Macro consensus and understanding market-implied macro pricing

It is well-established that asset prices embed market consensus expectations. Depending on which asset we looking at, prices reflect expectations of company fundamentals, monetary policy rates, inflation, and a range of other drivers. Understanding what is priced into assets, and how the market’s macro consensus expectations evolve over time, is a key foundation for asset allocation and active macro investing.

These expectations cannot be observed directly, however. There are some useful gauges of consensus estimates on companies’ earnings (e.g. Visible Alpha, I/B/E/S), or macro variables (e.g. Consensus Economics, Survey of Professional Forecasters), but they provide an incomplete picture especially for long-duration assets such as equities and long-term bonds.

The main issue is that these consensus estimates are focused on the outlook for next few years. For understanding prices of assets such as equities and long-term bonds, we need to understand macro consensus expectations over much longer horizons. In addition, these consensus estimates do not cover macro drivers beyond output growth/earnings that determine asset prices, and investors need to gauge the market consensus for them too. Finally, there is no guarantee that consensus estimates are consistent with market pricing, and there are present-value relationships that impose discipline on how consensus expectations impact market pricing.

We apply models that exploit discounted cash flow logic (DCF), applied at an asset class level, to extract macro consensus expectations of macro drivers from market prices. We break down asset returns to underlying drivers such as the market consensus about dividend growth, real rates, inflation expectations and risk premiums across horizons and to track the evolution of these drivers over time.

Applying DCF logic to extract market-implied expectations

Although many investors are used to building DCF models for individual companies or deals, the same logic applies at an aggregate level for equities, bonds, or any other asset class. Instead of building a DCF model by forecasting cash flows and discount rates to arrive at an estimate of fair value, we reverse this process.

We combine current market prices with DCF logic to extract market expectations about the components of pricing in equities and bonds. We refer to the outputs from this implementation of DCF logic at the asset class level as “market-implied macro“.

We apply proprietary modelling frameworks across a range of asset classes, that use a broad range of forward-looking data such a futures, swaps, options, and surveys. In essence - where we have data - we can fill in short- or long-term macro consensus expectations and risk premiums in the DCF formula. We then estimate complete term structures of expectations by ensuring discounted cash flows align with the market price. Since we use forward-looking data, we can produce term structures of macro consensus estimates daily, giving investors a timely gauge of what's priced into markets.

Investors and asset owners lack commercially available solutions that provide timely and robust coverage of market-implied macro pricing. While there are models used by investors that are based on similar DCF logic, they tend to impose strong assumptions on term structures, make little use of forward-looking data, and are not commercially available.

Using market-implied macro estimates: making sense of markets and changing macro consensus under the Trump presidency

We have seen significant volatility in markets in the past weeks and months. In volatile times, it is useful to have timely gauge of market-implied macro pricing. Given the American origins of market volatility, we provide some snapshots of how our US estimates have changed in the recent past.

In the first two charts below, we show how the market consensus has shifted for expected dividend growth and the corresponding risk premiums for the S&P 500 index, since Donald Trump was elected US president.

The charts indicate that the policies of the new administration have significantly lowered the growth outlook over the short- and medium-term, while long-term expected dividend growth has remained stable, perhaps even increasing marginally. These term structures show the degree to which investors have revised down expected corporate cash flows over the next few years, and how persistent these impacts are expected to be.

The growth moves are mirrored in the risk premium term structures, shown below. Short-term risk premiums have jumped significantly while the risk premiums attached to long term dividends have dropped a little. This tells us that even though investors are applying higher discounts to shorter-term cash flows, they still assign high valuations to long-term cash flows.

Overall, this suggests the market-implied consensus still has relatively bullish elements despite the market sell-off. This picture at longer horizons means there is still significant potential for large market declines if long-horizon growth expectations and risk premiums were to reprice. We can see evidence of markets pricing increased downside risk in option markets. The option-implied distribution for the index level, shown in the chart below, has shifted to the left and re-shaped to price a large left tail. Even after a downward move in the S&P 500 index level between the two dates, the likelihood of extreme negative outcomes has increased drastically.

In addition to covering macro consensus expectations and probability distributions, our models also break down how day-to-day changes in macro consensus account for market price moves. The chart below decomposes daily returns on the S&P 500 index into repricing of expected dividend growth, risk premium and the yield curve.^[1] Yield curve and risk premium moves tend to partially offset each other, thus reducing return volatility. Periods where they do not offset generate sizeable realised returns.

Asset allocation solutions guided by macro consensus

We provide asset allocation solutions that all derive in some form from identifying macro consensus pricing. As a standalone solution - Market-implied Macro - we deliver daily market-implied estimates of macro consensus, decompositions into market drives, option-implied distributions, and risk premiums. We also cover market-implied equilibrium real interest rates and long-term inflation trends.

Macro consensus is also a central part of our new generation Capital Market Assumptions (CMA), in which estimates of expected returns are aligned with the current market pricing. Macro Risk Factors are derived directly from macro consensus: where changes in expected dividend growth across horizons constitute a “growth” factor; changes in the risk premiums an “equity risk premium” factor, etc. Finally, macro consensus is also central to our Macro Scenario Analysis, where the market-implied macro fundamentals serve as a starting point for creating scenarios. We create scenarios by translating narratives to shifts in macro drivers away from the market-implied levels, which allows for us to provide a coherent price/portfolio impact.