Minding the gap between short-term and long-term trends

The Invesco Multi Asset team believes that identifying investment opportunities requires a comprehensive view of economic and market dynamics – one that accounts for short-term, cyclical drivers but also looks beyond to incorporate longer-term, structural trends. We believe a two- to three-year time frame can help account for both types of trends to reveal attractive investment opportunities. In this blog post, we explain why.

Cyclical versus structural drivers

First, let’s define what we mean by structural versus cyclical drivers.

• Cyclical drivers, or indicators, tend to be more volatile, reflecting shorter-term changes. For example, the Purchasing Manager Indices (PMI), which reflect growth in the manufacturing sector, are a cyclical indicator of economic recovery

• Structural drivers are typically slower-moving factors that can reflect longer-term, secular changes across economies and markets. At the macroeconomic level, one such example is public debt, which is accumulated over an extended time period and may take an even longer period to unwind

Case study: Bond yields

Let’s explore an investment opportunity in bond yields around the fall of 2010, and the potential impact of considering both cyclical and structural drivers. Historically, bond yields have tended to rise during periods of economic growth, as increased economic activity creates upward pressure on inflation and increases the demand for borrowing.

• Cyclical signals. In the period following the 2008 financial crisis, short-term indicators like the PMI signaled the economy was moving toward recovery. Expectations of higher inflation and increased borrowing would then suggest higher bond yields. But that conclusion would fail to take into consideration the impact of longer-term factors, such as debt
• Structural drivers. Borrowing – especially in developed markets – grew rapidly in the early 2000s, leading to unsustainable levels of private sector debt in the run-up to the financial crisis. Historically, unwinding these heavy debt burdens has been a major component of post-crisis periods. Such episodes of deleveraging have often been protracted and complicated, and have weighed heavily on the pace of economic recovery, as credit creation slows dramatically. New banking regulations introduced after the 2008 crisis compounded that effect, further reducing credit creation. Other structural drivers such as demographics and quantitative easing created additional downward pressure on yields.

An intermediate time period of two to three years to evaluate an investment opportunity – such as this one in bond yields – provides the team with the appropriate framework to consider a more complete investment picture.

Incorporating a medium-term outlook into our investment process

Examples like these help confirm our belief that taking a two- to three-year view is the most appropriate for our investment process. We believe this time frame has the potential to uncover investment opportunities by taking into consideration both structural and cyclical economic drivers, especially if other market participants are exclusively focused either on shorter-term views or much longer-term, mean-reverting valuations.

This perspective is imbedded into every step of our TEAM investment process, which suggests that for every investment idea considered, the sponsor of the idea needs to lay out the: (T) Theme of the idea; (E) Economic drivers; (A) Analytics and valuation supporting the idea; and incorporate the views of the relevant Invesco managers (M) outside of the Multi Asset team to reflect the views of a bottom-up, asset-class specialist.

Conclusion

In financial markets, accounting for and considering both structural and cyclical drivers can help reveal investment opportunities. In order to identify these opportunities, an appropriate time frame – one that captures both types of drivers – must be defined. We believe this time frame is reflected in a two- to three-year period, which is an under-researched outlook in the marketplace.

This time frame is a critical component of our investment process. It not only helps shape our view of the markets and the economy in the intermediate term, it helps us identify and vet investment ideas that are considered for the strategies we manage. Generating a comprehensive picture of the investment landscape represents one way in which the team can distinguish its approach to investing.