Equity markets, particularly at the industry group level, have been mean-reverting this year (HERE). At the factor level, risk factors have also been mean reverting, but the return spreads have narrowed significantly compared to the past two years. The result is more difficulty profiting from risk rotations because investors need to predict more turns, and the gains associated with those turns are smaller. Fundamental factors are delivering stronger and more consistent returns, which is common in economic expansion periods.
Historically, risk-on vs. risk-off rotations have been a function of financial condition changes, with easing financial conditions supporting risk-on rotations. So far this year, financial conditions have eased, but at a slow pace. The relative stability of financial conditions has helped dampen risk rotations and allows other factors, like shifts in policy expectations, to have a larger impact on risk factors. Overall, inflation and growth data are exerting more influence today. Recent risk-off outperformance has been driven by stronger inflation even as financial conditions remain easy.
Focusing on Low Vol within mega caps shows it has consistently lagged behind all other indices. Investors are willing to take on more risk within mega caps. For other indices, Low Volatility outperformed high Volatility names broadly YTD. That has been especially true for smaller caps, where financial condition influence, specifically credit risk, is higher. Clarity on the outlook for inflation/policy would help determine the path of financial conditions. Stable financial conditions would encourage a rotation out of Low Vol, particularly in the SMID space.
Longer-term, leading indicators also impact risk-on/off factor performance. Stronger PMI readings support risk-on factor gains while falling LEIs encourage risk-off rotations. Currently, Risk-on factors have failed to keep up with the improving momentum of the PMIs. Signs inflation is slowing and that the Fed will not need to tighten financial conditions are necessary before a stronger risk-on rotation is likely.
Divergent Risk Preferences Within Market Caps: Equity markets, particularly at the industry group level, have been mean-reverting this year (HERE). At the factor level, risk factors have also been mean reverting, but the return spreads have narrowed significantly compared to the past two years. In addition, rotations have been shorter than before. The result is more difficulty profiting from risk rotations because investors need to predict more turns, and the gains associated with those turns are smaller. Fundamental factors are delivering stronger and more consistent returns, which is common in economic expansion periods.
Part of the reason for less return dispersion between Earnings Turbulence/risk-on and Low Volatility/risk-off is that their stock rank correlations have increased to their 90th percentile. The absolute correlation remains negative, but like Value and Growth rankings in early 2023, there is more overlap between risk-on/off rankings than normal, which limits returns during rotations.
Historically, risk-on vs. risk-off rotations have been a function of financial condition changes, with easing financial conditions supporting risk-on rotations. So far this year, financial conditions have eased, but at a slow pace. The relative stability of financial conditions has helped dampen risk rotations and allows other factors, like shifts in policy expectations, to have a larger impact on risk factors. Overall, inflation and growth data are exerting more influence today. Recent risk-off outperformance has been driven by stronger inflation even as financial conditions remain easy.
Longer-term, leading indicators also impact risk-on/off factor performance. Stronger PMI readings support risk-on factor gains while falling LEIs encourage risk-off rotations. Currently, Risk-on factors have failed to keep up with the improving momentum of the PMIs. Signs inflation is slowing and that the Fed will not need to tighten financial conditions are necessary before a stronger risk-on rotation is likely.
Risk rotations have been inconsistent across market cap segments. Over the past month, small caps with Low Volatility gained more than large caps. Within mega caps, investors slightly favored risk-on names at the expense of Low Volatility. Historical Low Volatility exposure for S&P 500 and S&P 400 have been consistently positive, while the small-caps have negative exposure to Low Volatility. Put another way, smaller cap names tend to be higher beta.
Focusing on Low Vol within mega caps shows it has consistently lagged behind all other indices. Investors are willing to take on more risk within mega caps. For other indices, Low Volatility outperformed high Volatility names broadly YTD. That has been especially true for smaller caps, where financial condition influence, specifically credit risk, is higher.
In addition to divergent factor sensitivities, Low Volatility NTM EPS growth expectations have diverged between market caps. For large caps, high volatility names tend to have higher growth expectations, while lower vol small caps have higher NTM EPS growth. That helps explains why profitable names within S&P 600 worked better this year (HERE).
