Equity risk factors - The volatility regime may dominate the business cycle environment

 

Equity risk factors are sensitive to changes in the business cycle, yet beyond the business cycle are regimes based on volatility. These longer-term regimes not only influence return but may dominate the impact of the business cycle. See "Do factors carry information about the economic cycle? Part 2: New thinking: Rebooting the investment clock for the new normal and QE regime".

The researchers find the US economy can be classified as either high, moderate, or low volatility. The high volatility period was 1970 though 1982 period which includes the Great Inflation and the high interest rates of the early 1980's. The moderate inflation and growth period has been described as the Great Moderation and Goldilocks period. The low volatility environment includes the QE and new normal period through the pandemic. 

The investment clock defined by the business cycle will have a different framework based on boom and bust with high, moderate, and low economic cycle volatility.

The economic cycle or regime is based on three levels of volatility and make for a different conditional environment. Value and momentum do well in high volatility while the market risk factor will do well in the low volatility environment. 

Investors should not only focus on business cycle dynamics, but also have an idea of the overall economic environment or regime. Currently, we are moving out of the low volatility regime and are entering the high volatility environment with greater real economic risks and higher inflation. This economic volatility regime may dominate the business cycle.