The terms that shape us
We’re surrounded by them every day. They appear as push notifications on our phones, pop up in dinner party debate and dominate news headlines, but how deeply do we grasp their meaning? Understanding macroeconomic terms means understanding the world – and investing – better. Let’s dive into some central concepts.
Black swan event
This term is a metaphor for an unpredictable, unexpected, rare or improbable outlier event that weighs heavily on markets. Such an event produces a widespread negative impact, both short and long term, leading to high levels of uncertainty. Coined by Nassim Nicholas Taleb, a former Wall Street trader, a black swan event tends to be rationalized after the fact, with people suggesting the foretelling signs were there all along.
How is the term used in today’s world? Well, many people refer to the pandemic as a black swan event. The start of 2020 saw Chinese reports of a mysterious lung disease met largely with an out-of-sight-out-of-mind attitude. Yet just two months later coordinated lockdowns forced the world into a virtual standstill – an unprecedented occurrence, the effects of which are still being felt in many parts of the world. And, though you may have heard Covid-19 referred to as a black swan event, Taleb himself has said it doesn’t count as one, pointing out that pandemics have happened before and can be expected to occur again in the future.
So, what is a recent and commonly accepted use of the term? The most famous black swan event in recent history is probably the crash of the U.S. housing market during the 2007-2008 financial crisis. As the movie ‘The Big Short’ depicted, only a handful of experts in the financial industry were able to detect that something wasn’t quite right, predicting the housing bubble, its collapse and the devastation that ensued in the U.S. and European economies. The rest of the world was caught off guard: People’s livelihoods disappeared overnight, millions of jobs were lost, and government bailouts were needed for many financial firms. The consequences were felt for years to come.
Recession
Recessions are generally considered to occur when a country’s gross domestic product posts a decline two quarters in a row. While the US has already had such a “technical recession” during the first and second quarters of this year, the National Bureau of Economic Research (NBER) must declare when a recession is taking place. The NBER considers a recession to involve a significant decline in economic activity that is spread across the economy and lasts more than a few months, treating its three criteria (depth, diffusion and duration) as somewhat interchangeable. It’s these criteria and the different ways they play out during each recession that flavor the discussion about the “type” of recession taking place.
Recessions come hand-in-hand with widespread, prolonged economic downturns, which bring higher unemployment levels and weaken consumption and economic output. Such a downturn can create a vicious cycle: companies feeling the pinch from lowered consumer demand can resort to layoffs, which in turn constrains consumer spending further. Amid bearish market conditions, the risk of businesses going bankrupt increases. A case in point is The Great Recession, which followed the black swan event we discussed above. Referring to the worst economic downturn since the Great Depression (1929-1941), the term refers to the US recession from end 2007-mid 2009 and the global recession that followed in 2009.
So, why are we currently hearing so much talk of recession right now? The one brought about by the pandemic was relatively short lived, with a fast and furious recovery propped up by stimulus checks and revenge shopping that contributed to today’s inflationary situation. We will go into more details below, but in a nutshell: a series of events, including the war in Ukraine on the heels of the pandemic, created inflationary pressures that have put central banks between a rock and a hard place. Central bank attempts to bring inflation down by raising interest rates means some countries risk slipping into recession.
Inflation
Have you noticed you’re suddenly shelling out more for the same groceries and to fill up your car’s tank? That’s a tell-tale sign of inflation. Rising consumer prices benefits those with tangible assets, such as real estate, because it means the value of their property or assets increases. However, rapid inflation can result in others struggling to keep up with the cost of living. This can ultimately slow economic growth as discretionary spending decreases due to tightening purse strings. This is where central banks step into the spotlight: they play the lead inflation-fighting role on our financial stage, using money supply as a tool to regulate the economy.
Let’s return to our (simplified) analysis of recent events. The Covid-19 pandemic saw lockdowns and restrictions disrupt supply chains, with closed factories and ports causing bottlenecks and shortages of various products and raw materials. In response to the pandemic, governments issued stimulus checks and boosted unemployment benefits to support individuals and small businesses.
