All Eyes on Rates & Inflation Amid Rising Recession Concerns

Over the past several weeks, we've introduced Extreme Movers, the latest tool in our arsenal to understand what is driving markets from week to week. We also debuted an international version of the Extreme Movers portfolio to help investors compare fluctuating alpha opportunities and factor-driven dynamics between the US and the world. The Extreme Movers portfolios allow us to apply hindsight to the prior week's momentum to understand the following key questions better:

1. Was the preceding week an alpha-driven or factor-driven week?
2. What are the factor characteristics of the stocks that drove the market?

The Extreme Movers portfolios are weekly-rebalanced, market-neutral portfolios that consist of the top decile of stocks from the Russell 1000 and the MSCI ACWI ex-US, respectively, based on performance on the long side and the bottom decile on the short side. You can find additional information on the construction of the Extreme Movers portfolio in the May 22 edition of Factor Spotlight.

US Market Summary and Extreme Movers Metrics

US Market: 07/08/22 - 07/14/22

• All three major US indices slipped following a positive week prior. The Nasdaq had the sharpest fall, losing -3.2%, while the S&P 500 and Dow were down -2.9% and -2.4%, respectively.
• On Wednesday, June's Consumer Price Index data showed a 9.1% year-over-year increase: 30 basis points higher than the Dow Jones estimate.
• As a result of sharper consumer inflation, the possibility of a 100 basis point Fed rate hike looms over investors.
• Earnings releases ahead of the July 27th Fed meeting will shed some light on the economic outlook and the recession's severity.

Extreme Movers Portfolio Performance

Please note that the portfolio's return will always be positive by constructing a portfolio that is long the top movers and short the bottom movers in an index. That said, there are several areas we want to observe around weekly performance:

1. Is the weekly performance below or above the recent median weekly performance? Above the recent median means that the Extreme Movers portfolios had much higher dispersion than a typical week, most likely driven by higher factor volatility.
2. Is the weekly alpha contribution below or above the recent median alpha contribution? Above the recent median demonstrates that the significant market moves were more alpha-driven than in a typical week. Below the median, the market moves were more factor-driven than in a typical week.

• The US Extreme Movers portfolio continues to sit below its year-to-date weekly median return for the fourth straight week, yielding 14% from Jul 7 - Jul 13.
• The majority of that return (72%) was driven by idiosyncratic alpha, in stark contrast to the prior week, which was dominated heavily by style factors.

• The International Extreme Movers Portfolio’s return was consistent with its US counterpart this week, dropping well below its year-to-date median to 15.5%.
• Like in the US version, the international portfolio’s performance was influenced mainly by idiosyncratic alpha as systematic factor forces took a back seat, adding only 26% of the overall return.

Extreme Movers Portfolio Exposure

Looking at the Extreme Movers from an exposure lens helps us decompose the individual styles and sectors associated with the portfolio's factor-driven performance and better understand broader patterns such as risk-on / risk-off or sector rotation.

• The Energy sector right-sized this week after being the most prominent short position last week. Much of the Energy sector has outperformed the market dramatically on a year-to-date basis but has recently shown mixed performance, falling from its 2022 highs.
• The US Extreme Movers portfolio also reversed course on Information Technology, making it the most significant short position in the portfolio this week.

• While value factors weren’t a huge driver of returns for the US portfolio, the portfolio did gravitate toward high earnings yielding stocks and, once again, moved away from growth.
• The portfolio remained overexposed to beta and residual volatility factors, but overall, exposures were closer to neutral vs. last week.
• The sharpest reversal took place around the Interest Rate Beta factor. Stocks that have a historically positive relationship to interest rates have recently been underperforming. However, that changed this week as the outperformers in the US market were predominantly those positively correlated with rates.

• Sector allocations in the International Extreme Movers portfolio showed much less dispersion than its US counterpart.
• The most prominent long positions were in Industrials and Utilities, but the short side of the portfolio saw a significant shift in Health Care. In just one week, Health Care went from being the largest long allocation to the largest short allocation.

• The consistencies between the US and International portfolios resided in their tilt toward value-oriented, high-interest rate Beta stocks.
• However, a significant difference showed up in beta and residual volatility. This week, the International Extreme Movers portfolio gravitated toward lower beta, less volatile stocks, noting a risk-averse posture.

Factor Surprise

As noted earlier, we are leveraging our surprise metric methodology to understand further the market movements since the publication of the CPI data in early June. We applied the surprise metric on various risk model factor returns and volatility from June 10th through July 13th. Not surprisingly, we see that macro continues to drive market movements. As noted last week, macro factors remain big movers, but style and industry factors have also started to show multi-standard deviation reactions.

Next week, we will monitor and update the surprise metrics focusing on the market's reaction to the June CPI data and a higher likelihood of dramatic rate hikes in the future.

• Macro factors continued to show substantial negative surprise. This negative surprise translated to downward price pressure on global risky corporate and long-duration securities and for inflation- and commodity-sensitive assets.
• The most notable change from last week came from the variations in value. Earnings Yield factors have shown positive surprises while broader value factors, particularly in the US, have sold off.
• Health Care and Materials experienced the lion's share of industry surprises. Biotech factors showed nearly five standard deviation positive movements while Chemical stocks faced steep downward systematic pressures.

Regards,
Kevin