Flash Update on Coronavirus and its Impact on Geopolitical Risk

As the markets have been roiled by losses stemming from concerns around COVID-19’s impact on the global economy, we wanted to provide an update on how Wolfe Research's Geopolitical Risk factor (which we introduced in our 1/28 Factor Spotlight) has trended during this time.

As a reminder - this factor is constructed as a long/short portfolio that is long names that are positively exposed to geopolitical risk headlines, and short names that are negativelyexposed to that news. In other words, if the geopolitical risk environment worsens, this factor will outperform. If fears of global risks like COVID-19 begin to dissipate, then we would expect to see this factor sell off.

‍Google Trends: Worldwide Interest Over Time - “Coronavirus” (1/1/20 - 2/29/20)

‍To help us identify key inflection points in the Coronavirus impact on Geopolitical news, we leverage Google search trends, and observe an initial rise when the outbreak in China was exposed (Jan 19 - Feb 1), followed by a dissipation (Feb 1 - Feb 24) when it was believed that the virus was mostly contained to that region, and a follow-on rise over the past few days driven by reports of an increase in non-China cases of the virus in Iran, Italy and South Korea. On 2/26, the US CDC issued a warning that the coronavirus will spread to the US, and then on Friday we heard of a second case in northern California.

Cumulative Return: Geopolitical Risk Factor (1/1/20 - 2/27/20)

If we line these charts up with the worldwide results in Google Trends for “coronavirus,” we see a similar trajectory to the performance of the Geopolitical Risk factor during this time. Looking at the cumulative chart for Geopolitical Risk, we see that return peaked and came down on 2/19, and then popped back up on 2/26 when the second US case was announced.

On a normalized basis, we can see an even starker chart in Geopolitical Risk:

‍Normalized Return: Geopolitical Risk Factor (1/1/20 - 2/27/20)

Clearly, this factor has been moving strongly against trend and is now Extremely Overbought, starting at -2.46 standard deviations below the mean at the beginning of the year, and now sitting at +2.32 SD above the mean. If the trend continues it will eventually normalize, but this does indeed highlight how companies that are positively exposed to coronavirus are seeing big tailwinds vs. names that are negatively impacted.

As the coronavirus continues to spread (or not), we’ll keep tabs on the Geopolitical Risk factor and see how it can potentially be harnessed as a hedge or stock selection tool, as we’d discussed in the third part of our series on the Geopolitical Risk factor - Geopolitical Risk Portfolio as a Risk Management & Stock Selection Tool.

Much more importantly, we hope for the utmost in health and safety for you and your loved ones as this situation sorts itself out.

US & Global Market Summary

US Market: 2/21/20 - 2/27/20

• As discussed earlier, markets everywhere saw a major pullback over the course of the week, with the S&P 500 losing over $3 trillion in value. This was the quickest correction the index had seen since the Great Depression.
• The VIX gapped up to almost 50 intra-day, closing at 40.11 (vs. 17 on 2/21), touching highs not reached since the Global Financial Crisis.
• The flight to safety has also resulted in extreme conditions among US Treasuries, with yield on the 10-year sitting at a record low of 1.15%.
• The Fed came out and said the coronavirus poses an “evolving risk” to the economy and will “act appropriately” as they keep a close eye on the situation. Fed futures have moved in kind, now auguring a 41% chance of a March rate cut, a 77% chance by April, and a 90% chance of a cut by June.

‍Factor Update: Axioma US Equity Risk Model (AX-US4)

• Unsurprisingly, this week’s factor movements were driven by a flight to safety and quality. Thus, Profitability was the biggest gainer, up +0.43 standard deviations and sitting right around the mean.
• We took a break from our Value series this week to discuss this week’s market action, but we’ve continued to see the reversion trend hold, with the factor slowly crawling up from the depths of near -3 SD below the mean. We’ll revisit our series next week to discuss sector exposures for Value names and how we can build a better Value-oriented portfolio.
• Momentum, Market Sensitivity and Volatility were all losers on a normalized basis, with Volatility re-entering Oversold space and Market Sensitivity heading towards Extremely Overbought territory.
• Growth took a 0.36 SD tumble and now sits at +1.19 SD above the mean.
• Size was about to cross into Overbought territory, but took a 0.44 SD plunge and was the biggest loser.
• US Total Risk (using the Russell 3000 as proxy) saw a massive increase of over 4%.

‍Factor Update: Axioma Worldwide Equity Risk Model (AX-WW4)

• Continuing the flight to safety theme, Earnings Yield, Value, and Profitability were the only winners this week, with Earnings Yield exiting Oversold space and Profitability on the rise after briefly dipping into Extremely Oversold territory.
• Similar to the US, the risk-on factors of Market Sensitivity and Volatility saw pronounced weakness, with Volatility now nearing an Extremely Oversold designation.
• Growth was the biggest loser, falling 0.31 SD and shedding its Extremely Overbought label.
• Global Risk (using the ACWI as proxy) also saw a big jump of +3.78%, which was slightly less than that of the US.

It is important to note that all of the factors shown above are built to capture security returns in excess of the market, and given the strong downward move in the market over the past week, most of the return can be explained by a general selloff in equities as shown below. Thus, last week’s move was not a factor rotation, similar to what we saw back in September, but a more traditional risk-off style selloff. If global growth does materially slowdown with a longer lasting impact on consumer behavior, we would expect to see more material movements factors such as Growth, Value, Volatility, and Market Sensitivity.

Regards,
Omer