The GRID Framework Part 1

qtf: “questions to answer in the future”

Pleasantries

The reason I started this “blog” about global financial markets is to learn and to stay consistent with learning something new about investing. The end goal I had in mind was to create value through quality predictive and prescriptive analysis. In order to complete that goal I will likely have to have a professional understanding of how markets work. Obtaining a professional understanding of anything is extremely difficult, and made even more challenging by constraints on time and attention that most adults have to navigate. Even so, there are structures and systems in place to help even the busiest people acquire new skills and learn new concepts.

I think that if I want to obtain a professional understanding I need to create an environment similar to a capstone course in school; consisting of teachers, lessons, and implementations of the lessons. Then I can develop insights that not only work on paper, but also in the real world. This paper is my attempt to become more aligned with my own goal and my plan to reach that goal. I have already had many teachers in the space, but this series will be focused on one: Darius Dale of 42 Macro. First I will study his GRID framework. GRID is a high level framework about how markets work.

Intro to GRID

The GRID framework is built on the theory that every economy can be categorized by the trajectory of growth and of inflation. According to GRID, environments with rising growth and falling inflation are Goldilocks periods. Rising growth and rising inflation environments are Reflationary. Inflationary periods have falling growth and rising inflation, and Deflationary periods have both falling growth and falling inflation.

[qtf: What is the difference between bottom-up macro regime cycles vs top-down market regime cycles]

Measuring Growth

The first hurdle that I came across in trying to understand this framework was answering the questions what is growth and what is inflation. Growth is synonymous with productivity, which is incredibly difficult to measure on a macro scale.

Many countries measure economic growth with gross domestic product (GDP). The US measures GDP by adding total spending and net exports. Two of the primary problems with using GDP are the inherent assumptions and the lack of ubiquity across economies. Because the US Department of Commerce measures spending when calculating GDP, they are assuming that all capital is allocated perfectly efficiently. The most common example of this fault in measuring GDP is the anecdote of hiring someone to dig and refill the same whole over and over again. This act would increase GDP thereby over inflating perceived growth and productivity. Additionally, methods of measuring GDP are different in every economy. For example, China measures GDP from political input rather than their economy’s output. From my understanding, they decide what target GDP should be, then they mandate direct leaders and local governments to work toward that target. If they can hit their targets by quarter end or a given deadline they record the target as the period’s GDP. My point being GDP is not a measure that can be used to measure growth accurately or precisely across economies.

Instead of GDP, Darius Dale and 42 Macro use the OECD Composite Leading Index time series. Dale views the OECD composite leading index as a superior metric to GDP partly because it is standardized across the economies. With it you can compare disparate countries like the US and China. The next most obvious question for me was what the hell is that. According to data.oecd.org the composite leading indicator “is designed to provide early signals of turning points in business cycles showing fluctuation of the economic activity around its long term potential level”. The composite leading index is a predictive ratio which attempts to show us where economic activity will be in the future based on today’s data.

The OECD (the Organization for Economic Cooperation and Development) is an organization reformed from the Organization for European Economic Co-operation (OEEC) member countries. The OEEC was formed to help rebuild Europe after World War II. Adding the US and Canada, the OECD was formed at the height of the Cold War as more of an economic alliance between democratic nations. While the OECD was originally a strategic alliance, I can only assume that their goal is to assist policy makers to make decisions that will be more beneficial to the world.

It would be easy to accept their composite leading indicator at face value, but, being an auditor, I was compelled to dig deeper and try to find exactly how they calculate the composite leading index. It was at this point that I ran into another wall. For a lay person such as myself, the OECD only vaguely explains how they produce their composite leading index. I spent time parsing through their website and googling the terms that I did not understand in order to come to what I am sure is a flawed understanding of the composite leading index. Even so, I believe the following explanation of the CLI will be beneficial for our study of Darius Dale’s GRID. Here goes:

Since each country has its own unique economy, the OECD determines which indicators are most indicative of each country’s economic condition six to nine months later. For example, the indicators used for the United States are: work started for dwellings, net new orders - durable goods, share prices: NYSE composite, consumer confidence, weekly manufacturing hours worked, manufacturing - industrial confidence, and spread interest rates. Each of these indicators is given equal weight and aggregated using the Laspeyres index formula, which converts the indicators to a score using a certain year as a base. If 2020 is the base year used, then an increase or decrease in the aggregated value of the indicators will produce a score above or below 100 respectively. No change will produce a score of 100.

