Qontigo Insight Q2 2022 Quarterly Risk Highlights: Higher volatility and correlations led to soaring risk, and equity investors sought stability and low beta

Top Takeaways:

• Most markets fell and risk increased in Q2 and YTD. US (Large and Small Cap) had the most negative returns, but Australia and Canada experienced the largest increases in predicted volatility (although are still at the low end of the risk spectrum)
• US expected risk is now higher than that of any other region, and although below the levels of prior bear markets is still in the 94th percentile relative to history. The US now contributes more to the STOXX Global 1800 than it has in at least seven years
• Individual and aggregate currency risk has continued to rise, while country risk for most countries, up YTD, fell in Q2
• Higher asset correlations meant less diversification, higher index risk and lower asset dispersion
• Returns to inflation-related macroeconomic factors were negative in Q2 as TIPS’ yield rose even more than the 5 year driving breakeven inflation down. Term spreads narrowed as well, as T-bill yields rose much more than the 10 year treasury. Wider credit spreads hurt equity returns more than any other macro variable
• Most style factors behaved as expected in Q2, except Momentum. Returns to Market Sensitivity and Volatility were highly negative in most regions. Style factor volatility fell and many factor risk-model correlations were unchanged
• Exposure correlations between Momentum and value-based factors rose, suggesting that Momentum is cheap or value now has momentum. Momentum and Market Sensitivity became much more negatively correlated since low Market Sensitivity outperformed

Short-horizon predicted volatility

Source: FTSE Russell, Qontigo

• Risk rose again in Q2 in every region except Japan and China. Proportional increases vs. Q1 ranged from 5-7% for European indices and Emerging Markets to as high as about 30-35% for Australia and Canada. US risk increased substantially as well
• Risk is up across the board vs. the end of 2021, from just a 12% increase in Japan to almost doubling for DAX
• Risk has climbed every quarter for at least the past year in the US, which is now expected to have higher volatility than any of the other regions, both large and small cap
• Despite the increases in Q2, Canada and Australia remain among the lowest risk regions, along with Japan and the UK

US Short-Horizon Fundamental Predicted Risk

• Predicted volatility for the broad US market rose about 25% in Q2, has almost doubled year to date, and is 2 ½ times higher than it was at its recent low in September 2021
• US risk has not reached prior peaks seen during COVID, the GFC and the 1987 crash, but it falls in the top 6% of observations since 1982

Source: Qontigo
Risk figures are based on the Axioma Market Portfolio US-LMS, which represents the broad US investment universe

Sector Weights and Risk Contribution – STOXX USA 900

Emerging vs. Developed: Benchmark Risk

• Dominated by the US, the STOXX Global 1800 index has seen its risk rise much more than for its emerging market equivalent
• EM ended Q2 at around 80% of DM risk, but dipped to 75% in mid-June. This is the biggest gap between EM and DM risk since at least 2006
• Adding EM stocks to a DM or all-world portfolio could lower active risk, but should also be closely monitored

United States Weight and Contribution to Short-Horizon Risk, STOXX Global 1800

• The weight of the US in the STOXX Global 1800 index fell in Q2 for the first time in six quarters and only the third time in the last 20 quarters. At almost 66%, however, it continues to dominate the index
• At the same time, US contribution to risk rose to almost 72%, the highest it has been in at least seven years and driving the gap between weight and risk to its highest reading since 2018
• Japan’s contribution to global risk is the most below its index weight (4% vs 7.6%)
• A US overweight may result in higher-than-expected tracking error’

Source: Qontigo

Macro Factor Returns: After Unusually High Returns In Q1 Many Factors Reversed Course in Q2

• Many macro factors’ returns reversed sharply from Q1, especially inflation-related factors, with the return to GB inflation the lowest in the history of the model. While reported inflation continued to climb, break-even inflation actually fell (see chart for US)
• The US Term Spread return was also negative, as 6-month bill yields advanced far more than 10-year bonds’

Macro factor influence waned in Q1 But Reappeared in Q2

• The influence of Macro factors on returns picked up in the second half of Q2 as the market impact became less negative
• Among the macro factors, widening US and EUR credit spreads produced the biggest drag on performance
• Exposures to GBP BBB and Term Spreads, along with Oil, helped the index this year but not nearly enough to offset the drag from other factors
• See Appendix for macro influence on other markets

STOXX Global 1800 Correlations and Diversification

• 60-day correlations rose in Q1, and are now relatively high, falling into the 84^h percentile relative to history (up from the 70^th at the end of Q1)
• They remain well below the levels seen during other crises, such as COVID, European debt crisis or the global financial crisis
• Higher correlations make diversification more difficult, which we can see in the declining level of the diversification ratio, which is approaching 10-year lows
• Higher correlations also drove benchmark risk higher and asset dispersion lower

Source: Qontigo

Despite increasing market volatility, most factors’ returns were within the expected direction and not outsized vs. beginning-of-quarter expectations

Q2 2022 Performance

Note: an “*” indicates that the return was two standard deviations or more away from the long-term average, with the standard deviation defined as the risk forecast at the beginning of the period. The highest and lowest regional return for each model is highlighted.

A Closer Look at US Style Returns:

• Momentum had a tough quarter in the US, and returns to Market Sensitivity and Volatility were among the lowest in the history of the model, reflecting investor caution

*Normalized: (Actual Return – Long-Term Average)/Realized Standard Deviation
**Rank: Percentile relative to long-term history. Bold means top or bottom decile
Red denotes typically compensated factors with big returns opposite to the long-term average

A Closer Look at Trading Model Style Returns: Trading-specific factors

• The performance of Downside Risk mirrors what we saw in the longer-horizon model, especially for the YTD period
• Short interest also produced negative returns for the quarter and YTD – those stocks with the highest short interest had the worst returns, and YTD that performance was almost three standard deviations below average

*Normalized: (Actual Return – Long-Term Average)/Realized Standard Deviation
**Rank: Percentile relative to long-term history. Bold means top or bottom decile
Red denotes typically compensated factors with big returns opposite to the long-term average

US Factor Exposure Correlations

• Momentum and Value remain uncorrelated, while Momentum and Earnings Yield, and Momentum and Dividend Yield became more positively correlated: Momentum is cheap or EY and DY have Momentum?
• Momentum and Market Sensitivity are now  negatively correlated, after highly positive correlations in 2021
• Volatility and Momentum are now slightly positively correlated
• The relationship between Market Sensitivity and Value remains negative
• Most other factor pairs’ correlations have not changed substantially