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Editor's Note: Hamish Risk | November 18, 2020
As we highlighted yesterday quant factor investing continues to get plenty of attention following the recent vaccine news and the flux around the ”the great rotation,” which has created some big name casualties. Factor investing isn’t just for equities by the way. As Joachim Klement from Liberum explains, currency investors learned the hard way (sometime back) that factors can stop working altogether, including the legendary carry trade. As for the equity rotation, one might need to consider more than the standard model factors, argue Quant Insight, a firm that specialises in deciphering macro factors within their regimes. Their models find the reality of relative sector valuations looks somewhat different when seen through a macro prism. One other relationship not quite playing by the book is that of equities versus bonds with Christophe Ollari explaining how this will feed a risk parity nirvana for a while yet. Back to vaccines and away from quant, in the real world the challenge of distribution promises to be a road pocketed with pot holes. Capital Economics analyses the state of play regarding vaccine distribution, estimating that restrictions on activity are likely to be removed by next spring in advanced economies, but EM faces a much longer road to vaccinations, and that perhaps will hold back EM assets over that time. Finally, in our ESG segment today we highlight Bank of America’s instructive primer on the proposed Carbon Border Tax which is set to be passed into European law next year.
carry trade Currency factors ZIRP Liberum
1. Central banks killed currency tradingIt is ironic that factor investing became popular in equity markets just when currency investors learned the hard way that factors can stop working altogether, says Joachim Klement at Liberum. The most popular anomalies (aka factors) that are traded in the currency markets are the carry trade, momentum trades, and the valuation trade, he explains – and all of these factors have been described in the literature and shown to make substantial profits in back-tests. And just like equity market factors, says Klement, many of them become less effective after they have been published and lose a large chunk if not all of their profitability. In fact, he shows that the only factor that kept working after publication was the carry trade, and then only when investors avoided the US dollar. Worse still, Klement shows the carry trade only worked for currency investors until 2008, since when, factors have completely lost their efficacy, with nothing working in the currency markets for more than a decade now. Of course, he notes what changed after 2008 was that developed market central banks lowered interest rates close to zero across the globe, making it impossible to make money in currencies in any systematic way. This, says Klement, makes him wonder if this regime change after the financial crisis also contributed to the decline of factor performance in equity markets over the last decade.
equity rotation macro regimes Quant Insight
2. Rotation Party with a macro chaperoneIs this latest rotation the genuine article, or another false dawn? Asks Quant Insight. If the global economy is to look forward to a new normal, it first needs to navigate it’s way through an uptick in COVID-19 cases and a soft patch in US economic data. QI say that inherently involves taking a macro view on deflation versus reflation, which requires a framework that enables investors to assess how different sectors are priced versus their macro environment. That’s Qi’s edge, and the firm has developed a heat map that captures the relative value between US sector ETFs. The map shows which pairs are in a macro regime, and the degree to which they are rich or cheap versus macro fair value. There are some standout conclusions, some of which may surprise. For instance, Technology is uniformly cheap versus its peers, Metals and Mining are rich versus all other peers, while Industrials are typically either fair value or rich versus other sectors (with the exception of XME). As for the broader market, the aforementioned skew is also evident. Versus SPY the extremes are Metals & Mining (rich to SPY) and Technology (cheap to SPY).
equity-bond correlations rotation Ollari Consulting
3. Risk parity nirvana – how long can it last?Equities and US rates are simply trading two different time horizons, according to Christophe Ollari at Ollari Consulting, with the former riding the vaccine news to envision a fully-functioning post-pandemic world, while the latter is concerned the current wave of the coronavirus will have lasting economic ramifications that will force the Federal Reserve into further supportive monetary action. He says this prevailing dichotomy has been highly supportive of investors running long duration against any reflationary/ rotation position. The question, says Ollari, is whether this risk parity nirvana can last for longer. He believes so, with the Fed likely to continue to demonstrate its determination to immunise financial assets from macro uncertainty in the face of the stalemate over fiscal support in Washington. Meanwhile, says Ollari, equities continue to be in full rotation mode, with stocks deep into positive gamma territory that will contribute to smooth intraday moves as dealers actively hedge by selling strength and buying weakness.
COVID vaccines Emerging markets Capital Economics
4. How will vaccines be distributed?Jennifer McKeown at Capital Economics says the production and distribution of coronavirus vaccines clearly has a strong bearing on the economic outlook, and has set out her understanding regarding six key questions on the topic and how the answers could influence her economic forecasts. She addresses how quickly vaccines can be produced, which groups will be vaccinated first, as well as which countries have pre-ordered, who will take priority, whether storage issues will complicate distribution and if international agreements will ensure equitable distribution. The upshot, says McKeown, is that vaccines offer hope of a return to normal economic activity in advanced economies, but logistical difficulties and limited production capacity suggest that it will take several months for vulnerable populations to be vaccinated. She suspects that restrictions on activity will largely be removed in advanced economies around next spring, allowing a sharper recovery to take hold in the second quarter. But limited access to vaccines is likely to mean that some EMs have a much longer struggle ahead, warns McKeown, with distribution to many regions including large parts of Latin America, India and Sub-Saharan Africa will take much longer, implying that recoveries there will lag behind.
carbon border tax ESG Bank of America
5. Carbon Border Tax– the whys and whereforesThe carbon border tax is one of the highlights of the European Commission’s Green Deal, and should be presented around June 2021 in view of implementation the following year. There are many uncertainties surrounding the operation and expansiveness of this mechanism, which is aimed at preserving Europe’s competitiveness by preventing “carbon leakage”, where companies relocate to countries with lower pollution costs. Bank of America’s ESG research team have just published a very useful primer on the carbon border tax where they discuss the premise of its application, consider its design options, and which sectors will most likely benefit from the carbon tax itself. Their conclusion is that it will benefit carbon-intensive industries like Steel and Building materials.