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Equity Risk Monitors — November 28, 2023

Equity Risk Monitor Highlights | Week Ended November 24, 2023

  • Country risk in developed markets has risen across the board
  • Diversification ratio declines on higher asset correlations
  • US Sectors with Momentum have shifted

Country risk in developed markets has risen across the board

Short-horizon risk for the STOXX® Developed World Index bottomed out in early October and has been rising since then, as measured by Axioma’s Worldwide (WW4) model. Medium-Horizon risk forecasts tend to follow their short-horizon counterparts, and we have seen those forecasts (both fundamental and statistical) rise as well. Looking at the breakdown of the components of risk, we note that the drivers of the increase are Market Risk and Country Risk; other components have been relatively flat recently.

Managers making country bets may want to gain a better understanding of which countries are driving the change, so we drilled down into the individual developed-market countries to see if any stand out. Interestingly, country risk (risk of the country over and above all the other risk factors in the model, including the market) is higher than at the beginning of this quarter for every developed-market  country except Spain and Italy. Proportionally (relative to the level at the end of September), the US and Japan have seen the highest increases, although the US remains the lowest risk of all the developed market countries. We also note that there has been little change in the correlation between countries, so the increase in benchmark country risk was mainly the result of higher country volatility.

See charts from the STOXX Developed World Equity Risk Monitor as of 24 November 2023:

The following chart does not appear in the Risk Monitors but is included in our Quarterly Insight Webinar and Summary, and is available on request:

Diversification ratio declines on higher asset correlations

By comparing the weighted average volatility of the stocks in an index to the total predicted volatility, we are able to determine the diversification impact of the correlations between the assets. If all assets had a correlation of 1, the total index risk would be equal to the weighted average of the individual total risks. Of course, all assets are not 100% positively correlated, so there will be a gap between the two measures, and the gap for the index – the Diversification Ratio – suggests how well diversified a manager targeting that index can be.

Over the past two months, the Diversification Ratio for most of the indices the Risk Monitors track closely has fallen substantially, as longer-term asset correlations have risen. The major exception to falling diversification capability is in the STOXX® Europe 600, where correlations have been much more stable than they have been in the rest of the world. After reaching near-term highs recently, the diversification ratio is now just about average for the STOXX® Developed World index. This suggests no cause for alarm, but also that the ratio bears watching. As we enter 2024 and many global events will continue to dominate the headlines, correlations between individual stocks may very well continue to rise, as stock returns are driven more in the same direction by top-down global events rather than bottom-up individual asset characteristics such as earnings.

See charts from the STOXX Developed World Equity Risk Monitor as of 24 November 2023:

US Sectors with Momentum have shifted

The 7.6% gain over the past month in the STOXX® US Index has once again been dominated by Information Technology, with Financials and Consumer Discretionary each also contributing more than 1% to the overall return. All sectors except Energy have seen a positive return in the past month.

Sector-Style exposures (the weighted average of the exposures of each stock in the sector to each factor) tend to remain fairly consistent over time but return differences can impact the Momentum exposures of sectors. Since the end of the third quarter, we have seen a few big changes in Momentum exposures for the US4 model, most notably higher exposure for Communications Services (which now has the highest exposure of all the sectors) and Consumer Discretionary (which went from negative to positive), and lower exposures for Industrials and Materials (both of which went from negative to even more negative). Utilities, Real Estate and Consumer Staples have maintained their lowest-Momentum status, and Information Technology has slipped from the highest rank on Momentum to second place.

Price changes can also impact exposures to Market Sensitivity and Volatility. Info Tech still has the highest level of Market Sensitivity although it has dropped in the last couple months. Utilities’ Volatility exposure  has increased (to 0.23) and it is the third-highest Volatility sector, while Consumer Staples went from a negative exposure to a small positive one.

Finally, trading action can impact Liquidity. We observe increases from negative to positive Liquidity for Energy and Utilities, with insignificant moves in other sectors.

See charts from the STOXX US Equity Risk Monitor as of 24 November 2023:

The following chart does not appear in the Equity Risk Monitors but is available on request: