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Equity Risk Monitors — January 2, 2024

Highlights of Highlights 2023

Happy New Year to all our readers! On behalf of SimCorp, Axioma’s new parent company[1], we wish you a happy, healthy, and prosperous 2024.

This week’s edition of the Axioma Equity Risk Monitor covers the major trends in 2023 with links to many of our blog posts; for more details, please register for our Axioma Insight 2023 Risk Review webinar, taking place on 10 January.

In this year-end analysis we discuss market performance, its impact on risk, and other elements of the overall environment.

Click on the subtitles below to jump to each respective section:

  1. Strong market performance
  2. Low Volatility, Low Volume and High Concentration
  3. Sector Reversal
  4. 2023 Global Style Factor performance, in line with 2022
  5. Risk decline driven by fall in factor and stock volatility and buoyed by lower correlations
  6. Developed vs. Emerging Markets Risk and Diversification

Strong market performance

While gains were not smooth throughout the year, most markets saw a strong finish to 2023. Japan was in the lead for most of the year, although a strong December for the US, coupled with a small negative return for Japan, rendered the two countries neck-and-neck for the year.  These two markets propelled the Developed World index to a return of more than 20%. In the first half of the year, Developed Markets ex-US fared better than US market, but as stocks continued their ascent, the US market has been outpacing the ex-US market since May. US Small cap stocks substantially lagged their large-cap peers until December, when they soared more than 11%. US Small Caps still lagged Large Caps for the year but with the help of tailwinds, ended ahead of Europe and Emerging Markets.

China’s return, in contrast, was negative, , as concerns about the Chinese economy have been mounting. Asia Pacific ex-Japan is the only other region to finish the year in the red, among all geographies tracked by Axioma Equity Risk Monitors.

The global economy seemed to remain resilient when confronted with unruly inflation, rising interest rates, a banking crisis, and an inflamed geopolitical environment (with at least two wars in progress, Russia-Ukraine and Israel-Hamas, both having had the potential of expanding to other regions at some point).

In fact, sentiment actually improved, particularly in the fourth quarter, buoyed by optimism that the Fed and other Central Banks would stop hiking rates and potentially even lower them, avoiding a hard landing.

See graph from the STOXX US Equity Risk Monitor of 29 December 2023:

Low Volatility, Low Volume and High Concentration

Risk Down Everywhere (except in Japan)

As stocks rose, equity markets around the globe witnessed a substantial decrease in risk since the beginning of the year, despite significant uncertainty in the market conditions and multiple adverse events. While rising in Q4, Global Developed Markets volatility (as measured by the short-horizon fundamental model) ended the year 35% lower than at the end of 2022.

All regions tracked by the Risk Monitors, except Japan, are now less risky than they were one year ago, as measured by Axioma’s respective regional models. The UK market’s risk was just slightly lower, while in the US, volatility fell more than 40%.

The US started the year as the riskiest region and is now somewhere in the middle of the pack. While US risk has trended downward for most of the year, the large spread between the statistical and fundamental forecasts at both medium and short horizons in Q2 and Q3 pointed to additional sources of risk captured by the statistical variants. This, we believe, may have been related to mega-cap concentration in the US. The gap closed in Q4, when the US fundamental and statistical variants were mostly in agreement.

See graph from the STOXX Developed World Equity Risk Monitor of 29 December 2023:

Low trading volume coupled with a narrow market

Another trending theme of 2023 has been the relatively low level of trading volume, which went hand-in-hand with the narrow breadth. The two observations together suggested a lack of conviction from investors for most of the year, in what otherwise looked like a strong equity market.

The average daily trading volume (in US dollars) for Developed Markets was subdued in 2023. After hitting a 12-month low in January, trading volume climbed to a near-term high in June, before coming down in the third quarter and almost regaining the June high in the fourth. The June record, however, was much lower than the highs seen in the last couple of years and the year-end surge came along with substantially higher prices.

The most recent increase in trading volume may indicate that investors are shifting back into equities as bond yields fall and the most recent rotation, we have seen in style factors could also point to a change in leadership, which may require more trading. US Small Caps, in particular, have seen a surge in volume; year-end volume was well above highs earlier in the year, and more than 40% higher than at the end of 2022.

Still, the increase in most markets was mostly driven by few stocks and on low volume, suggesting the market recovery is fragile. The average five-day breadth (percent of stocks that had beaten the index) has been frequently at 40% and even dipping to 30% in a few of the weeks. More so, the United States has been more concentrated this year than in any time, in at least the last 33 years.

See graphs from the STOXX Developed World Equity Risk Monitor of 29 December 2023:

Sector Reversal

Global cyclical sectors, such as Information Technology, Communication Services and Consumer Discretionary gained the most, while defensive sectors, such as Utilities, Energy Health Care, and Consumer Staples recorded relatively small gains of less than 5% in 2023.

Energy ceded its leadership role from last year to Information Technology. After a terrible 2022, when Info Tech dropped nearly 30%, the sector was the biggest winner in 2023, gaining almost 60%, while Energy, which gained nearly 50% in 2022, rose less than 5%. Yet, Energy has a small impact on the global market due to its small weight (~5%). The Developed World market’s outperformance has mostly been driven by technology (and especially the Magnificent Seven in the US), while sectors in Developed Markets ex-US contributed much more evenly. Note however that while Energy is underperforming in the US and in the global arena, it is up quite a lot in Europe.

