Part 1 - December 30, 2020
The investment clock: linking factor behavior to the economic cycle
Institutional investors are often faced with the question of which factor strategies should be implemented in different phases of the economic cycle. In this paper, we examine how factors behave across economic cycles for the US market:
- Over a long period, we find that Size and Value have anticipated subsequent inflections in GDP growth, while Quality has anticipated contractionary periods. The results are intuitive as Value and Size are more likely to do well when the outlook for the economy is good, whereas Quality provides protection when investors are more nervous about an economic decline. Momentum is found to contain little information about the macro-economy
- We apply the Investment Clock framework to create four economic cycles based on different combinations of economic growth and inflation expectations. We find that Quality tends to do well at the peak of the cycle and continues to do so into a contraction; then, when the market hits its trough, Value, Size and Momentum tend to be the best performing factors; subsequently, Value fails, but Size and, in particular, Momentum continue to do well into an expansion
- However, we have observed lower average factor returns since the post-Global Financial Crisis (GFC) period, which was characterized by quantitative easing, and 12 years of stagnation. We will examine this phenomenon in more detail in our Part 2 report
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Part 2 - February 01, 2021
New thinking: rebooting the investment clock for the new normal and QE regime
Institutional investors often pose the question of how factors perform across economic cycles. The concept of a normalised cycle has come under pressure in the post-Global Financial Crisis (GFC) era that has seen sustained quantitative easing, financial repression and lower trend growth. Consequently, this has necessitated a reappraisal of the traditional investment clock. In this paper, we focus on the new thinking, rebooting the investment clock to link factor behavior to secular regime shifts in the US market.
- The investment clock’s analysis is predicated on the notion of a discernible economic or business cycle, whose existence is questionable post-GFC due to quantitative easing.
An evolution of the investment clock is to observe a pattern of secular regime shifts
- We find that regimes have a significant impact on factor payoffs, driven by the level and volatility of economic indicators
- Since GFC, below trend growth and inflation have oscillated in an all-time narrow range, and have proven to be a difficult environment for broad-based factor performance
- If the past is any indication of the future, a more favorable environment for diversified factor investing is trend economic growth and target inflation
