Marlies van Boven
Investors often ask themselves which factors should be implemented in different phases of the economic cycle.
The Investment Clock applies changes in economic growth and inflation expectations to create four economic cycles (Figure 1). As factors differ in their sensitivity to these macro indicators, tracking the clock through each of the four quadrants can guide factor rotation.
Figure 1: The Investment Clock: linking factor performance to economic cycles
Note: The Investment Clock creates four ecoconomic regimes based on different combinations of Inflation and growth expectations.
Our analysis of US equity market performance over 60 years shows that factors “behave” as expected. The Quality factor tends to do well at the peak of the cycle and into a contraction. And when the market hits its trough, Value, Size and Momentum tend to be the best performing factors. Subsequently, Value fails, but Size and—in particular—Momentum continue to do well into an expansion.
However, data from the years since the Global Financial Crisis (GFC) in 2008 reveals a breakdown in the relationship between the cycle and factor performance.
Why has the relationship broken down?
Factors over this period have struggled to deliver consistent performance, with the exception of Quality (Figure 2, Panel B). In this era of weak growth, low inflation, and unprecedented quantitative easing, low interest rates further punished low duration stocks, resulting in the poor performance of Value stocks. As the table below shows, from 2.70% over the full period to -1.74% since 2008. Momentum’s performance was worse—from 8.41% over the full period to 0.74% since 2008).
Overall, we found that steeper sell-offs combined with less upside has resulted in lower average factor payoffs post GFC. Quality was the only exception to this.
Investment Clock: Factor performance over economic cycles - Panel A: Q3 1957 to Q1 2020
| Market | Size | Value | Quality | Momentum | % Months | |
|---|---|---|---|---|---|---|
| Expansion | 8.48% | 3.12% | -5.44% | 2.74% | 14.90% | 19.84% |
| Slowdown | -4.17% | 0.98% | 6.28% | 6.86% | 6.18% | 28.31% |
| Contraction | 9.42% | -1.61% | 1 .67% | 5.48% | 5.37% | 25.00% |
| Recovery | 13.09% | 4.91% | 5.89% | 1.22% | 8.79% | 26.85% |
| Full Period | 6.37% | 1.81% | 2.70% | 4.18% | 8.41% |
Investment Clock: Factor performance over economic cycles - Panel B: Q1 2008 to Q1 2020
| Market | Size | Value | Quality | Momentum | % Months | |
|---|---|---|---|---|---|---|
| Expansion | 9.91% | 2.65% | -13.43% | 4.26% | 13.78% | 19.84% |
| Slowdown | -20.76% | -4.71% | -3.20% | 17.16% | 4.81% | 28.31% |
| Contraction | 15.40% | 2.58% | 3.53% | 2.34% | -12.08% | 25.00% |
| Recovery | 26.35% | 2.87% | 4.52% | -3.41% | 1.35% | 26.85% |
| Full Period | 8.33% | 1.01% | -1.74% | 4.88% | 0.74% |
Source: AQR and Refinitiv. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
The assumption that underpinned the Investment Clock—a normalized economic cycle—is not applicable at present. Twelve years of secular stagnation, as well as a period of quantitative easing and negative rates, have dampened the business cycle. Even before COVID-19 further warped the world’s economy, the unprecedented QE which followed the GFC, demanded an Investment Clock reboot.
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