Macro Risk

What is “Macro Risk”?

Macro risk refers to events that can occur within a country that impact the financial markets, such as political events or changes in government policies and taxation.

We often witness changes in asset prices or values (such as stock and bond prices) across various markets (developed and emerging), due to unanticipated demand-side or supply-side shocks (such as the global financial crisis of 2007-2009, the Covid-19 pandemic, or an unanticipated surge in oil prices), economic slowdown, recession or accelerating GDP growth, and/or inflation in an economy or economies, or major developments such as US-China trade war and Brexit among others. These are examples of macro risks, which are a type of financial risk usually associated with various types of economic factors (including political) or developments.

Key Indicators to Assess Macro Risk

Some of the key macroeconomic indicators required to gauge or assess the macro risk of an economy or economies (developed and emerging) across the globe are:

• Real GDP annual growth
• Interest rates
• Exchange rates
• Inflation indices (such as the consumer price index)
• Budget or fiscal balance
• Government debt as % of GDP
• Unemployment rates
• Housing starts
• GDP per capita
• Current account balance as % of GDP
• Government stance of monetary and fiscal policies

While assessing macro risk, it is imperative not only to take into account the aforesaid economic factors but also to analyze the global economy. The four major global economies – US, China, Eurozone, and Japan – account for over 70% of global GDP and retain significant influence on smaller countries. Key macro risk issues include the global trade in goods and services, changing global economic order, geopolitical risks, trade policy and protectionism, capital flows across borders, and international competitiveness of an economy or economies.

Why is Assessing Macro Risk Important?

Macro risks can have a significant adverse influence on investment performance or returns, as they tend to reduce aggregate demand in an economy (or economies) and weaken the economic outlook. This, in turn, can have downside implications for profit margins, earnings growth, and share prices of companies (listed on stock markets) across varied sectors.

Asset prices, such as stock prices, tend to be significantly affected by macroeconomic-related developments and risks. Such developments can affect the dividends and earnings expected from a company and it might be useful to remember that the intrinsic value of a stock depends on these two variables. According to research, 30-35% of the changes in stock prices can be attributed to economy-wide factors.

Macro risk exerts a significant influence on the magnitude of volatility in assets, portfolios, investments and intrinsic values of companies. Consequently, such risks are included in the macroeconomic scenarios constructed by institutional investors for their asset allocation process. For investors with longer-term horizons, macro risk related to stocks, funds, and portfolios and its assessment is usually of importance.

Macro risks are particularly important in the context of international or global investing. Exchange rate risk is a particularly important type of macro risk in this context. A well diversified portfolio and carefully planned risk and return trade-offs can help mitigate this macro risk.

Investors tend to improve portfolio risk-return trade-off and can lower the risk in their portfolios, without lowering potential returns through diversifying investments across different asset classes, markets, sectors and investment styles. Assessing the risks of international investing is imperative for successful diversification.

Investors have increasingly been interested in emerging markets due to the potential for higher returns than in developed economies. However, investment in such economies is usually riskier (at least, when risk is measured by the total volatility of returns) than in developed economies, as they tend to have more volatile macroeconomic environments – in terms of growth, inflation and exchange rates. This results in higher volatility vis-a-vis asset values and returns.

In an era of globalization and increasing interconnectedness of economies and financial markets, it is imperative for investors to assess “macro risk” even while investing only in assets denominated in the currency of the domestic economy. The international economy is increasingly influencing domestic GDP growth, inflation, interest rates, employment prospects, and the economic outlook of the domestic economy (for example the UK economy) – over the short, medium and long term.

Exchange Rate Risk – A Key Macro Risk

While diversifying portfolios across countries has its advantages, it does introduce unwanted exchange rate risks (i.e. fluctuations or movements in exchange rates) that can be quite unpredictable, swift or large – particularly in the context of emerging economies or markets.

This can significantly lower the returns on investments or adversely impact portfolio returns. Whether it is turbulent or normal times, investors have to take into account exchange risk, as it can make a substantial difference to portfolio returns.

Example

Given below is a workout – an example of how fluctuation in exchange rates (US$ vs. GBP) can have a significant impact on returns on stocks.

Example: If a UK resident just sold Coca Cola Inc stocks that he bought a year ago and earned a rate of return of 10% in terms of the US dollar. If, during this same period, the US dollar appreciated by 6% against the GBP, the realized rate of return in GBP terms from this investment is 16.6%. Please refer to the calculations in the workout.

In other words, the realized return for a UK resident (Rr GBP) from investing in the US market depends on US$ denominated return multiplied by the change in the exchange rate between the US$ (foreign currency) and the GBP (domestic currency).

Now, if the US dollar depreciated by 10% against the GBP during the same period, then the realized rate of return in GBP terms from this investment is -1%. Even though the investor earned a rate of return of 10% in terms of the US dollar, the realized return of return in GBP terms i.e. the GBP denominated return is -1%.