Internal volatility from sector rotations offers investors a chance to get more defensive, analysts suggest
The past two months have brought ups and downs across several financial markets, a supply shock to the global energy sector, a shift in central bank policy, and more signals teasing a U.S. recession. But in spite of that, U.S. equity markets have remained near all-time highs with surprisingly few bouts of broad market volatility — “broad” being the operative word.
“[S]ignificant sector rotation and style dispersion have generated meaningful internal volatility in the equity markets,” observed Wesley Chan, Yang Lu, and Bill Smith, portfolio managers at PIMCO, in a recent blog post.
The most notable episode in the past few weeks was observed between U.S. equity momentum and value factors, which the analysts said have had their sharpest moves in over 15 years.
“While we believe this internal volatility warrants some caution and defensive equity positioning overall, we think it also presents opportunities for investors,” they said.
To explain the rising dispersion and volatility of factor returns, the PIMCO portfolio managers pointed to the lengthy period of slowing economic activity around the world, most notably in manufacturing and trade sectors, which have collided with changes in central bank policy. As investors make a beeline for “winners” and insulate themselves from “losers” in response, the momentum factor has experienced strong outperformance, while value has underperformed.
Highlighting the contrast between the internal turbulence in equity markets and broad overall volatility, they conducted a comparison of factor volatility and moves in the VIX index. As of September 16, average factor volatility — as measured by the average of rolling 60-day value, quality, momentum, and size factors in the S&P 15000 universe based on PIMCO definitions — was shown to exceed volatility as indicated by the VIX.
“Historically, when markets experience volatility divergence of this sort, we become more cautious because violent rotations suggest that markets are more fragile than they may appear,” they said.
While they were careful to note that the divergence doesn’t constitute a perfect forecast for broad market volatility, they said it raises the odds and suggests a need for higher risk awareness.
“We think the six-month period of significant factor returns relative to trend in the equity markets left factors vulnerable to short-term mean reversion,” they said, noting that the magnitude and speed of the move in factor volatility was more concerning to many market participants than the direction of the move.
It’s possible to design quantitative equity strategies to navigate through such volatile periods, they said, emphasising potential benefits from “stable allocation to a variety of time-tested factors and dynamic allocation to factors for present macroeconomic environments.”
Referring to a recent asset-allocation outlook they shared, they expressed a preference to modestly underweight equities within multi-asset portfolios, focusing on high-quality, defensive sectors.
“Now, we think the recent velocity of factor movement presents investors with potential market dislocations – and opportunities to take advantage of them,” they said.