But, once the world started to reopen, pent-up demand was unleashed and quickly started to outpace supply. With labor shortages across multiple sectors, supply chains had not yet rebounded to pre-pandemic levels when the geopolitical situation escalated with Russia’s invasion of Ukraine. Among the many impacts of this war, limited oil and gas supplies have led to a surge in energy prices. Reduced agricultural exports have also prompted price hikes across value chains.
This brings us back to the dilemma central banks are facing. Further increases to interest rates are likely, even as inflation numbers inch down from their peaks, heightening the risk of recession. Central banks also won’t want to lower rates too early, just to watch inflation inch up again.
But not all inflation is equal. Let’s look at some of the variations:
Central banks
Each country and/or region has a central bank. The major ones you’ve probably heard about are the U.S. Federal Reserve (the Fed), the European Central Bank (ECB), the Swiss National Bank (SNB) and the People’s Bank of China.
Their role as a financial institution is to issue cash, control the amount of money in circulation and adjust the availability or cost of credit. A central bank’s main objective is to defend price stability. In the US, the Fed is also mandated to maintain maximum employment.
Interest rates serve as the main tool for central banks – they raise or lower interest rates via the so called ‘key rate or policy rate’ to ensure price stability and guide the economy through any turbulences. If the key rate rises, the cost of lending money at the central bank rises for commercial banks. Commercial banks then raise their own interest rates, passing on the cost to end consumers in the process.
Economic eyes are currently fixed on central banks, which have been raising interest rates amid rising inflation. They’re likely to remain in the spotlight a little longer. It’s commonly expected among economists that central banks will continue to raise interest rates, but the big question is at what pace? And will efforts to tame inflation stall the economy to the extent it throws countries into recession?
Interest rates
Borrowing money usually comes at a cost. Excluding processing fees and transaction costs, the difference between the borrowed amount and the total repaid amount is referred to as interest.
The actual amount of interest charged to end consumers by commercial lenders depends on multiple factors, including how the loan is structured (do repayments cover interest only or interest plus principal), the type of interest rate selected (fixed versus variable; simple versus compound) and the credit rating of the borrower.
Another influencing factor is the interest rate set by central banks. When commercial banks borrow money from central banks, they too are subject to interest rates, known as ‘key rates’. If central banks raise the key rates, then it follows suit that commercial banks pass these increases onto their consumers.
In other words, the cost of borrowing money throughout the economy is increased when central banks raise interest rates. In this regard, as explained above, central banks use interest rates usually as their key monetary policy tool: interest rates are hiked to slow growth and avoid inflation, and lowered to spur growth, industrial activity and consumer spending.
After years of living in a historically low interest-rate environment, the world is now undergoing a transition. Central banks, grappling to bring down inflation, have indicated we’ve entered a period in which interest rates will be higher than during the pre-pandemic or post Global Financial Crisis years. This was made clear at the Jackson Hole Economic Symposium in August 2022.
Hawkish
Monetary policy is considered hawkish when it favors high interest rates to fight inflation. In this instance, promoting economic growth takes the back seat policy-wise.
The message delivered by central bankers at Jackson Hole clearly indicates that their current top priority is to bring inflation down, displaying a willingness to bite the bullet and allow the economy and the labor market to weaken. This hawkish stance began in June, when the world’s major central banks – led by the Fed and followed by the ECB, SNB and a number of emerging markets – started tightening their monetary policy at the most aggressive pace since the 1980s.
Dovish
Monetary policy is described as dovish when it favors low interest rates in order to spur economic growth. A dovish stance is one that tolerates some degree of inflation, with its negative effects considered to be somewhat normal and bearable. In other words: low interest rates are seen as stimulating and therefore benefitting the economy overall
Quantitative easing
Quantitative easing refers to monetary policy that involves central banks buying financial assets, like government bonds, with the aim of boosting liquidity in the financial system. The desired result is a stimulated economy, achieved by more liberal lending and investing by banks. This type of monetary policy was seen for a prolonged time period after the 2007-2008 financial crisis.
Quantitative tapering
This is the process of central banks scaling back asset purchases when the economy improves. They do this because stimulus is no longer considered necessary. It’s viewed as a precursor to higher interest rates.
Quantitative tightening
This is the opposite of quantitative easing. It’s a monetary policy that involves central banks selling financial assets in order to remove liquidity from the markets. The desired result is to stop the economy from overheating by making borrowing more expensive. (An overheating economy is one characterized by rising inflation paired with unusually low unemployment rates).
Hard landing
A hard landing is exactly what it sounds like: the economy is forced to slow down suddenly after a period of rapid growth. Hard landings often translate into periods of stagnant growth or recession.
Investors are currently keeping close tabs on whether a hard landing is in the cards. Central banks are completely focused on curbing inflation – a policy approach that may mean recession is unavoidable. The pace of interest-rate hikes is a key factor to watch when it comes to looking for signs of a pending hard landing.
Soft landing
By contrast, a soft landing sees the economy slow down at a less dramatic rate, in an attempt to tame inflation while avoiding high rates of unemployment. The economy does not slip into recession in the case of a soft landing.
Bull/bullish
An investor who sees the market, a security or sector positively and expects gains is bullish. It means they are buying securities, convinced they can sell them at a higher price at a later point in time. Signs of a bull market include a prolonged period of rising stock prices (usually a 20% minimum increase over at least two months), a strong economy and high investor confidence.
Bear/bearish
The opposite of bull/bullish. An investor who thinks that the general direction of prices in the market trends toward a decline.
Asset classes
The three main asset classes are stocks, bonds and cash equivalents. But real estate, commodities and derivatives also have a place in the asset class mix – and are often referred to as alternative asset classes. In order to avoid a concentration of risk, investment advisors often recommend diversifying portfolios across various asset classes. Together with consideration of an investor’s financial goals and investment horizon, diversification can be implemented as a risk management tool.
Active management
When an investor chooses active management investing, it means that fund managers will help identify the best market opportunities with the aim to outperform a benchmark or index. Often this translates into a focus on individual securities.
This type of approach requires expertise, industry knowledge and continuous analysis of the market environment. Because an actual specialist(s) is actively selling and buying securities in reaction to news flows and price changes, it’s considered more ‘hands on’ than passive management.
Another difference is that active management tends to involve larger trades than passive investing. This type of investing is often considered to require more extensive industry knowledge, needs a proper risk management to keep the active decisions well balanced and is thus usually left to professionals. Depending on the strategy of an active fund, risk can be high or low and the fund’s performance can more or less deviate from its index or other benchmarks.
Passive management
When an investor chooses passive management investing, it means that instead of attempting to actively outperform a benchmark or index, passively managed instruments just follow a certain index. So, while multiple buy and sell transactions take place, this is not occurring at the discretion of an active manager and is thus considered a less ‘hands on’ approach.
This type of investing is often considered to require less extensive industry knowledge than active management. Passive management may also be more fitting for investors seeking to keep risk low, as the passive instrument itself is almost by definition broadly diversified because it usually follows a broad index (e.g. of stocks, like the S&P500) or another benchmark of aggregating many securities. However, if an index drops a lot the passive instrument will follow too.
ESG investing
ESG stands for environmental (“E”), social (“S”) and governance (“G”) factors. ESG investing is thus a broad term for an investing strategy that either considers these factors or aims to improve them in some way as outcomes.
With ESG issues seen by many as among the world’s most serious and urgent, ESG funds have seen massive inflows in recent years. Many of those pursuing ESG investments assume that firms working to tackle ESG issues are paving the road to above-average growth, while contributing to a long-term better future. The logic can be summarized as follows: companies with good ESG ratings could earn a premium, while those with bad ESG ratings may carry price risks.
Whether an investor buys a stock after considering the ESG factors depends on what their individual investment goal is – is it maximum return, or something more? This is why the meaning of “ESG investing” can get fuzzy and may not mean the same thing to all of those using it. The term is often used alongside “SRI (socially responsible investing)” and its subset of “impact investing”. However, differences exist among all three terms.
As the nuances between these terms indicate, there’s not one type of investing and people take varied approaches. When it comes to ESG investing, recent media discussion, in particular on greenwashing, highlights the existence of inconsistencies in the usage and understanding of this term.
