Setting the Stage for Upcoming Rate Hikes

As inflation continues to skyrocket to 40-year highs and Fed rate hikes remain imminent, investors are finding themselves facing continually rocky markets. Further exacerbating the already tenuous environment, the yield curve has been flattening. Many predict that the curve could even invert, signaling that slowing economic growth could be on the horizon.

Given the rising inflation alongside rate hikes, a flattening yield curve, and an aggressive value vs. growth rotation, the current environment feels unprecedented, all in front of the backdrop of a global pandemic. Though no period in recent history looks the same as today’s market, recent periods have some key shared characteristics to the current environment. Analysis of these periods could provide opportunities to learn how to defensively position portfolios for the uncertainty ahead.

Over the next few weeks, Factor Spotlight will highlight these historical periods and provide analyses to help investors identify opportunities for risk mitigation in today’s macro-driven, rising rate environment.

Identifying Relevant Rising Rate Periods

To identify relevant historical periods for our analysis, we looked at the behavior of three macroeconomic variables, proxied by the following indicators: 1) Rates (10-year US Treasury yields) 2) Yield Curve Shape (10- vs. 2-year US Treasury yield spread) 3) Inflation (YoY change in CPI). The current market is characterized by increasing rates, flattening yield curve, and inflation. Using data from FRED, Federal Reserve Bank of St. Louis, we were able to identify September 2017 to October 2018 as a recent period within the last ~15 years that is similar to the current environment.

While there was a period in 2009 of rapidly rising inflation coupled with rising rates, the yield curve was steepening, and the post-financial crisis environment was still quite different from today. Moreover, markets were only starting to recover from the throes of economic recession. Given this, we believe the period from Sep 2017 to Oct 2018 to be the most analogous to today for comparison purposes.

However, it is essential to note that the current inflationary conditions are unlike any other over the past several decades; so, while we will proceed with our analysis, we must bake in adjustments to account for the extraordinary levels of inflation we are currently facing.

Factor Behavior in Past Rising Rate Periods

To set a baseline for our expectations of what could happen in the coming months and quarters as rate hikes occur, we can look to the performance of the factors from the Axioma US 4 Medium-Horizon (“AXUS”) risk model.

From Sep 2017 to Oct 2018, the factor returns show us that high quality and high momentum names did exceptionally well. High beta and high dividend yield names also fared well under these conditions. Conversely, highly volatile, over-levered, and cheap (i.e., high Value) names struggled in this environment. Larger caps and high-growth names also had a rough time during this period.

Interestingly, a view of the factor returns from 2017/2018 compared to the last three months sheds light on where we may see similarities in factor behavior moving forward and where we may also experience some differences. Below are the AXUS factor returns from Nov 18, 2021, to Feb 18, 2022.

In particular, Growth, Size, and Volatility are currently experiencing similar bouts of downtrodden performance, while Profitability and Momentum are seeing boons in performance, much like what we saw in Sept 2017 to Oct 2018. However, a stark difference between the historical record vs. today lies in the Value and Earnings Yield factors. These factors are seeing massive upswings compared to the downturn in 2017/2018.

While we’re likely only in the early innings of the rising rate environment, these comparisons can identify where we may have more confidence in our historical analysis and where we may need to consider adjustments to account for differences between the historical environment and now.

In next week’s Factor Spotlight, we’ll leverage the analysis above to create a stress test and shock market portfolios to help investors understand where there is opportunity (or pain) as markets combat the rising rate environment.

US & Global Market Summary

US Market: 02/14/22 - 02/18/22

• Stocks capped a week of volatile trading with a broad sell-off on Friday in the run-up to a long US holiday weekend. For the week, the S&P 500 fell 1.6%, the Dow lost 1.9% and the Nasdaq declined 1.8%.
• Markets have been turbulent all week as investors watch the latest developments in Ukraine, where Russia has been amassing troops on the border. The tensions add more concerns for investors trying to determine how the economy will react to rising inflation and interest rate hikes.
• Federal Reserve Bank of New York President John Williams said Friday that the central bank should start raising interest rates next month to help rein in too-high inflation.
• General Electric fell 5.9% after it warned that pressure from inflation and supply chain problems have hurt several of its businesses including healthcare, renewable energy and aviation.
• 78% of the 417 S&P 500 companies have in this reporting season posted quarterly earnings above analyst estimates as per Refinitiv data.

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

• Market Sensitivity (beta) shows no signs of slowing as it secures a three-peat atop the U.S. leaderboard and crosses into overbought territory.
• Medium-Term Momentum keeps climbing and moves closer to the positive threshold.
• Growth continues its rapid ascent of late while Value gets pummeled again and barely misses this week’s bottom spot.
• Size and Volatility continue to be neighbors in the weekly rankings but diverted direction after several weeks of tandem movement.
• Profitability fell yet again and crossed the oversold threshold.
• Earnings Yield scored a four-bagger at the bottom of the leaderboard as it finally crossed into negative territory.
• U.S. Total Risk rose by 0.17% this week.

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

• Volatility kept on the jets for a third consecutive week to finish atop this week’s global leaderboard.
• Size dropped a spot in the rankings but maintains impressive upward momentum.
• Profitability countered last week’s severe drop to push upwards once again and is now in reach of exiting oversold territory.
• Market Sensitivity slowed its ascent vs. its US counterpart, but both end the week separated by only 3 basis points.
• Exchange Rate Sensitivity fell after last week’s slowdown hinted signs of weakness during its seven-week rocket-like push up the rankings.
• Earnings Yield fell for the eighth straight week and moves within sight of hitting oversold status.
• Value repeated last week’s bottom finish as it looks to exit the overbought threshold.
• Global Total Risk fell by 0.06% this week.

Regards,
Alyx