The CLI is graphed next to the business cycle. The business cycle consists of the fluctuations in a country’s economy ( or in this case the world’s economy ) in aggregate economic activity. (Most individuals in finance or who have even taken a finance course understand broadly what the business cycle is but anything that I felt the need to research further I am documenting here.) When both the CLI and business cycle are in a rising or falling phase, the economy is steadily growing or declining, respectively, but eventually the CLI will peak (or trough) and, in theory, the business cycle will later do the same.

So when Darius Dale uses the OECD CLI we can infer that he is determining where an economy’s level of growth will be in six to nine months based on an aggregation of each country’s leading economic indicators. And here is my healthy reminder to myself and to the reader what exactly it is we are trying to do.

Measuring Inflation

Darius Dale uses what he calls the GRID framework to analyze what phase a given economy is in; whether it be in the Goldilock, Reflationary, Inflationary, or Deflationary phase. The GRID framework is based on two factors: growth and inflation. To measure an economy’s growth, Dale uses the OECD’s Composite Leading Index, as explained above. To measure economic inflation he uses the “trending impulse of headline CPI on a year over year basis”. No, I am not speaking French; I am speaking “finance”, which is much easier to understand if you break it down. According to Investopedia, “an impulse wave pattern is a technical trading term that describes a strong move in a financial asset's price coinciding with the main direction of the underlying trend.” Market price, market measures, and economic indicators fluctuate up and down every day, hour and second. Trending impulse is the overall trend over a given period. “Trending impulse of CPI year over year,” simply put, is the overall trend of CPI measured over a year. So what is CPI？

The Consumer Price Index (CPI) is created by taking a basket of goods, usually the goods purchased by the average/median household in a given country, and measuring the percent increase in prices. Unlike the composite leading index, CPI is fairly easy to understand. In the base year, the prices of all the goods purchased in a particular region are recorded weighted based on consumer spending. In the following years those same goods are measured again. The percent increases in prices as compared to the base year prices become the following year’s index. The indices for neighboring regions are averaged to produce a given city’s index; cities averaged to counties, counties to states, and states to nations.

As a point of notice, a major flaw in measuring inflation is the further to get from the individual consumer the less it represents their increase in prices. Now, February 27th 2022, US CPI sits at 7.5%, but my individual price inflation could be 5% and my city’s average maybe closer to 10%. For this reason, many investors, financiers, and economists use their own formulas to calculate inflation that provide better utility for their particular purposes. I do not think that is necessary. We just need to understand what inflation is beyond an increase in price.

To understand inflation, we need look no further than basic economics, supply and demand. When demand is increasing above supply, prices increase. When that happens, there is not enough of a certain good to meet demand, therefore suppliers can charge more and/or consumers are willing to pay more for the good. On the other hand, there may also be a supply shock, such as the one we have been experiencing recently. In this situation, supply falls below demand, and there is not enough supply of goods to meet the demand for goods. These same supply and demand dynamics also explain deflation (price decreases), reflation (price increases amid a shrinking economy). We can determine whether it is demand or supply dynamics affecting price by considering where we are in the growth cycle, which brings us back to GRID.

[qtf: In Ray Dalio’s Principles for Dealing with the Changing World Order he says, “All markets are primarily driven by just four determinants: growth, inflation, risk premiums, and discount rates. How do risk premiums and discount rates factor into the GRID framework?]

The GRID Framework

Dale graphs the delta ( first derivative or rate of increase/decline ) of growth and inflation over a given period with the 3 month delta of inflation on the X-axis and and the three month delta of growth on the Y-axis.

While the OECD CLI (our measure for growth) is a predictive measure, headline CPI is not. But, by measuring the rate of change in CPI rather than CPI itself, we can determine whether inflation is likely reaching a peak or a trough. I hope I am not giving painful flashbacks of pre-calculus, but the idea is actually fairly simple. If the 3-month delta of CPI (e.g. the rate of change in inflation) decreases from 10% to 5%, it means in the first three months inflation was increasing at a rate of 10%, and in the next three months it is increasing at a rate of 5%. Inflation is still rising, but it is rising at a much slower rate. If in the following three months the delta of CPI falls even further to 3%, we can infer that inflation is likely to peak and begin to fall. Using deltas, we want to predict where growth and inflation will be in the future, so we can make the best possible investing decisions now.

Darius Dale and 42 Macro, performed backtest to examine the performance of various asset classes in each economic environment in his GRID framework. He determined which investment strategies have worked best in which regime. He shows us the results of his test in three areas of investment; equity style factors (various strategies of risk and return within the equities) , the equity sector (stocks), and the fixed income sector (bonds).

...Continued in Part 2...