- Lower factor volatility has driven down overall risk over the past 12 months
- Most, but not all, factors participated in the volatility decline
- Momentum’s potential turnaround
Lower factor volatility has driven down overall risk over the past 12 months
At the outset of the war between Russia and Ukraine a year ago, risk shot up quickly and substantially. The increase in expected volatility continued through June as concerns about the war’s impact, along with a realization that the increase in inflation appeared to be more than transitory and consequent Fed tightening dragged markets down. By the summer, investors were speculating that inflation had peaked and observed better-than-expected earnings and continued strong employment. Markets recovered sharply and volatility fell. But by fall, the specter of continued high inflation was raised, the war dragged on, the Fed reiterated its tight stance, and rates remained high, all while trading volume was subdued. Once again predicted risk rose, back to its high from a few months prior. Fast forward to the present, and we see that market volatility expectations have fallen again, and at least at the short horizon are finally below the level of a year ago.
We break down the change in risk into changes from the composition of the index, risk exposures of the components, specific risk, changes in factor volatility and changes in factor correlations.
Across markets, factor volatility has dropped substantially and driven down overall market risk. At the same time, factor correlations for single-country benchmarks have had little impact on changes in risk, whereas factor correlations — currency and country correlations specifically — have offset some of the impact of lower factor volatility in multi-country benchmarks. Other components have had little impact.
For a more detailed analysis of the impact of the war on market risk a year after its start, see our recent blog post.
For an analysis of why lower risk may not last, see last week’s Equity Highlights.
The following charts consolidate data from across our equity risk monitors. Individual index breakdowns can be found in Chart 9 of each risk monitor.
Decomposition of the change in risk over the last 12 months, single-country (top) and multi-country (bottom) indices
Most, but not all, factors participated in the volatility decline
As noted, lower aggregate factor volatility has driven benchmark risk down. Most style and industry factors’ current volatility level is near the low end of its 12-month range, suggesting that, all things being equal, active risk has probably also fallen. However, there are some notable exceptions to this, and they show up in many of the factors style-based investors tend to tilt on. Specifically, according to the Axioma Worldwide (WW4) model, predicted risk of the Earnings Yield factor is at the high end of its (relatively small) 12-month range, while risk for Medium-Term Momentum, Market Sensitivity and Size are above their 12-month median levels.
Style factor risk in other models looks somewhat different. For example, Earnings Yield in Developed Markets ex-US is at its one-year low as is Market Sensitivity’s in Europe. In the US, Momentum and Size are below median, but not at the lowest level. And risk for most industries is at or near the low end of the range, even for the seemingly see-sawing internet- and communications-related industries.
See charts from the Global Developed Markets Equity Risk Monitor of 3 March 2023:
Momentum’s potential turnaround
When market leadership changes abruptly, as it has over the last few months, Momentum, which expects winners to continue winning and losers to underperform, takes a hit. It often takes several months, and depends on whether the new leadership actually took hold, for the Momentum scores, and therefore Momentum performance, to appear.
Recently, Energy has ceded its leadership role from last year to Communications Services, Consumer Discretionary and Information Technology year-to-date. Momentum, which had one of its worst months ever in the US in January 2023 (after a disappointing November and December 2022), picked up in February and returned more than 2% for the month ending March 3. It is difficult to say whether a new trend for Momentum performance has started, but at least it is a move in the right direction.
See chart from the US Equity Risk Monitor of 3 March 2023: