Factor returns move with the economic cycle. These factor relationships with the economic cycle are well-documented, so if the economic cycle changes or expectations about economic growth change, there will be changes in the relative performance of factors. This can help explain some of the factor switching that was seen in the spring, summer, and fall of 2020. Great upheavals in the business cycle will not only lead to changes in the market risk premium but significant shocks to factors returns even though they are often expected to be less volatile that market returns.
Recent research show shows these relationships are more complex yet potentially valuable for global macro timers. Factors are forward-looking, that is, a factor may anticipate changes in the economic cycle. They embed expectations about the cycle; however, these relationships are often unstable. (See "Do Factors Carry Information About the Economic Cycle" by Marlies van Boven at FTSE Russell)
When economic growth is divided into three regimes, there are strong differences in conditional factor returns. Clearly, market returns are significantly higher in high growth periods over low growth regimes. On the other hand, quality and momentum factors do very well during low growth periods.
These investment factors also tell us something about future economic growth. Size returns have a positive prediction on growth while quality has the opposite sign. On the other hand, value and momentum have less predictive power concerning future GDP. Nonetheless, value has additional predictive information beyond market returns. These market signals have actually strengthened since the GFC as noted in the second conditional panel.
This evidence can be further sliced with inflation to provide a four regime world of expansion, slowdown, contraction, and recovery. Investors want to avoid value and hold momentum factors during an expansion, and avoid size in a slowdown and contraction. In a recovery period, holding market risk and momentum will be rewarded. Still, these rules are not hard and fast especially when looking at the post GFC period.
Markets, which include the performance of factors, are forward-looking and provide expectation signals. They can anticipate economic expansion and slowdown, so the global macro trader who wants to engage in factor rotation has a tough job. The macro manager has to form economic cycle expectations and determine whether those view have already been discounted in factor returns. The gains can be significant, but these relationships are volatile and require strong opinions no different than those needed to forecast the overall direction of the market.
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