- Inflationary pressures, rising interest rates and the Russian invasion of Ukraine have combined to take the shine off growth stocks this year.
- There has been a notable rotation within markets, with value and low risk significantly outperforming.
- However, regional discrepancies exist, and Europe has been the notable underperformer for low risk, while emerging markets fared best.
- Our analysis indicates that it may be time for investors to reaffirm their faith in low volatility as a driver of long-term outperformance.
After several quarters of rhetoric citing inflation as transitory, major central banks changed their tune at the start of 2022, delivering more hawkish messages as they vowed to tame inflation, sending interest rates markedly higher. Since then, Russia’s invasion of Ukraine and the subsequent sanctions imposed on the country have sent energy prices rocketing, adding to already strong inflationary pressures, and equity markets have been highly volatile.
Figure 1 charts the steep trajectory of these inflationary pressures since their lows in 2020, which have pushed key interest rates to two (US) and three (Europe) year highs, as shown in Figure 2.
Figure 1: Inflationary Pressures Have Plateaued at Elevated Levels
Source: Bloomberg, Unigestion. Data as at 23.03.2022.
Figure 2: Sharp Rebound in US and German 10-Year Yields
Source: Bloomberg, Unigestion. Data as at 15.02.2022.
Low volatility and value are once again providing the downside protection for which they are usually known
Against this changing macroeconomic backdrop, growth stocks, long the darlings of investors, have been among the hardest hit. Even before Russia’s actions, they had begun to lose some of their sparkle, as investors assessed the impact of higher inflation and rising rates on their growth prospects. At the same time, we saw the traditional low volatility and value sectors outperform significantly and provide the downside protection that they are usually known for but that many had been questioning over the last couple of years.
Figure 3 details the sector hierarchy year-to-date and highlights these stark differences. As can be seen, cyclical value sectors such as Energy and Banks have outperformed significantly, while growth sectors have suffered. It is also interesting to note that some traditional bond proxies, such as Telecoms, have not suffered due to rising rates, supported instead by relatively attractive valuations.
Figure 3: Year-to-date Sector Performances for MSCI World (in USD)
Source: Bloomberg, Unigestion. Data as at 17.03.2022.
The discrepancies become even more obvious when we look at the factor performances in Figure 4.
Figure 4: Year-to-date Factor Performances
Source: Bloomberg, Unigestion. Data as at 28.02.2022. Unigestion Global (ACWI) Equities Factor Model.
We believe that central banks’ policies and the Russia/Ukraine conflict may have triggered a longer-term shift in equities
Looking ahead, we believe that central banks’ policies and the Russia/Ukraine conflict may have triggered a longer-term shift in equities, signalling a prolonged period of uncertainty, price volatility and lower growth. Against the current backdrop and outlook, our analysis indicates that it may be time for investors to reaffirm their faith in low volatility as a driver of long-term outperformance.
Figure 5 highlights how low risk and value are once again starting to move in sync, with their strongest cross-sectional correlation levels since 2007. And, as illustrated in Figure 6, historically, the stronger this correlation, the stronger the performance of the low risk factor over the next 12 months. When the correlation is above 0.18, a level close to where we stand currently, the low risk factor has historically delivered positive performance over the next year 70% of the time, with an average next 12 month return of 12.9%.
Figure 5: Cross Correlation of Low Risk and Value Scores (for MSCI ACWI)
Source: Bloomberg, Unigestion. Data as at 28.02.2022.
Figure 6: Average Next 12m Performance of Low Risk
Source: Bloomberg, Unigestion. Data as at 28.02.2022.
So far in this paper, we have demonstrated the good downside protection shown by the low risk factor year-to-date within global equities. However, there have been significant differences across regions, notably with European equities, where low risk has been particularly disappointing in terms of capital protection. As Figure 7 shows, EU low risk has actually delivered a negative return so far this year. Looking at the behaviour of other factors, we can see that value has also underperformed in Europe relative to global equities, while growth has suffered less. Companies with solid ESG credentials have also underperformed more in Europe compared to the rest of the world. It is a similar story with size, with the performance of mid-caps (in which low risk often finds a sweet spot) being more muted than large caps.
Europe has been the notable underperformer for the low risk factor
Figure 7: Year-to-date Factor Performances Across Regions
Source: Bloomberg, Unigestion. Data as at 28.02.2022.
In terms of sectors, the less pronounced lag of growth stocks in Europe, combined with a lower weighting of growth sectors such as Software, Media and Semiconductors in European indices, led to a much less pronounced positive impact of the traditional underweight of low risk strategies in growth exposures. We estimate this impact to be only 0.9% in Europe, while it provided between 2.3% and 3.1% of relative returns in our other regional strategies, as shown in Figure 8.
Figure 8: Year-to-date Total Relative Contribution in Growth Sectors
Source: Bloomberg, Unigestion. Data as at 28.02.2022. Regional representative accounts on World ACWI, World Developed, Europe and USA vs their respective benchmarks: MSCI ACWI TR Net USD, MSCI World TR net USD, MSCI Europe TR Net EUR, MSCI USA TR net USD. Performance is stated gross of fees.
Contrary to Europe, emerging markets have been the best place to be invested in the low risk factor year-to-date
Contrary to Europe, emerging markets have been the best place to be invested in the low risk factor year-to-date. Russia’s invasion of Ukraine has had a significant negative impact on both Russian stocks and the rouble. We estimate that the relative performance contribution of our divestment from Russia, which was implemented in early December 2021 on the back of the growing geopolitical risks, to stand at approximately 1.6% so far in 2022. Combined with our exposure to more defensive countries such as Thailand and Saudi Arabia, our geographical allocation, which is a consequence of our low risk approach and our active management of the Russian risk, has proved very successful, as shown in Figure 9.
Figure 9: Year-to-date Key Country Allocation Impacts – Emerging Markets Strategy
Source: Bloomberg, Unigestion. Data as at 28.02.2022. Representative account on Emerging Markets vs MSCI Emerging Markets TR net USD. Performance is stated gross of fees.
Over the last three years, low risk strategies have been something of a disenchantment for investors. However, it is now time for investors to reassess the place of such strategies in their equity asset allocations. In an inflationary, low growth and uncertain environment, valuations of growth stocks are likely to come under continued pressure, while low risk names with attractive valuations, good credit quality and solid visibility on earnings should attract investors and could deliver above average results. Combined with risk characteristics more favourable than market averages, risk managed strategies will likely find a suitable environment to strive in the coming years. Having said that, low risk alone will not be enough, and investors will need to carry out a full 360-degree risk assessment, addressing factors such as fundamentals, interest rate sensitivity and ESG.
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Document issued April 2022.