indeed shown exceptional outperformance over the last decade since the Global Financial Crisis. And it has done so in previous periods as well. But it has not dominated every single decade in the past, and the reality is that when economic regimes change – both in the US and in other countries and regions – dominance in outperformance shifts and rotates. One just needs to look at a sufficiently long time horizon.

Understanding why this is the case and that it underpins asset returns over long periods is precisely the point of having awareness of macro matters and events. Economies might gain a relative advantage over others because they are, for instance, still developing and growing faster, have expanded the flow of credit, have become attractive due to lower labor or resource costs, beneficial treatment for new and foreign investors, high level of competitiveness and significant growth in the highly skilled labor force, etc. Not all of these factors are sustainable over the long run, and not all of them are implemented in ways that ensure there would be no malinvestment or speculative growth. Being aware of the difference is exactly what will help you protect yourself from allocating capital to an unreasonably risky country, sector, or market, much more prone to crashes or high volatility.

why is all this important?

Given the above introduction, you might have noticed several key reasons:

1. Expectations as basis for investments
Investing is a forward-looking process and as such, it requires an outlook, or an expectation, about the future performance of assets. Allocation to specific assets or asset classes should be based on expected returns, correlations, volatilities, cash flows, etc. To look at markets today is to look at an aggregate picture of both expectations for the future and investor sentiment. Both of those are influenced by new information (i.e., different from what is already known or expected) and therefore change over time, leading to reactions of market prices. For example, changes in the expected growth of the economy or profitability of companies could impact the expected future cash flows; changes in the expected path of policy rates could lead to a change in the expected long-term interest rates. Both of these would, for example, influence stock prices, as investors could view their fair value through the lens of a present value calculation (that is, discounting expected future cash flows at a rate reflective of the required return for investments with identical risk characteristics for each respective tenor). As an investor, your decisions need to be grounded in economic reality and the outlook about the path of the economy – because it is the economy’s performance over time that will help you earn those returns you are counting on to grow your wealth. And it is the economy’s problems that will contribute to higher or lower risks for your portfolio over time.

2. Cycles and investment strategy
The nature of economies is cyclical. Markets also have a cyclical behavior. But that’s not all – credit expansion and contraction are cyclical (and can amplify/deepen the swings of the business cycle); revenues, profits, and corporate costs can be cyclical; the levels of distress in various debt market segments are cyclical; risk appetite and market sentiment are cyclical; real estate is cyclical, etc. And while those cycles are often interrelated and causally linked, they need not coincide. It is not the job of a regular individual investor to be an expert in predicting the timing of the phases of those cycles – in fact, many experts fail at that task consistently. However, an individual would benefit greatly from knowing the signs and indicators by which they can recognize the phase of the cycle and the usual or extreme dynamics. The goal is to be able to identify (1) investment opportunities in each phase based on what is likely to follow, (2) assets or asset classes that may already be overvalued and should therefore be avoided, and (3) potential risks that may be realized going forward, possibly causing losses. Understanding what the cycles are and how they behave and impact asset markets is crucial for correct positioning both in the short and long run.

3. Global mega-forces and investment opportunities
At any time, there could be global megatrends – macroeconomic and geostrategic forces – shaping regional economies or the world economy in both expected and unforeseeable ways. The implications of these forces are usually broad and varied, and they create both significant opportunities, especially for investors, and potentially extremely dangerous risks that need to be managed. Some of these could change the entire structural setup of economies in profound ways that can, for instance, increase productivity or remake the setup of the labor market (e.g., AI, work from home, etc.), causing eventually some industries to diminish or disappear, and others to flourish. This is extremely important for long-term investing.

4. Global diversification and investment flows
Investing in a single economy’s stock market may be a necessary or desired choice, but it can also expose an individual investor to significant concentration risks and they can miss profitable investment opportunities. Think about the relative performance chart shown above – being aware of foreign investment options and their potential can enable you to take advantage of outperformance outside your domestic market. But that might also mean exposure to foreign exchange rate fluctuations against your domestic currency. The exchange rates themselves are often a reflection of the perceived relative strength of different economies, of interest rate and inflation differentials, of growth differentials, etc. – and hence, their moves are influenced by unexpected changes in those global macro variables. Additionally, aggregate investor sentiment and willingness to invest more or less in a given region or country can be driven by economic policies, interest rates, expected growth potential, etc. – thereby, driving an increase or decrease in aggregate investment flows. Understanding these factors and their impact allows investors to profit from such shifts in flows which are eventually impacting asset prices.

