Flows and Positioning – How They Impact Portfolio Construction
Flows and positioning play a vital role in shaping the performance of various macro asset classes within the context of portfolio construction.
Understanding these factors can help investors make informed decisions about their trades and investments and optimize their portfolios for maximum returns.
In this article, we’ll discuss the implications of flows and positioning on different asset classes, including bonds, stocks, gold, oil, and currencies.
Key takeaways – Flows and Positioning
- Flows and positioning significantly influence the performance of different macro asset classes in portfolio construction.
- Bonds are strongly correlated with shifts in flows and positioning. Their prices can rise when growth and inflation expectations decline, risk premiums decrease, or when imbalanced positioning triggers buying.
- Stocks, gold, oil, and currencies also exhibit unique responses to flows and positioning. Factors such as growth expectations, inflation, risk premiums, and central bank credibility play roles in shaping their performance.
How Flows and Positioning Affect Various Asset Classes
Bonds
Nominal government bonds with high enough yields, exhibit a strong correlation to shifts in flows and positioning.
Their prices typically increase when growth and/or inflation expectations decline, risk premiums decrease, or when positioning is offside (i.e., too bearish) and triggers buying.
Stocks
Stocks can be more complex when examining their relationship with flows and positioning.
At a basic level, equities can be viewed as nominal bonds with uncertain coupons, which are discounted at a rate determined by a long-term risk-free rate plus a risk premium.
The interplay between growth expectations, inflation, and risk premiums can result in varying responses in the equity market.
Sector-level responsiveness to growth expectations can also differ.
Moreover, inflation can impact revenues and costs with varying timing, leading to a range of stock performance outcomes during periods of high or low inflation.
Lastly, offside positioning can affect stocks similarly to other assets. For example, if everyone is very bearish, this can be supportive of equity prices.
Gold
Gold is an important asset class as it serves as an alternative to fiat currency and a store of value.
It’s the third-largest reserve held by central banks, behind dollars and euros.
Its price typically responds to shifts in monetary conditions and risk premiums. When real yields on financial assets fall, this generally benefits gold as it provides a competitive alternative.
However, its correlation to growth and inflation expectations is generally low in the short and medium term.
Gold’s price is primarily driven by a combination of falling growth and/or rising inflation expectations resulting in declining real long-term rates.
Furthermore, gold contains an embedded call option that pays off when central banks lose credibility and the fiat money is devalued (or even falls apart, as all currencies are eventually devalued or destroyed over time).
Shifts in central bank credibility impact the implied volatility of this tail option and gold’s price.
Over the long-run, the price of gold tends to mirror the amount of money in circulation relative to the global gold stock.
Oil
Oil functions as a reliable pro-growth and pro-inflation asset.
It has an inconsistent risk premium connection for spot contracts but a more reliable link for longer-term contracts.
Currencies
Currencies represent the most complex asset class when it comes to flows and positioning.
For developed market (DM) currencies, there is no risk premium.
However, this does not apply to emerging market (EM) currencies, which are likely to have a risk premium.
Growth and inflation drivers for currencies are relative between two countries’ expectations.
Trade Flows vs. Investment Flows
Flows in currency markets occur due to trade and investment.
Trade flows, which tend to be slow-moving and substantial, usually set the long-term trends.
On the other hand, investment flows can be fast-moving and impactful enough to affect short and medium-term levels.
As a result, major pools of savings shifting between countries can drive currency moves and asset flows.
FAQs – Flows and Positioning
What is the significance of flows and positioning in portfolio construction?
Flows and positioning help determine the performance of various macro asset classes within a portfolio.
Understanding these factors allows traders/investors to make informed decisions, optimize their portfolios, understand risk, and achieve their financial goals by constructing a portfolio that maintains a reasonable balance.
How do bonds respond to changes in flows and positioning?
Nominal government bonds (considered risk-free in the sense that they don’t have default risk) with high enough yields to them tend to have a strong correlation to shifts in flows and positioning.
For bonds with low yields, market players know there’s less juice to squeeze out of them, so there is less incentive to buy them.
How do stocks react to changes in growth expectations, inflation, and risk premiums?
Stocks can respond differently to changes in growth expectations, inflation, and risk premiums based on sector-level responsiveness (e.g., tech can be very different from consumer staples or utilities), the timing of inflation impacts on revenues and costs, and investors’ positioning effects.
Why is gold considered an important asset class, and what factors drive its price?
Gold is an important asset class as it serves as an alternative to fiat currency and a store of wealth.
Its price is driven primarily by a combination of falling growth and/or rising inflation expectations, resulting in declining real rates, and shifts in central bank credibility.
How does oil function as a pro-growth and pro-inflation asset?
Oil serves as a reliable pro-growth and pro-inflation asset, with an inconsistent risk premium connection for spot contracts but a more reliable link for longer-term contracts.
As global economic growth and inflation expectations rise, the demand for oil tends to increase, driving its price higher.
What makes currencies the most complex asset class in relation to flows and positioning?
Currencies are the most complex asset class from a flows and positioning perspective because growth and inflation drivers are relative between two countries’ expectations, and there’s no risk premium observed for owning developed market (DM) currencies.
Additionally, flows in currency markets occur due to trade and investment, with trade flows setting long-term trends (they’re steadier because of real-world economic circumstances) and investment flows impact short and medium-term levels (e.g., flows of hot money chasing yields).
How can investors use the information on flows and positioning to construct a well-balanced portfolio?
Investors and traders can use the understanding of flows and positioning for different asset classes to make informed decisions about their investments.
By considering how these factors impact bonds, stocks, gold, oil, and currencies, investors can allocate their assets strategically, diversify their portfolios, and manage risks effectively to achieve their financial objectives.
Conclusion
Understanding the nuances of flows and positioning in various asset classes is an additional perspective for constructing a well-balanced portfolio.
By looking at the different ways these factors impact bonds, stocks, gold, oil, and currencies, traders/investors can make better-informed decisions and optimize their portfolios to achieve their financial goals.