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MACRO MECHANICS

Why Does GDP Growth Matter?

Macro Mechanics

PROMETHEUS RESEARCH

OCT 01, 2024

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.

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Today, we offer our thoughts on what we consider table stakes in trading markets and a
precise understanding of why Growth markets to investors.
We think that GDP Growth is particularly important to macro investors. However, the
specific measure and definition of growth are less important than the conceptual
understanding of why growth matters to macro assets, i.e., stocks, bonds, and
commodities, constantly experience price changes to reflect ongoing changes in
expectations for their demand, supply, and cash flows. At an individual level, each of
these assets has extremely specific drivers, such as earnings announcements (stocks),
interest rate policy (bonds), inventory reports (commodities), etc., all of which impact the
price for a specific asset. To an investor unaware of the impact of macro conditions,
each of these instances is highly precise, with one instance having little to do with
another. Said differently, with a zoomed-in perspective, most market price changes look
idiosyncratic.

However, what this zoomed-in perspective often misses is that what often seems
idiosyncratic is, in fact, systemic. A company may not have missed earnings solely due to
mismanagement but rather because the demand for the products of the entire sector has
decreased; the interest rate on a bond did not rise because the probability of default rose
but rather because the government raised interest rates, and perhaps orange juice
demand didn’t rise because of a lack of oranges but rather because consumers now have
increasing incomes.

In essence, what a macroeconomic approach seeks to do is to zoom out to smooth

out the noise coming from the idiosyncracies of an individual asset, and aggregate
 the signal for entire asset classes.

This macro-perspective allows you to capture the factors that are not just driving one
asset but all of them. What that means for investors is twofold: you can have a more
diversified set of positions by focusing on macro, and you can spend most of your time
focusing on the principal driver of assets rather than a litany of less important drivers.
The combination of these creates tremendous portfolio benefits, as macro drivers
account for the majority of variance in asset markets. Focusing on whether macro
conditions are supportive or detrimental will deliver the best portfolio improvements to
most investors by reducing idiosyncratic noise and increasing systemic signal.

The most important macro driver of asset markets over time is economic growth.

More rigorously, we define growth as the mosaic painted by income, spending,

production, and employment measures. We find this mosaic best captured by GDP
growth. GDP growth is the widest definition of economic growth across countries,
accounting for domestic spending by households, businesses (profit & nonprofit),
governments, and foreigners. The other side of the GDP accounts is GDI, which
accounts for the incomes that finance the ongoing spending recorded in GDP. These
two measures of activity are two sides of the same coin and are conceptually equal at all
times in an economy. If we adjust these measures for inflation, we obtain total output,
i.e., real GDP & GDI. Finally, central to all of this output is the labor market. Employees
are at the center of the circular relationship between income & spending. Without a
growing labor market, incomes can’t grow much, which, by definition, weighs on
spending. This centrality of labor markets makes output and incomes inextricably
linked.

A holistic approach to macro tracks all of these variables, but it is also important to
recognize that due to their interlinked and circular nature, GDP does an excellent job of
capturing the dynamics happening across them. Crucially, this discussion is not about a
specific measurement provided in the NIPA accounts, released with a one-quarter lag.
This discussion pertains to the concept of GDP as a comprehensive measure of
economic activity. The timeliness of this measure can be employed through nowcasting
models, which we use extensively.
We can now turn to how these GDP conditions flow to asset prices. All changes in asset
prices are a function of changes in expectations for the demand, supply, and cash flows
associated with the asset. GDP impacts these expectations for each asset differently.
The headline GDP number rarely matters to any asset, but rather the implications for its
specific drivers. We examine them individually.

