Quantifying the Impact of an Increasingly Hawkish Fed

This week, we’re temporarily pausing our “Where’s the Alpha?” series to help our community analyze the potential impact of the Fed’s hawkish surprise earlier this week.

The Fed’s Dec 14-15 meeting minutes became publicly available on Tuesday, revealing that the Fed intends to accelerate the reduction of the bonds held on its balance sheet. While most observers expected measured rate increases, the runoff in the balance sheet was a shift in its prior position and signaled a more hawkish stance. As a result of the news, the NASDAQ Composite fell 334 bps, and the S&P 500 fell 194 bps during Wednesday’s market hours. The NASDAQ sell-off represented a three standard deviation downward move in the index.

The primary goal of Factor Spotlight is to keep our readers up-to-date on the most timely and topical systematic market movements and to leverage our applications and datasets to help the investment community stay ahead of the curve. In that spirit, this week, we will be discussing the macro environment and the implications of the Fed’s Dec 14-15 minutes on the equity market through the lens of the Quant Insight macroeconomic dataset in Omega Point.

A Macroeconomic Lens

The Quant Insight dataset, as introduced in a prior edition of Factor Spotlight, provides macroeconomic models to deliver factor exposures, risk decompositions, asset valuations, and more across a multi-asset class landscape. Qi’s macroeconomic factors span Financial Conditions, Economic Fundamentals, and Risk Appetite on a global scale to help better explain asset volatility and return.

According to Quant Insight, the factors that most closely measure the impact on securities from the U.S. Federal Reserve actions are FED Rate Expectations, FED QT Expectations, and USD 10Y Real Rates. These three factors (“Fed Factors”) represent projections on rates, quantitative easing, and inflation-adjusted yields.

Measuring Benchmark Sensitivities to the Fed Factors

To establish a baseline for Fed Factor sensitivity in the U.S. market, we analyzed these factors' impact both individually and cumulatively on a set of broad market, sector, and selected popular benchmarks.

The sensitivities below indicate the estimated % impact on the asset’s return given a positive one standard deviation move in the factor. ETFs with negative return contributions can be considered vulnerable to a more aggressive pace of Fed policy normalization, and ETFs with a positive implied return generally benefit from easy financial conditions. The effect of each factor is independent of the other factors, so we can conveniently sum them to analyze the total impact (rightmost column).

As expected, Communication Services and Information Technology are the most adversely impacted by a hawkish Fed policy, driven mainly by rising rate expectations. Health Care as a sector is also negatively exposed but, when we isolate Biotech (IBB), we notice that much of the Health Care downside is industry-concentrated. As a result, the IBB ETF would expect a 142 basis point drawdown from these three factors in a one standard deviation event.

Given the historical environment of Quantitative Easing, we anticipate that these factors could potentially see multiple standard deviation moves given that we’re working off a ground-level baseline.

Who is Most At-Risk?

Much attention has been paid to the NASDAQ Composite index as a headline measure of tech’s initial reaction to the minutes and will continue to live in the spotlight as the year progresses. Although the sensitivity is much lower than ARKK or IBB at a top-line level, we were curious to look at the underlying stocks in the Invesco QQQ ETF, which tracks the NASDAQ Composite index, to understand the dispersion of sensitivities and identify those most at-risk.

Of the stocks in the ETF, 62% would be described as negatively impacted by rising rates. Below, we have highlighted the stocks with the most downside risk from these factors in aggregate. In addition, the R-Squared values of these stocks, which measure the percent of asset volatility that the broader macro model can explain, are considerably high, indicating that macroeconomic factors play a significant role in dictating their price movements.

Peloton’s Uphill Ride

Peloton currently exhibits the most vulnerability to the recent Fed news. If rate expectations move upward by one standard deviation, it will impact PTON’s stock price by -8.7%. Of course, a more significant move would result in an even more dramatic price impact. An interesting context to also consider is the trend in the sensitivities of these stocks. We can reasonably assume that rate expectations will rise. Still, we see that the stock is becoming increasingly vulnerable to the macro environment based on the last two months of PTON's sensitivity to rate expectations.

