Using macro scenarios to understand portfolio risks and positioning

What are macro scenarios and why are they useful?

Macro scenarios are tools for thinking through counterfactual macro environments and how individual assets, asset classes or portfolios perform under these environments. Scenario analysis is an essential component of investment processes and risk management.

Scenarios help us understand how macro conditions can plausibly evolve and how portfolios/strategies would perform. This exercise attaches specific narratives to the distribution of performance outcomes. Long-term investors can assess whether these risks are tolerable when setting strategic asset allocations, and portfolio managers can understand whether scenario outcomes align with their tactical views.

Important features of scenario frameworks

Scenarios are often heavily shaped by historical episodes and data. However, they are much more useful when they can represent future investment outcomes that are different from what happened in the past. It is more feasible to construct ’forward-looking’ scenarios when a scenario framework has several key features.

First, it is important that assets and asset classes are viewed as bundles of exposures to underlying macro drivers. With this view, we can use factors as core building blocks to represent the key risks in an asset or portfolio. As a result, a good scenario framework accounts for the overlapping exposures of asset classes to underlying macro drivers.

Many scenario frameworks represent macro drivers through traded asset class proxies. For example, expressing macro scenarios in terms of changes in long-term government bond yields or equities does not account for common drivers of asset classes and can therefore lead to misleading outcomes.

Second, asset prices reflect investors’ current expectations about the evolution of macro drivers. This implies that the natural starting point for creating a scenario is the current market pricing of all macro drivers. For example, to gauge the impact of a downward shift in inflation expectations, the correct starting point must be the current inflation expectations across horizons implied by market pricing. Nevertheless, existing macro scenarios rarely start from the market-implied macro consensus that is reflected in asset prices. Failing to do so distorts the estimates of portfolio impact.

Finally, a scenario framework needs to distinguish between transitory and permanent shocks. While transitory shocks dissipate within quarters or few years, persistent shocks impact cash flows far out in the future. As a result, they are much more consequential for long-duration assets such as equities, real estate and long terms bonds. In addition, statistical properties of short- and long-horizon expectations tend to differ significantly-- short-horizon expectations tend to be more volatile while long-horizon expectations tend to move slowly over time. Sticking with inflation expectations, short-horizon inflation expectations are much more volatile but less consequential for long-duration assets than the long-horizon expectations which tend to move slowly over time. This follows from using present-value models to understand how changing expectations affect asset prices. It also provides an extra discipline to forming macro scenarios.

Despite the importance of the distinction between persistent and transitory effects, explicit and precise modelling of term structures is rarely done in the current scenario frameworks.

Building macro scenarios

We follow a three-step approach when designing scenarios:

1. Outline a qualitative narrative for the scenario. This step is not as simple as it sounds. The aim is to set broad parameters of the scenario before attempting to quantify it. Its nature depends on the application of the framework. If, for example, an investor is interested in scenarios that are relatively likely to occur, e.g., how can the growth-inflation mix evolve over the next 12-24 months, the narrative is bound to be more precise and nuanced than a narrative for a tail risk event. The key considerations are the level of asset class or geographic aggregation, horizon and the likelihood of the scenario. It can be helpful to refer to historical episodes as a reference point, while changing the details of the episode when looking forward.

2. Translate narrative to macro drivers. The main step for designing a scenario is to express the high-level narrative into shifts in macro drivers. As mentioned earlier, it is key to consider what is already priced into markets in terms of expectations. This gives us a way to benchmark scenarios. For example, a scenario with a growth slowdown has a lesser impact on markets if growth expectations are already weak to start with. An important part of this process is to determine the direction and the magnitude of the moves in macro drivers other than expected growth. For example, if growth slows down, it is likely that real rates will fall too, which partially offsets the negative impact of growth slowdown. Determining the direction and the magnitude of the moves is guided by economic intuition, present-value restriction, historical properties of macro drivers combined with expert judgement. This can be relatively involved: in future posts we will provide case studies and examples showing how we go about calibrating scenario magnitudes.

3. Estimate portfolio impact. In this step, we map asset class returns to macro drivers. For example, equity returns are a bundle of exposures to changes in expected cash flows, equity risk premiums, real rates and inflation. Pairing up the shocks to macro drivers with the exposures delivers the portfolio impact at any level from single asset through asset class to the portfolio level.

How do macro scenarios benefit investors?

Although challenging to implement precisely, forward-looking macro scenarios are a useful tool for investors that complements other macro models and risk management. They especially add value when included alongside tools that rely heavily on historical data.

Macro investing and hedging

Scenarios help investors explore a full spectrum of near- and medium-term macro and policy outcomes, and how they impact portfolios. This leads to sharper tactical positioning and more transparent risk management. An economically intuitive and internally consistent factor structure is an ideal framework for designing macro hedging strategies, either through static adjustments to asset weights or dynamic trading programs in liquid asset classes.

Risk management

A forward-looking and consistent scenario framework provides investors and asset allocators with powerful tool for stress testing multi-asset portfolios, including those with private assets. Performing stress tests using an intuitive framework with clear links to macro drivers improves the understanding of the nature of portfolio risks for all stakeholders and leads to a better asset allocations.