Stocks are the most sensitive to real GDP conditions. As discussed, GDP measures the
total amount of spending in the economy. This spending forms the basis for the total
potential revenues for corporations. After accounting for costs and reinvestment,
corporations may redistribute earnings via dividends or corporate buybacks. As such,
during periods of rising revenues, the likelihood of higher revenues, higher profitability,
and higher shareholder returns all increase, particularly if these increases are in excess
of what’s priced into markets. Furthermore, increasing GDP conditions create a larger
savings pool for households and businesses to invest in a given stock of existing
equities, potentiating gains. Now, we must recognize that these revenues, profits, and
shareholder payouts are nominal. However, a large part of whether businesses are
generating significant profits or not depends on whether they are seeing sales increase
at a pace faster than their input costs increase. Thus, it is rare for businesses to increase
their revenues durably solely based upon price increases in the macroeconomy because
costs tend to be commensurate with the rice in sales prices. As such, the best outcomes
for equities come from rising sales and rising output, which translates to rising profits.
The converse is also true, where falling output, sales, and profits hurt equities
dramatically. Avoiding these periods is a key focus for macroeconomic conditions.

Bonds are indirectly affected by GDP conditions. Unlike stocks, where cash flow from
GDP to earnings directly determines price outcomes, bonds are not directly affected by
GDP conditions. But rather, bond prices are premoninantly driven by expectations of
monetary policy by the Federal Reserve. The Fed seeks to protect the economy from
outlier macroeconmic events, particularly, excessive inflation or deflation, and extreme
weakness in labor markets. The Fed moves monetary policy based upon evolving
macroeconomic data, which determines the majority of bond yields. As such, bond
markets are highly responsive to what growth conditions mean for labor and inflation,
and the Fed’s reaction function to these conditions. Furthermore, bonds are a fixed
income asset, and changes in the economy make this fixed rate of income look more or
less attractive in comparison. During a rising nominal GDP environment, where output
is rising and equities are seeing rising expected payback to shareholders, the value of a
fixed income payment begins to look less attractive. During periods of recessionary
GDP, the fixed cash flows provided by bonds begin to look far more attractive. As such,
while bond markets do not receive a direct compensation or cost from GDP, the Fed’s
reaction function to growth conditions and inflationary pressures makes bonds move
countercyclical (better when the economy is weaker, and worse when the economy is
stronger).

Commodities depend on nominal spending. Unlike equities and bonds, commodities

have no cash flows associated with them. As such, the primary linkage for commodities
to the economic cycle is through the simplest and most fundamental relationship:
demand and supply. The productive capacity to make commodities is a relative slow
moving component of the economy, i.e. it takes a long time to move supply upwards.
However, the demand for commodities can be quite flexible, because companies and
individuals and borrowing money to amplify their purchases near instantaneously. As
such, commodity prices are highly sensitive to the ongoing changes in nominal GDP
conditions. Particularly, commodities are responsive to the rate of change of nominal
growth conditions than the ongoing level of growth. Nominal growth accelerations can
only be met with a limited about of commodity production increases, after which point
there becomes a significant demand and supply mismatch. As such, signficant
accelerations and declerations in nominal GDP result in strong and persistent
commodity price pressures to the upside and downside.

Given the centraility of macro conditions to portfolio outcomes, and the nuanced
linkages of GDP to all macro assets, we thing that a strong Growth conditions should be
prioritized by all investors. Consistent with thes principles, we have built our systematic
process around having both a rigorous understanding of growth conditions, but also it’s
nuanced transmission mechanism to various asset markets.

In a recent interview, Aahan, the Founder and CEO of Prometheus, joined Felix Jauvin
on Forward Guidance to discuss our macro outlook, which is consistent with these
principles. We highly recommend giving this a watch if you haven’t already:
 Slowing But Growing: Why The U.S. Isn’t Headed For Recession | Promet…
Promet…

Until next time.

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General Gen X Oct 2 Liked by Prometheus Research

Outstanding work! Very thorough and thoughtful, and most importantly, helpful for those of
us who want to go deeper on your process. I can’t wait for the next piece!

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Odin Oct 2

Great piece! Can we have more going forward perhaps on leading, lagging indicators, futures
and options positioning. Thanks

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