There is No "Market": Risk Factors and Scenarios

What does inflation mean for the market? What does recession mean? We can’t say, because there is no “market”. It is like asking, “What will higher oil prices do to the world”. Do you mean Germany or Saudi Arabia? United Airlines or Exxon?

Instead, we look at scenarios using risk factors. Why factors? Because there are few “pure” stocks. Stocks are affected by many factors. Those that are within, say, the consumer durables sector might also be affected by energy, or by China. Or take Amazon. It is in retail, but has a high factor loading to technology because of its cloud services.

There is an array of risk factors — multidimensional across sectors, countries, and investment styles. Every scenario affects risk factors differently. Every asset is affected differently by each of these factors, and every portfolio — including any index — is built up lego-like from these.

So a better question to ask is: What risk factors will be most affected? And then ask, how exposed is my portfolio to these factors?

It is one of the great advantages of posing risks in factor space and then seeing how those factors feed through to assets, rather than trying to look at risk directly with assets. I’ve made this point elsewhere; it is central to how we develop scenarios at Fabric. It is why we look at our relationship with MSCI and our ability to use their Multi-asset factor model as being so valuable for risk assessment.

Using inflation as an example, we’d expect basic materials to be less affected by inflation than downstream product like retail. We’d also expect real estate and mortgages to be adversely affected because inflation leads to higher nominal rates.

We have the benefit of hindsight to see if such intuition is correct. The bar chart gives a sense of this using MSCI’s Multi-asset factor model that is at the core of our risk factor approach. Since the start of the year, we see that oil and gas, chemicals, and metals factors all do well. Real estate and mortgages, and retail and consumer durables factors, which are at the end of the supply chain, do poorly.