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Market Insight - Macro-Sensitive Portfolio Strategies and Defining Macroeconomic Risk - November 2012

Global economic conditions have seen a weak recovery since 2008, with major economies experiencing sub-par growth rates relative to long-term trend growth. As a result, investors are interested in designing portfolio strategies that explicitly recognize macroeconomic risk. The design of macro-sensitive portfolio strategies relies on how we define macroeconomic risk and measure the relationship between asset prices and macroeconomic risk. In this paper — the first in a series that addresses these issues — we argue that macroeconomic risk is the change in asset value due to persistent shocks to real economic growth. This definition underscores the role of long horizons in macroeconomic risk and the principal issue facing investors: how should asset allocation respond to large macroeconomic shocks, given that their consequences are likely to be resolved over long time periods?  We advocate going back to the basics of asset pricing and analyzing the impact of macro shocks on both asset cash flows and discount factors.