Economic Regimes and Asset Allocation: A Primer

I used to spend all day in front of my trading platform. It was part of my job, scrutinising every tick in the bund futures market back in 2008-2009 (heady days to be a prop trader). I had to be in the market, constantly trading in and out of positions in the hope that at the end of the day I would be ahead. My emotions would flow with the market. I now spend about 1 minute a day looking at my portfolio. Market movements now elicit a slight curiosity rather than a full-blown anxiety attack. Executing portfolio re-balance trades is now just a chore, I have zero emotional reaction.

What changed?

I began to formulate methods to peer through the noise. My focus shifted away from micro market dynamics towards portfolio construction. Trading through the last great recession made it readily apparent that no single asset class performs across all economic conditions.

Static asset allocation is not sufficient in a dynamic economic environment.

You don’t need to forecast

Economic regime change signifies that the future is going to change. This is not forecasting. The only way to accurately forecast is if you have an informational advantage. Arguably, this is possible in very short time frames such as high frequency trading but the advantage is not available to the vast majority of market participants. The ability to reliably forecast markets is an illusion. Despite this, there is still a way to gain an edge.

You just need to know when the future is going to change.

For example, a regime shift into a low growth & deflation environment signifies that equity markets will under perform compared to other asset classes like bonds and precious metals.

Recession Proof

A regime-based asset allocation strategy adapts to economic conditions. Throughout 2008 – 2009, an investment in the SPY ETF lost over 50%. In contrast, a portfolio based on regime allocations returned approx 12% in 2008 and 19% in 2009 with a maximum drawdown of only 5%. Proper regime based asset allocation not only limits drawdown in recessions, the returns are often strongest under conditions that would decimate a static portfolio.

Once you know the active regime, you have a variety of asset allocation options. At the most basic level, you could simply carry a portfolio heavily weighted in equity markets in periods of economic growth and moderate inflation, then move into cash as the regime shifts into low growth / deflation. This is a purely defensive play. Alternatively, you can move into asset classes like short duration bonds and precious metals that perform well in low growth regimes.

Defining Economic Regimes

To read more about the proprietary economic regime model check out the next article in the Start Here series: Defining Economic Regimes