What’s Priced In?

The best information we can ever provide investors is the mechanics of how we think about macro conditions over time rather than what we think about them at any particular time. Consistent with this idea, we present our Macro Mechanics, a series of notes that describe our mechanical understanding of how the economy and markets work. These mechanics form the principles that guide the construction of our systematic investment strategies. We hope sharing these provides a deeper understanding of our approach and ongoing macro conditions.

Let’s begin with how what’s priced determines beta. Recall that we define beta as the expected return for holding an asset at the opportunity cost of consuming or buying other assets as compensation for the inherent risks embedded in the asset’s economic biases.

Every beta (stocks, bonds, commodities) derives its expected return from two factors: its implicit economic bias and the uncertainty around achieving the macro environment the asset is biased toward. These factors create a discount in the current price of an asset to its future expected value. The discount in the price today reflects the uncertainty that the asset may not experience a favorable economic environment tomorrow. This discount reflects the expected return that investors can expect to achieve by holding the asset despite its risks. This expected return is often referred to as a risk premium. Crucially, these risk premiums are inversely related to returns, i.e., the weaker the performance of an asset, the higher the risk premium on that asset. Of course, this relationship requires that the fundamental nature of the asset has not shifted.

These risk premiums exist across macro markets and are an integral part of market structure. Said differently, risk premiums cannot be arbitraged away by market participants because markets are structured to create long-term demand/supply imbalances in favor of buyers of assets. Without persistent risk premiums over time, investors would not be enticed to invest in assets, and borrowers would not be able to access capital markets. As such, compression or expansion of risk premiums is a self-correcting mechanism. If the risk premium on an asset is too high relative to its risk, investors will flock to that asset, increase its price, and simultaneously decrease its expected return. On the other hand, if the risk premium on an asset is too low, it will see outflows and increased issuance. What risk premium is too high or too low? There is no precise number that determines the fair value of an asset and its corresponding risk premium over time. However, it is crucial to recognize that all risk premiums exist relative to one another. As such, what determines whether a risk premium is too high or too low is dependent on where other risk premiums are just as much as the level of risk premium relative to itself. The relative attractiveness of risk premiums versus each other and their self-correcting demand & supply forces is what drives the mean reversion characteristics of macro markets.

Every asset’s premium has its own specific drivers. These risk premiums are discounted in current asset prices to reflect uncertainty of expectations for the future. We expand on this discounting for each asset class.

Commodity market risk premiums depended on the term structure of commodities, i.e., the difference in expectations baked into commodities futures relative to the prevailing spot price. Investors are rewarded for holding longer-dated contracts when spot prices are elevated due to demand short-term demand conditions. These demand conditions are driven by the intersection of the pace of nominal GDP growth and the supply of commodities.

Treasury market risk premiums depend on the expectations for policy rates over the life of the bond. Policy rates are largely dependent on interest rate policy expectations set by the Federal Reserve, which responds to GDP conditions. In particular, the Fed responds to heightened inflation by hiking policy rates and contracting employment by cutting policy rates. Since the economy largely expands over time, markets largely discount rising interest rates over time, reflecting the potential for policy tightening over the future.

Stock market risk premiums are largely driven by the expectations around the total shareholder return generated by businesses. This shareholder return can be in the form of dividends or buybacks. This shareholder yield is largely a function of the ongoing earnings of corporations. These earnings are driven by both the level and composition of GDP. Given the natural drift upwards of the economy via population and productivity growth, typically, expectations are for earnings to rise over time. However, corporations guide expectations in a manner that allows them to surprise those expectations, cognisant of the impact of outperforming expectations.

The combination of risk premiums reflected in each of these markets combine to paint the picture of what’s discounted in macro markets. However, in addition to these risk premiums, the recent price performance of macro markets is also indicative of macro conditions. Much like the relative nature of what’s discounted, the recent price performance of an asset matters more on a relative basis than an absolute one. Macro conditions have momentum, and when the constellation of macro markets begins to move in a manner consistent with a certain economic regime, the dynamics become self-reinforcing. For instance, rising equity markets cause a wealth effect, which creates potential spending in the economy, potentiating further earnings surprises. This self-reinforcing nature of macro conditions is what drives the momentum characteristics of macro markets.

Thus, a comprehensive picture of what’s priced in has a cross-asset assessment of changing risk premiums and evolving market trends. Quantitatively, this holistic approach accounts for the momentum and mean reversion characteristics of markets while recognizing their origins. This comprehensive understanding is what is needed to generate alpha over time. Recall that we define alpha as returns generated purely as a function of skill, independent of beta. A hallmark of alpha is positive expected returns, with a low long-term correlation to a balanced beta portfolio. A macro alpha strategy seeks to achieve independent returns by assessing one of two things: whether what’s discounted in risk premiums needs to mean-revert or whether what is priced in via current market trends needs to continue. The difference between alpha and beta is mostly that alpha strategies take an active view of what’s priced in, while beta portfolios are designed to benefit from the structural discounting of asset prices today relative to their future expected value. An alpha portfolio seeks to answer the question, is what’s priced into markets consistent with the likely path of the macroeconomy? Specifically, are stocks likely to achieve the earnings expectations reflected in their prices? Are bonds likely to achieve the expected policy path reflected in their yields? Finally, are commodity markets likely to achieve the path priced in by their term structure?

An alpha portfolio seeks to constantly assess whether what’s priced into macro assets creates a return profile that is largely unrelated to an underlying beta portfolio of those assets. This lack of correlation is because the beta portfolio is designed to benefit from the structural discount embedded into asset prices over time. However, an alpha portfolio seeks to capture inefficiencies in what’s priced in at a particular point in time. An alpha portfolio seeks to benefit from changes in what is priced rather than benefit from what’s already priced.

This relationship, if leveraged appropriately, creates extremely strong diversification potential. For instance, if an asset is extremely rich, to the extent that they are now likely to have negative expected returns versus other assets, an alpha portfolio that successfully shorts that asset will be an immense value add to a long-only beta portfolio. Doing this requires both a precise understanding of what’s priced in and whether it is likely to continue.

Successfully assessing what’s priced in requires a careful examination of what’s discounted via risk premiums, cross-asset trends, and an evaluation of the likely trajectory of the macroeconomy. This assessment of what’s priced in is the bridge between beta and alpha.