Interest rates play a crucial role in forecasting business conditions and have a significant impact on asset prices and market direction.
The steep trajectory of short rates is a major concern for US equities, and the equity sell-off in 2022 is just the beginning of challenging market conditions.
To navigate the bearish outlook, investors should focus on style factors like quality, profitability, and low beta, and consider US-centric investments.
Deep dives
Framework for Forecasting Markets
Francois Trejan developed a framework based on econometric models and leading indicators that have proven to be reliable in forecasting market direction. He emphasizes the importance of changes in interest rates as a key variable that leads the business cycle and provides information on future market movements. This framework has helped him anticipate challenging times for risk assets, distinguishing crisis episodes like the 2008 Global Financial Crisis from bear markets experienced in 2001 and 2022. Trejan forecasts a bearish outlook for U.S. equities due to the steep trajectory of short rates, and he believes that the equity sell-off in the past year is just the beginning of more challenging market conditions to come.
Implications of Fed Tightening and Economic Slowdown
Trejan's analysis highlights the potential negative impact of rapid Fed rate hikes on economic growth and asset prices. He points out the historical pattern where Fed tightening in a slowdown leads to an eventual decline in earnings for companies. Trejan believes that the impact of rate hikes takes time to fully materialize, with about a two-year lag before the effects are reflected in economic indicators such as GDP and S&P earnings. He predicts that the decline in U.S. equity markets seen in 2022 is just the beginning, and that 2023 will bring further challenges as profits fall due to the lagged impact of rate increases.
Investment Recommendations for Challenging Market Conditions
In light of the bearish outlook, Trejan suggests specific investment strategies to navigate the market conditions. He advises focusing on factors like low beta, quality, profitability, and US-centric investments. Low beta or countercyclicals tend to be less sensitive to economic downturns, while quality and profitability factors can provide stability during challenging times. Additionally, investments focused on the domestic market are recommended as they tend to perform better in a global downturn when the dollar appreciates. Trejan believes that the next bear market rally will be short-lived and encourages investors to position their portfolios accordingly.
Understanding Business Cycles and Housing Indicators
Trejan's framework is based on understanding the business cycle and key indicators that are leading indicators of economic and market conditions. He explains that business cycles are often driven by changes in interest rates, and housing indicators can offer valuable insights into the future direction of financial markets and the economy. Housing indicators, such as building permits and home builder sentiment, tend to react earlier to changes in rates and can provide a window into future economic prospects. By studying the historical relationship between interest rates, housing, and financial markets, Trejan has gained confidence in the predictive power of his framework.
Introduction to the Macro Specialist Designation
In addition to his market analysis, Trejan is also working on the Macro Specialist Designation, an education initiative that aims to bridge the gap between academia and the knowledge required for successful investing in the financial industry. The program, structured similarly to the CFA designation, offers participants three levels of online courses and exams. The Macro Specialist Designation focuses on teaching macroeconomic principles and their application in understanding financial markets from a top-down perspective. Trejan aims to provide professionals with the tools and knowledge needed to navigate the complexities of macroeconomic factors in investment decision-making.
For Francois Trahan, early exposure to econometric models that sought to forecast business conditions illustrated the importance of changes in interest rates. Over a 25 year time frame, he’s developed a framework that utilizes variables that lead the business cycle and consistently have information content with respect to where markets are heading. We talk about challenging times for risk assets – distinguishing crisis episodes like the GFC in 2008 from bear markets experienced in 2001 and 2022. For Francois, these are all linked, with commonality in how interest rates created an economic slowdown which then left asset prices vulnerable.
Now the founder of Trahan Macro Research, Francois has a decidedly bearish outlook for US equities, very much a consequence of the exceedingly steep trajectory of short-rates, moving from essentially zero at the start of 2022 to 4.5% now. His set of macro leading indicators all point in unwelcome directions and his view is that the equity sell-off last year is just an appetizer for the challenging market conditions that approach. We walk through the specifics of his call and his recommendations that investors seeks refuge in style factors – like quality, profitability and low beta - that are typically more durable when growth is falling. If the 2022 decline in US equity markets was about a re-rating lower of the index multiple, 2023 will introduce flagging profits, largely a function of the lagged impact of rate increases that lower demand.
We finish by learning more about the efforts Francois is making in establishing the Macro Specialist Designation, an initiative designed to help professionals establish an understanding of markets and the economy from a top down perspective in a way similar to what the CFA designation seeks to offer from a bottoms up standpoint. I hope you enjoy this episode of the Alpha Exchange, my conversation with Francois Trahan.
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