Investors should think risk factors, not asset classes

Rather than using the traditional asset class analysis, I have found employing a risk-factor approach particularly helpful in understanding the impact of economics and policy on markets this year — not only in explaining the evolution of valuations, correlations and volatility, but also in pointing to what to look for in the near term.

One of the simple ways to think of risk factor analysis is breaking down a financial asset or an asset class into the attributes of its market sensitivity — be it interest rates, credit, liquidity or momentum, for example. With that, certain bond classes, such as high yield, can be shown to be more sensitive to risk factors that affect stocks more than government bonds.

Risk factor analysis can also be used to explain general movements when, as has been the case this year, markets are affected by common top-down drivers.

For most of 2022, markets have been responding to moves in key interest rate paths caused by persistently high inflation and the related realisation that the Federal Reserve is being forced to exit its long-standing policy paradigm of near-zero interest rates and predictable liquidity injections.

This sudden and strong domination of markets by the “interest rate factor” broke down the traditional inverse price correlation between stocks and bonds, resulting in significant losses in both the Nasdaq composite index and 10-year US treasuries, for example. It also fuelled unsettling volatility, adding to investor discomfort and raising concerns about negative spillbacks for the real economy.

As the markets aggressively repriced the path of interest rates for the economy, concern shifted to the implication for consumption and investment. This brought into play the “credit risk factor”, retaining pressure on stocks, fuelling further volatility but, in a stark change from what happened in the first five months of the year, starting to restore the traditional correlation between stocks and bonds.

Looking forward, it looks as if markets will continue to oscillate between these two risk factors as they await evidence on three key economic and policy questions:

• How successful will a lagging Fed be in battling inflation, and how much collateral damage will be associated with its catch-up process?
• To what extent will a strong labour market shield the US from an economic recession?
• How sticky will inflation prove to be in the context of declining aggregate demand?

Those advocating large general increases in holdings of risk assets are assuming that the answers to these three questions would combine to deliver what economists call a “soft landing” — a reduction in both actual inflation and inflationary expectations without notable damage to the real economy.

Specifically, that would result from the Fed succeeding in regaining its policy credibility and effectiveness, the labour market anchoring a still-buoyant economy, and inflation not being propped up by persistent supply-side disruptions. Importantly, it would deliver not only friendly interest rate and credit risks but also ensure that a looming third risk factor does not come into play: a liquidity dislocation that undermines the orderly functioning of markets.

The triggering of such a “liquidity risk factor” would compound still-disruptive interest rate and credit risks, rendering the second half of 2022 as challenging for investors as the first half has been. And between these two extremes, various permutations tend to favour selective investment approaches and careful selection of individual stocks. 

As of now, and as hard as we all try, there are simply no clear and confident answers yet to the three key economic and policy questions and, therefore importantly, how the various risk factors will evolve from here. It is a fact to keep in mind as many rush to assertively predict what is ahead for markets.

Bloomberg Opinion. For more articles like this please visit Bloomberg.com/opinion.