What is going on with equity ARP? Just a poor period or something more

What has been going on with classic equity alternative risk premia like size, value, and momentum? This has been a key investor question for the last few years given their return underperformance. This return shortfall has caused some investors to exit or avoid the equity ARP market and argue that it is not working.

The researchers at Scientific Beta in their work “What Really Explains the Poor Performance of Factor Strategies Over the Last 3 Years?” conclude that the performance is unusual but perhaps not extraordinary. They find that other factors within the equity space have performed well and that some of the current underperformance is associated with macro factors. Additionally, we conclude that active involvement in the ARP space requires a broader diversification view of alternatives across all asset classes and intra-market factor strategies.

How bad has been the return performance for long/short size, value, and momentum factor strategies? The numbers show that the returns are in the bottom tail. This has not the worst period, but it should be a concern. However, the chance of having a negative three-year period for these ARPs is about one in three. On the other hand, low volatility, profitability, and investment ARP portfolios have performed well. This has been a poor period for some strategy factors, but not for all. The likelihood that multiple factor strategies all turn negative is rare.

It seems that before we announce the death of some factor strategies there should be some empirical context for their performance. All of these risk premia are time varying. There is no alternative risk premia that will generate positive returns in all market environments. They will be sensitive to the business cycle, interest rates, and other macro factors. 

The macro factors suggest that there are some valid reasons for the underperformance based on the macro trend of turning from a good to bad economic environment. These macro links suggest that an improvement in the macro environment will likely see an improvement in these key equity factors. Value and momentum are both sensitive to the macro outlook spread. 

Similarly, some risk premia are very sensitive to macro factors. For example, value and momentum are both sensitive to the term spread, albeit in opposite directions. 

This paper does not try and explain away the poor performance of some equity ARP. It has not been good; however, the underperformance is partially tied to the macro environment. There has been some positive return movement into value over the last three months, so there may be slow switch to value ahead. The long-term performance and change in the macro environment may suggest that there are current opportunities in holding some underperforming ARP factor strategies.

Lagarde - First lesson of central banking - Do not provide clarity

Lagarde:  We expect ECB interest rates to remain at their present or lower levels until we have seen the inflation outlook robustly converge to a level sufficiently close to, but below, 2% within our projection horizon and until such convergence has been consistently reflected in underlying inflation dynamics

-      From ECB transcript

Simple language forward guidance: The ECB will continue current policy until core inflation reaches 2%.

This was Lagarde’s first press conference and there was the desire to not upset the markets and continue the status quo, but why should there be so much nervousness over a press conference? 

The press words are used to mute clarity and provide flexibility. Clarity associated with policy change is not desired. Some clarity of thinking that will help all market participants understand ECB monetary policy would be to define clearly these terms:

“robustly converge”

“sufficiently close to”

“projection horizon”

“consistently reflected”

“underlying inflation dynamics”

These undefined clarifying terms all lead to market uncertainty. Perhaps we get so used to the current ambiguity that we are immune to this uncertainty. What was said may make perfect sense, but would you make large investment decisions based on this current clarity? A change from the past for any central bank would be to say what you mean. 

Inflation is a global issue, but what if globalization reverses?

The US has a 2% inflation target. Other countries have similar targets. All are frustrated by the their inability to consistently reach those targets even though they have tools that should push prices higher. The US is an especially interesting case given that current unemployment is so low. 

However, the latest CPI numbers suggest that the US is at the target; slightly higher for the core CPI and slightly lower for the headline numbers. The problem will be staying at the target; consequently, there is a strong reason to place a hold on any further Fed cuts at this time. 

Nevertheless, there is still a need to understand the drivers of inflation. One answer is that inflation is not just a domestic slack issue but a global phenomenon. There is a link between inflation in the rest of the world and the US. This is the conclusion of one leading inflation researcher, Kristin Forbes, who wrote an extensive paper on this issue in the Brookings Papers on Economic Activity "Inflation Dynamics: Dead, Dormant, or Determined Abroad".

Her conclusion is that CPI inflation across countries has become more synchronized since the Financial Crisis in 2008; however, this synchronization has not carried over to core inflation and wages. The inflation components tied to core domestic pressures are still local. Still, Forbes finds that global factors such as commodity prices, world economic slack, exchange rates, and global value chains all impact headline inflation. The world has gotten more connected with respect to inflation and accounting for this globalization will improve median prediction error for inflation by about 12%. There may still be a Philips curve trade-off but it has flattened since the Financial Crisis. Of  course, these conclusions are generalizations across all countries. The impact of global versus domestic inflation factors will vary across countries. 

While there has been an increase in inflation globalization, the obvious next question is whether a reversal of globalization will lead to more localization of inflation. This would mean more potential inflation dispersion and a greater impact from local slack over global economic slack. It also means that core and headline may start to have a tighter relationship. 

Any diminished global effect will have a carry-over effect on global interest rate dispersion and currency dislocations. This is unlikely to be a short-term effect, yet it should be worth watching for greater inflation dispersion. Overall, the inflation question is more complex for a globalized economic system over a closed economy; consequently, following international developments is essential for effective inflation forecasts.