Trend following has long been a cornerstone of systematic equity strategies. The principle is simple: when prices rise, they tend to continue rising; when they fall, they often keep declining. But financial markets don’t move in a vacuum. Economic forces—such as inflation, employment dynamics, and real yields—can either support or oppose price trends. Integrating these macro signals into trend-following strategies can make a substantial difference in performance, especially over long horizons.
When Markets and Macro Clash
Financial trends often influence—and are influenced by—underlying economic conditions. Over time, strong market moves can create environments that ultimately push back against those same trends. For example, rising stock prices boost consumer wealth and corporate sentiment, which can fuel growth and eventually lead to inflation and tighter monetary policy—creating a headwind to continued market gains.
This cyclical relationship between prices and the economy forms the basis for the concept of macro headwinds and tailwinds. Tailwinds occur when economic conditions reinforce prevailing price trends. Headwinds arise when the economic landscape begins to resist them.
Why Combine Trend Following with Macro Context?
While trend following is built on market momentum, it has limitations. It typically doesn’t account for the underlying causes or sustainability of the trend. That’s where macro data comes in. When trends align with favorable economic conditions, they’re more likely to persist. Conversely, if economic indicators suggest deteriorating fundamentals, even a strong market trend may be vulnerable to reversal.
On the flip side, incorporating trend signals into fundamentally driven strategies adds a kind of dynamic risk control. If market prices start moving against the macro thesis, trend data can serve as an early warning or stop-loss trigger.
Constructing a Macro Support Indicator
To integrate economic insights into trend signals, a macro support score was developed for the equity futures markets of eight major developed economies: the U.S., Eurozone, U.K., Japan, Australia, Canada, Switzerland, and Sweden.
The score includes three main components:
- Labor Market Slack: Measures how loose or tight job markets are, based on employment growth, relative unemployment, and wage pressures compared to productivity and inflation targets.
- Inflation Shortfall: Captures the gap between current core inflation and each country’s target. A negative gap suggests more room for growth without policy tightening.
- Excess Real Equity Carry: Calculates the attractiveness of equities relative to short-term real interest rates, using expected earnings and dividend yields.
Each component is normalized to account for volatility and scaled equally. The resulting composite score reflects the general macroeconomic environment’s favorability for equity markets.
Adjusting the Trend Signal
A standard trend signal is derived from the difference between the 50-day and 200-day moving averages of equity index prices. While this captures directional momentum, it doesn’t consider the context of that movement. To address this, the trend signal is modified based on the macro support score.
A logistic function is used to scale the signal. If macro conditions strongly support the trend, the signal is amplified. If macro data contradicts the trend, the signal is dampened. The core idea is not to change the direction of the trade but to adjust its size and conviction.
Global Testing and Results
To evaluate this approach, equity futures returns and signals were aggregated across the eight countries, weighted by their GDP in U.S. dollars. This avoids overstating significance by treating highly correlated markets as independent datasets.
The enhanced strategy showed clear improvements. Modified trend signals had higher correlation with future returns than the standard trend alone, both by linear and rank-based statistical measures. When applied to a simplified backtest of monthly rebalanced positions:
- The modified trend strategy had a Sharpe ratio of 0.55, nearly double the 0.27 Sharpe of the unadjusted version.
- The enhanced strategy exhibited negative correlation to the S&P 500, indicating potential diversification benefits.
- The improved performance was consistent across multiple economic cycles and not overly reliant on any single macro component.
Interestingly, each of the three macro indicators—used individually—also improved the strategy, with Sharpe ratios between 0.44 and 0.49. But the combination of all three delivered the most robust results.
Conclusion
Incorporating macroeconomic context into trend-following strategies makes intuitive and empirical sense. Market prices don’t operate in isolation—they reflect and affect broader economic conditions. A strategy that adapts to this reality stands a better chance of navigating shifting environments.
By blending trend signals with labor market dynamics, inflation trends, and real return potential, investors can refine their approach and increase the odds of success over the long term.