‍Peloton Interactive Inc. (PTON) FED Rate Expectations Exposure

Taking Action on the Fed Factors

Using the Omega Point platform, investors can take several approaches to mitigate risks surrounding the Fed news and the macroeconomic environment as a whole. The first method is to screen for trade ideas. Through Security Search, managers can filter their coverage list by qualitative and quantitative parameters to identify names that meet their criteria. Below is an example of a US TMT manager screening for stocks with positive sensitivities to a hawkish Fed. In the TMT space, the manager likely has many downside risks in his portfolio but will still find upside opportunities to explore.

The second method is through the application of a Fed Factors hedge basket. Managers can leverage Omega Point's Smart Portfolio functionality to test the effectiveness of existing assets and ETFs or create a custom basket of securities tailored to their portfolio and their needs. Omega Point users can also screen for stocks to include or exclude in a custom basket. Our risk-aware optimizer will then develop the optimal names at the optimal sizing to minimize risk while adhering to user-defined objectives and constraints. For managers looking to hone in on specific macro drivers, Quant Insight's macroeconomic factor baskets in Omega Point target exposure to specific factors for a pointed, efficient approach.

A wide array of macroeconomic factors could potentially impact equity asset prices, and a holistic assessment is an important one to take. Quant Insight's dataset allows us to understand the forces at play and better align trade decisions, position-sizing, and hedging with macroeconomic forecasts in mind.

As always, if you are interested in exploring Quant Insight’s data or would like to evaluate your portfolio through the Omega Point platform, don’t hesitate to reach out.

US & Global Market Summary

US Market: 01/03/22 - 01/07/22

• The Nasdaq Composite fell 4.5%, its worst week since February 2021, while the S&P 500 and DJIA lost 1.9% and 0.3%, respectively.
• U.S. employment rose by a less-than-expected 199,000 jobs in December, well below the 400,000 forecast by economists. The unemployment rate dropped to 3.9%, underscoring near full employment.
• The Federal Reserve confirmed its intention to pull back stimulus and suggested it might do so sooner and faster than previously planned.
• The yield on the 10-year Treasury note jumped to its highest level since January 2020.
• Bitcoin slumped by 5% amid a broader sell-off for cryptocurrencies, driven by tighter U.S. monetary policy concerns.
• Global benchmark Brent crude gained 5.1% to $81.75, finishing a third consecutive week of gains.

‍Normalized Factor Returns: Axioma US Equity Risk Model (AXUS4-MH)‍

• Value leaps to this week’s top spot after its previous runner-up finish as it speedily approaches the overbought realm.
• Earnings Yield resumes its 3-month climb following last week’s surprise tumble to move closer to extremely overbought terrain at +1.59 SD above the mean.
• Market Sensitivity continues to show strength following an extended slump of bottom finishes.
• Volatility moves higher for the second straight week following a ten-week slide.
• Profitability continues to slide and is approaching oversold status.
• Medium-Term Momentum stumbles once again to cross the oversold threshold.
• Growth plunged following several weeks of middling performance to cross into oversold terrain.
• US Total Risk rose by 0.09% this week.

‍Normalized Factor Returns: Axioma Worldwide Equity Risk Model (AXWW4-MH)‍

• Value snags the pole position following consecutive top-two finishes and crosses into overbought terrain.
• Market Sensitivity once again shows some pop and finally exits oversold territory.
• Exchange Rate Sensitivity showed strength for the second straight week following its recent multi-week slide and leaves oversold status.
• Growth reversed on recent strength in the global arena as it crossed the negative threshold.
• Profitability slid hard for the fourth consecutive week as it entered negative territory.
• Size plunged once again to finish at the bottom of the global leaderboard for the second consecutive week and crosses over the oversold threshold.
• Global Total Risk rose by 0.01% this week.

Regards,
Kevin