Rather than using the traditional asset-class analysis, I have found employing a risk-factor approach particularly helpful in understanding the impact of economics and policy on markets this year — not only in explaining the evolution of valuations, correlations and volatility, but also in pointing to what to look for in the near term.
One of the simple ways to think of risk-factor analysis is breaking down a financial asset or an asset class into the attributes of its market sensitivity — be it interest rates, credit, liquidity or momentum, for example. With that, certain bond classes, such as high yield, can be shown to be more sensitive to risk factors that impact stocks more than government bonds.
Risk-factor analysis can also be used to explain general movements when, as has been the case this year, markets are impacted by common top-down drivers.
For most of 2022, markets have been responding to moves in key interest rate paths caused by persistently high inflation and the related realization that the Federal Reserve is being forced to exit its long-standing policy paradigm of near-zero interest rates and predictable liquidity injections.
This sudden and strong domination of markets by the "interest rate factor" broke down the traditional inverse price correlation between stocks and bonds, resulting in significant losses in both the Nasdaq Composite Index and 10-year U.S. Treasury, for example.
It also fueled unsettling volatility, adding to investor discomfort and raising concerns about negative spillbacks for the real economy.
As the markets aggressively repriced the path of interest rates for the economy, concern shifted to the implication for consumption and investment.
This brought into play the "credit risk factor," retaining pressure on stocks, fueling further volatility but, in a stark change from what happened in the first five months of the year, starting to restore the traditional correlation between stocks and bonds.
