This quarter marks the beginning of the Systematic Equity Active quarterly, a publication that touches on a number of key themes in financial markets including macroeconomics and volatility, developments in developed and emerging markets, as well as more in-depth research topics.
We begin with macroeconomic views on the current state of the economy — with a particular focus on economic growth, labor productivity, long-term interest rates, and on the components of national accounts as they relate to debt. In this first article, our main message is that the free markets have concluded, similar to our interpretations, that technological progress is the lynchpin for getting out of the debt cycle because the alternatives are not often pleasant.
Next, we discuss tightening cycles and their impact on theoretical factor portfolios using a blend of value and quality. We show that in contrast to past tightening cycles, the recent bout of tightening in 2022 has not led to consistent outcomes, though we are still awaiting the results of the later periods. More importantly, value has had lackluster performance in the current environment, driven by a handful of names that have hijacked the index with an unprecedented set of returns in 2023. This development is intrinsically tied to a macroeconomic discussion on economic output and technological progress.
Additionally, we review some extremities in major developed markets, by observing that a historically large gap has opened up between the performance of Cyclicals (vs. Defensives) and manufacturing activity (Purchasing Managers’ Index, or PMI). Specifically, the outperformance of cyclical stocks (vs Defensives) year-to-date (YTD) reached extremes last seen just prior to the Global Financial Crisis (GFC) in 2007. Therefore, we see some complacency in markets despite the overwhelming evidence as we examine comparable periods in history: where 11 out of 14 previous Federal Reserve Board (Fed) hiking cycles have ended in recessions.
The picture is similar and can be viewed through a different lens — i.e. the real interest rate. One can see clearly that there were two discontinuous periods in markets. While post-GFC equities market generated 10% per annum, the pre-GFC (1989–2008) was a more modest 5.7% per annum return. The real interest rate was markedly different also in both periods; for instance, in pre-GFC, real interest rates were in a more robust range between 1.5% to 4%. However, in the post-GFC period, they hovered near zero and at times, literally zero. During these years there was a significant buildup of excesses and one can see the level of underperformance of defensive themes (as indicated by the minimum volatility index) versus the broad market. For the first time since the GFC, we are now seeing normalization of the real interest rate and this provides some discipline in financial markets, thereby better days ahead for defensive strategies.
The penultimate article on Intangibles showcases some recent research as it relates to green patents and their impact on future returns. And finally, we conclude with a paper on the philosophy of our emerging markets small cap approach.