By Marlies van Boven, head of investment research, EMEA
Data since the Global Financial Crisis (GFC) demonstrates that the link between factors and economic cycles is broken—and in effect, the traditional “Investment Clock” framework for explaining factor behaviour is no longer applicable. If we look to evolve this thinking for the post-GFC period, we find in our recent paper that economic volatility regimes have a significant impact on factor payoffs.
Rethinking the Investment Clock
The GFC has left in its wake a prolonged period of weak growth, low inflation, and unprecedented quantitative easing (QE). This period has distorted both the economic cycle—as defined by the Investment Clock—and factor performance. Factors have struggled to deliver consistent performance since the GFC, as steeper selloffs combined with less upside have resulted in lower average factor payoffs.
In rethinking the Investment Clock framework, we define economic volatility regimes based on the level and volatility of inflation and real GDP. We identify three major shifts in economic volatility—High, Moderate, and Low. As shown, these align with distinct regimes for the time period from 1970 – 2020 (see chart below).
Post-GFC: An unfavourable environment for factors
If we look at returns within this framework, we can confirm that the Low Volatility Regime since the GFC has generally been unfavourable for factor payoffs. This is particularly true with respect to broad-based performance across all factors, where the average annualized return of an equal-weighted (EW) portfolio of the four factors was markedly lower than during the High and Moderate Volatility Regimes.
What’s also noteworthy is the EW portfolio’s relationship with the market return. As the market performance becomes more dominant—as it has in the current Low Volatility Regime—the EW portfolio return diminishes.
Factors fared best during the Moderate Volatility Regime
While the EW portfolio posted the strongest absolute returns during the High Volatility Regime, if we look at risk-adjusted returns we can see the portfolio of four factors fared best in the Moderate Volatility Regime. The below graphic is a visualization of the rebooted Investment Clock, showing the realized average real GDP and inflation rates during each economic volatility regime, as well as the risk-adjusted factor returns.
A new framework for what lies ahead
This approach to rethinking the Investment Clock gives us a framework for explaining factor behaviour in the past, and also has to potential to inform on how factors could respond to different regimes in the future.
The post-GFC period of QE and ultra-low interest rates have stimulated risk-taking, favouring high duration growth stocks—and resulting in poor performance of a diversified, equal-weighted four-factor portfolio. However, if the past is any indication of the future, moving towards a moderate regime with above-trend economic growth and contained inflation may help to deliver a more broad-based factor performance.
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