News in Charts: Explaining market risk with factor-mimicking portfolios

The relationship between macroeconomic risks and asset risks is neither loose nor casual. The two are intimately connected in driving market and investment dynamics. Inspired by this, over the course of 2020 Fathom Consulting has developed new ways to quantify that relationship between important macro drivers and financial market assets. This post will provide an overview of that work, with a more detailed account sent to Fathom’s clients earlier this week.

We have drawn on the vast factor-investing literature to reproduce exposures to macro factors through liquid assets. The three macro factors we chose to reproduce using liquid assets are the macroeconomic cycle, global liquidity and inflation surprises. We create financial market exposures to these macro factors by creating factor-mimicking portfolios (FMPs). These are portfolios of assets that can be combined in a way that closely replicates the changes in the macro factor.

These FMPs have been created using machine-learning techniques and some of the latest academic literature to mimic three different series: our in-house macro cycle indicator (FLI), the Fathom liquidity indicator (FLiq) and a measure of inflation surprises. FLiq, charted below, is available through Datastream.

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The chart below shows the three assets with the largest positive weights in our liquidity factor-mimicking portfolio: gold, agricultural prices and industrial metals. Each has a large positive weight in our factor-mimicking portfolio, which can be interpreted as taking a long position on those three assets.

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Want more charts and analysis? Access a pre-built library of charts built by Fathom Consulting via Datastream Chartbook in Refinitiv Eikon.

The next chart shows the asset with the most negative weight, interpreted here as a short position on the asset in the liquidity factor-mimicking portfolio. Oil takes the largest short position, with almost twice as large an exposure as the next largest short position.

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At this point a legitimate question might be: why bother? The mapping between macro and the asset world is useful, but what value does it add over and above using the original macro series? The answer to this question was provided by the COVID pandemic. Throughout 2020, Fathom’s Macro Portfolios enabled us to take the pulse of the markets on how key macro factors were evolving almost in real time. When most macro variables are released with long lags and generally on a monthly basis, the ability to observe macro factors through assets proved invaluable.

Interesting narratives also emerge whenever there are large differences between the macro series and the FMPs. For example, there was a large drop in FLiq in March as markets seized up at the prospect of a global pandemic. Yet, the FMP version of FLiq appeared broadly unscathed. The takeaway for us was that this crisis was different from previous crises, as proactive, large and coordinated policy stimuli effectively prevented rather than merely cushioned a liquidity crunch.

The usefulness of FMPs goes far beyond providing a clear and timely narrative about the evolution of markets. FMPs enable clients to analyse and structure trading ideas around macro views. We put this capability to the test early in the pandemic, suggesting that inflationary expectations had dropped too much, and assets more directly exposed to inflation looked potentially very attractive. Right now, the inflation surprise FMP is showing signs that the recovery is moving into its latter stages, when inflationary pressures are beginning to build.

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In the autumn we also advised clients to take a closer look at macro-sensitive assets, such as EMs and resource stocks, which tend to perform well as the macro economy recovers. This recommendation has outperformed less cyclical and more fashionable assets (e.g., pharma) thanks to an acceleration in the macro FMP.

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To find out more about Fathom’s Factor-Mimicking Portfolios, get in touch with Fathom’s Technical Director Andrea Zazzarelli andrea.zazzarelli@fathom-consulting.com.

Subscribe to join our upcoming event Climate economics: leading the way to net zero and beyond. Laura Eaton, Erik Britton and Brian Davidson from Fathom will be joined by Paul Fisher (Fellow, Cambridge Institute for Sustainability Leadership) and Leon Saunders Calvert (Head of Sustainable Investing, Lipper and I&A Insights, Refinitiv) to discuss crucial issues related to climate economics, including the economic consequences of global warming itself and the pathway to beyond net zero. For more on Fathom’s climate-related services please get in touch with Brian Davidson, Head of Climate Economics.

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