In terms of risk, within global developed markets, Information Technology started the year as the riskiest sector, but Real Estate took its place by year end causing the former to drop to the middle of the pack. Most other sectors’ relative riskiness remained stable during the year. For example, Consumer Staples started and ended 2023 as the least risk sector.

Even with the March banking crisis rattling the stability of the sector, Financials recorded a positive return in the US and a three-fold higher return than in the US in Developed markets ex-US, where it exerts a greater pull over the market, due to its weighting. 

On the other hand, the Financials sector in the US Small Cap market incurred a loss through November, perhaps not surprisingly given that it was smaller regional US banks that failed and are still struggling to retain clients, especially in the wake of the high Treasury yields that put pressure on banks’ balance sheets. As expectations of lower rates took hold, views on small US financials changed, however and the sector surged, gaining 18% in the fourth quarter and ending the year with a +15% return.

See graph from the STOXX Developed World Equity Risk Monitor of 29 December 2023:

2023 Global Style Factor performance, in line with 2022

The recoveries in cyclical stocks relative to their more stable counterparts in the beginning of the year meant that Momentum suffered in the first half of 2023. That is because when market leadership changes abruptly, Momentum, which expects winners to continue winning and losers to continue to underperform, takes a hit. But Momentum came back in the second half of the year and returns were positive in all models, except Canada and the UK.

Global risk appetites oscillated this year, reflected in the sinusoidal path of Market Sensitivity and Volatility returns. That is, investors went back and forth, from favoring low beta and low volatility stocks, to shunning high beta and high volatility alternatives. Both factors finished the year on an upward trend—reflecting an improvement in market sentiment, Market Sensitivity’s 12-month return was positive in almost every market, while that of Volatility remained negative in most.

It was a big year for Size. Across developed markets, the one-year return to the global Size factor was positive and large in magnitude and of the opposite sign, relative to expectations from the history of the risk models. Large Cap equities have outperformed their Small- Cap counterparts in Developed Markets, while the reverse was true in China and Emerging Markets.

The resurgence of cyclical sectors did not seem to hurt the Value factor. Just like last year, Value recorded a strong positive return, as did Earning Yield (except in US Small Cap). Profitability had an unusually strong year in developed markets, although the return was negative in emerging markets.

See graphs from the STOXX Developed World Equity Risk Monitor of 29 December 2023:

Risk decline driven by fall in factor and stock volatility and buoyed by lower correlations

From a factor model perspective, the decline in factor volatility drove down overall risk in all regions but UK and Japan. Factor volatility ranges have been narrower and of smaller magnitude than they were last year when factor volatility drove risk up.

The 60-day median pairwise asset correlation dropped precipitously in the first quarter, retraced its steps in the fourth quarter but remained below levels seen in the beginning of the year in most cases. The significant decline in correlations had a major impact on the overall decline of the equity markets’ risk over the past 12 months and was on par with the impact of declining stock volatilities in most major markets. Also, in some cases, such as UK, Japan and Asia-Pacific ex-Japan, correlations served to increase risk.

Mirroring the asset-asset correlation behavior, the asset diversification ratio climbed throughout the first three quarters of the year, only to come down in recent months. The higher the ratio, the greater the diversification on offer by the market, and therefore managers of equity portfolios were in a good position to diversify their portfolios in 2023.

See graphs from the STOXX Developed World Equity Risk Monitor of 29 December 2023:

Developed vs. Emerging Markets Risk and Diversification

2023 started off with the ratio of Emerging Markets to Developed Markets risk being well below one—where it had been stuck for all of 2022, indicating that Emerging Markets were surprisingly less risky than their developed counterparts. This was the longest period going back to 2006 where we observed this atypical behavior. The culprit was primarily the relative lack of diversification in Developed Markets, coupled with high volatility in its largest constituents.

Asset diversification improved in both Emerging and Developed markets in 2023, but the improvement was qualitatively different. In Developed Markets, it resulted from decreasing correlations between the mega caps driving developed market performance and the rest of the stocks. The increased diversification in Emerging Markets was due to the asset correlations falling more broadly, so the overall median correlation for Emerging Markets was lower.

While the lack of diversification relative to Emerging Markets hasn’t improved, the volatility of the largest names has dropped considerably in the Developed Markets and between June and mid-December, Developed Markets have been less risky than Emerging Markets, as one would expect.

After reaching a peak in August, the relative riskiness of Emerging Markets declined and by the second half of December they were once again less risky than Developed Markets.

The chart below does not appear in the Equity Risk Monitors, but can be provided upon request:

These are just a few observations about the risk, return, correlation, volume and factor environments we found ourselves in throughout 2023. Our weekly highlights centered mainly on these topics. Our quarterly summaries can be found here, and our weekly commentary can be found here. Please join us on January 10 for a more comprehensive review of the year in risk. You can register here, and find recordings of prior webinars here.

We look forward to another year of helping portfolio managers, risk managers, asset owners, hedge funds and other investors better understand the risk environment in which you are investing and providing tools and analysis to help you better position portfolios to achieve the best possible returns.

The Axioma Applied Research Team at SimCorp.

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