An economic regime can be defined in a multitude of ways. In its simplest form, a regime is a set of correlated variables that exist under a specific condition. This condition is called a regime. Increasing economic growth and strong equity markets are correlated variables. When the economy enters a recession and equity markets decline, the correlation between these variables breaks down. Conditions have changed and a new regime is at play.
The relationship is intuitive: asset returns are highly dependent on the underlying economic regime. The stock market is unlikely to continue rising in periods of economic stagnation marked by falling growth, high unemployment and deflation.
Economic regimes are one of the most important, yet frequently overlooked concepts in financial markets.
There isn’t a limit to the number of economic regimes that can be defined. Some academic literature use models with thousands of regimes. I use proprietary measures of growth and inflation to derive 4 regimes:
|1||Expanding Growth, Declining Inflation|
|2||Expanding Growth, Rising Inflation|
|3||Declining Growth, Declining Inflation|
|4||Declining Growth, Rising Inflation|
There isn’t a static portfolio weighting that is optimal across all regimes.
Being able to accurately spot regime change eliminates the burden of forecasting (a questionable ability at the best of times). If we know that the Regime has shifted from Regime 1 to Regime 4, we can be confident that having a portfolio heavily weighted in equities is no longer ideal.
If we have a quantitative gauge of economic regime changes, we can shift into asset classes best suited to the current regime.
Economic regimes and the business cycle: Not the same thing
The business cycle is defined using measures of GDP, moving between expansion and recession.
In the US, periods of expansion and recession are determined by the National Bureau of Economic Research (NBER). Given that asset returns are strongly correlated with economic expansion, can’t we simply use NBER data to avoid the recessions? Unfortunately, it’s not that simple because the NBER only classifies a period as either expansion or recession after the fact.
Regimes on the other hand are based on more than one measure, such as growth and inflation in our model above. Using a well-designed economic regime model gives us a better chance of defining the turning points as they happen.