5. Knock-on effects
A move in one macro variable can have second-order effects or indirect consequences. Since the economic system is complex, it is not straightforward to predict those effects, but understanding how it works, the mechanisms it has, and how it interacts with financial markets, provides a basis to consider how one shock could potentially cascade down to economic behavior and even cause other shocks. Even if an individual investor is not able to quantify the results of those for the individual portfolio, this kind of analysis will allow them to prepare for and protect themselves against the risks related to them. For example, a war that causes oil price and gas price shocks, as well as a structural shift in energy supplies, can lead to a rise in inflation and inflation expectations, driving up not just prices but also wage growth in reaction to it, which could spin out of control. In turn, central banks could try to counteract this by raising interest rates for a long time and tightening financial conditions, leading to a sharp drop in equity and bond prices, and increased volatility for a while, unaffordability of housing and credit, and a crash in the general economy.

ECONOMIC INDICATORS

Various observable or estimated metrics/variables can be used to gauge the current state and cycle phase of an economy, and/or to anticipate the following stage of the cycle. These indicators should be used with caution as their interpretation depends on the combination of economic conditions in which they are observed, and can on occasion give a false/misleading signal. By themselves, these indicators might not tell much and they must be read in conjunction with other available information, an understanding of the origins of their development to the current levels, concurrent data and outlook surveys, and very importantly – policy intentions and decisions.

1. Leading economic indicators – they generally have turning points that precede the turning points of the overall economy, and hence are considered to be useful in predicting the economy’s future state, at least in the near term (with the caution mentioned above).

2. Coincident economic indicators – their turning points are very close to or concurrent with the turning points of the macroeconomy, and are therefore useful for the determination of the present state of the economy.

3. Lagging economic indicators – they turn only after the macroeconomy has turned. They can be used to analyze and understand the past state of the economy and how it developed until it reached its current state.

Below you will see an example list of each category of indicators.

suggested framework and practical STEPS

The best practice is to have a framework for what to monitor, when, how to interpret it, and how to react depending on the conditions and the changes. And while such a framework is beyond the scope of this post and involves some advanced understanding of what we discussed so far, below is a simple example, on what to base your analysis and decision-making process:

1. Determine the indicators you want to follow and can observe for the economies, in whose assets you will be investing
At this step you will select, and learn about the indicators, how they are constructed and what they represent, respectively how to interpret their changes and what they signal for the various types of cycles.

2. Define thresholds and anticipated impacts
Based on the knowledge gathered in step 1, you can look at historical changes and see how changes in the indicators happened in contracting vs. growing economies and how that impacted markets. You can then anticipate how different asset classes might react. Be aware that there could be surprises and historical links may not hold depending on specific conditions or fiscal/monetary policy measures.

3. Monitor data releases
Observe the trajectory, rates of change and levels of the indicators. Break down the impacts to narrow down the key drivers. Judge whether these drivers and the factors behind them can influence what you already have in your portfolio or what you are planning to add:
– would the new information change your outlook?
– would it create risks you are not willing or able to bear?
– would it make sense to go for some alternative investment or to reduce some positions?
– based on the updated outlook and risk assessment, is this investment or the portfolio as a whole still aligned with your goals, needs, and circumstances?

4. Make a decision
Based on the answers to the above questions, you might decide to invest as initially planned or change something in your portfolio. Even if there is additional risk, it could be within what you are able to tolerate.

conclusion

The constant interaction between the overall economy and financial markets means that the macro perspective should not be ignored by individual investors. Macro shocks can cause severe, sometimes quite extreme moves in asset prices, causing headaches with your portfolio at the very least, or wiping out whole positions off your portfolio and leading to material losses at worst. Learn and be aware of some key leading, coincident, and lagging economic indicators that can help you judge better what decision is reasonable for your investments.