HiddenLevers Perspective: Economic Levers

In HiddenLevers, you can run economic what-if simulations on investments. For example, how would a Conservative Model perform if Oil prices double or the Fed unwinds its balance sheet? In addition to our built-in simulations, interactive stress testing allows you to create custom economic scenarios and adjust various economic indicators (levers). In this HiddenLevers Perspective, we will explore how our economic levers interact with one another. We will also discuss how scenarios play a role in modeling the economy when levers move unexpectedly or to extremes.

To get started, let’s look at an example from HiddenLevers. In interactive stress testing, you may notice that if you slide the S&P 500 lever down, all the other levers move as well:

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HiddenLevers regresses the S&P 500 against the 10-Year US Treasury yield to determine how changes to the market affect yields on average. This means that changes to the equity market will create a proportional change to treasury yields when creating a stress test. We call this feature 2nd order effects, and we calculate it for most levers. Typically, for economic levers that have at least daily or weekly data, we will use the rolling two-year regression calculation between the two levers to determine how one lever will impact the other.

While this works with most economic levers, we sometimes use the relationship of one lever to determine another lever. For example –the value of USD and the S&P 500. It makes sense that when the S&P 500 goes down, the value of USD goes up. After all, as participants sell their holdings, they are exchanging their shares of stock for cash, and US dollars often become a safe-haven for investors during periods of market volatility. What may not be as obvious though, is how changes in the S&P 500 might affect the value of the Euro. To account for these changes, we use the USD as an intermediary factor between the S&P and the Euro. So, if a drop in the S&P 500 portends an increase in the dollar, we know that relative to dollars, Euros should cost less. If we were to simply look at the S&P in isolation against the value of the Euro, it may be hard to map a meaningful relationship. We use this sort of mapping for several economic levers inside of our system, including our secondary indicators.

Our secondary levers can be particularly tricky because these levers often exhibit idiosyncrasies outside of regular market cycles. Levers like wireless sales and consumer confidence can be linked to market cycles, while levers like coal and BDI shipping ratesmight be better explained by mapping relationships to intermediary levers like the price of oil.

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While using historical relationships to map lever-to-lever correlations can be valuable, we know that these relationships sometimes break down. To account for lever relationships breaking down, we create scenarios. For example, our Rising Rates scenario shows examples of interest rates going up while equity markets and GDP growth contract, two indicators that usually move in the same direction as yields. For most users, our off-the-shelf scenarios make it easy to explain a wide range of economic possibilities. If advanced users want to go beyond our custom scenarios, they can turn off our 2nd order effects feature and move each economic lever independently of the others. This allows users to create their own custom scenarios.

If you want to learn more about creating economic scenarios, then check out our Scenario Creation white paper, or reach out to our support desk (800.277.4830 or support@hiddenlevers.com).  Try a free 7-day trial HERE.

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