Timing Factors with Macro Regimes

Market volatility is declining, even as Europe awaits its April 2 tariff announcement and despite new tariffs on automanufacturers hitting the news as we write this. Bond and equity swings have calmed since their peak on March 10, when U.S. recession fears were at their highest. More recently, U.S. equities have begun closing the performance gap¹ with European markets, driven by two key factors. In a way, markets are telling us that they’ve grown accustomed to political volatility.

First, Donald Trump’s announcement that reciprocal tariffs will be targeted has reassured investors. Markets are now pricing out certain tail risks², reducing overall uncertainty. Second, late-March economic data showed unexpected resilience. The U.S. Purchasing Managers' Index (PMI) exceeded expectations, easing recession concerns. Our Wave business cycle model³ had already suggested these fears were overdone.

While Europe’s shift away from fiscal austerity—alongside Germany’s ambitious investment plan—should support European equities in the medium to long term⁴, U.S. equities may have room to extend their rebound in the near term once the dust from tariff announcements has settled.

This raises a key question: which equity styles perform best at this stage of the cycle? In this edition of Quanta Byte we answer that question in two phases. First, we prove that, once you identify the macro regime, the style that best performs is a relatively easy choice. Second, we show that, at this particular juncture, minimum volatility – as a style – offers a practical way to navigate this tumultuous period.

Wave is in Slowdown

Our proprietary Wave business cycle model, which applies a big data approach, currently stands at 55%, as shown in Figure 1, which means that 55% of all economic time series tracked by Wave are showing positive momentum (not that, when isolating developed markets, the figure stands at 57%). However, as this percentage has been declining since late January, our model now signals a slowdown phase.

We have previously analyzed the link between equity returns and business cycle states, showing that the largest equity drawdowns historically occur during contraction phases. We also showed that the Wave does a reasonably accurate job at identifying and forecasting macro regimes. For example, the equity market decline following the Russian invasion of Ukraine and the subsequent energy crisis was anticipated by Wave as early as late 2021, when the model started to signal a contraction⁵.

If we can rely on Wave to determine macro cycle, the next obvious question is: how do different equity factors perform during a slowdown—or across the broader business cycle? While this topic has only recently gained traction in academic research, its importance for investors is clear.

Few factors matter

Since the 1980s, hundreds of equity factors have been introduced in academic literature. However, only a select few have consistently proven their effectiveness through rigorous in- and out-of-sample testing. Among the most widely recognized and studied are low-risk, value, quality, and momentum—factors that have demonstrated resilience across different market environments and continue to shape investment strategies today.

While factor research has a long history, the study of how factor performance evolves over time is relatively new. A key question in this area is whether factor performance depends on the state of the business cycle. Most research relies on traditional cycle indicators, such as the OECD leading indicator or Purchasing Managers’ Indices (PMIs) to define cycle phases and measure factor performance.

Given that Wave has a proven track record of anticipating adverse market regimes—such as recessions—earlier than traditional business cycle models⁶, we base our factor analysis on our proprietary model. For comparability, we use MSCI’s factor definitions as the foundation for our analysis.

Macro regimes drive factor selection

In our business cycle analysis, we measure the excess return⁷ of different equity factors by business cycle state⁸. Figure 2 shows the annualized monthly excess returns by factor, state, and over the full cycle.

We begin with unconditional performance—the average excess return of each factor since 1995. Quality and Momentum are the only factors with double-digit returns, at 11.7% and 11.3%, respectively. All other factors outperform the MSCI World benchmark (+8.1%).

Looking at the breakdown by business cycle state, we observe key trends. First, quality is the only factor to outperform the benchmark across all cycle states. Momentum shows slight underperformance only during contraction phases. Second, during a slowdown, strategies like quality, momentum, minimum volatility, and high dividend have outperformed the benchmark.

Min vol is best for now

Given that our business cycle model, Wave, is currently in a slowdown, min vol strategies are appealing, even to more risk-tolerant investors. As Figure 2 shows, min vol strategies have outperformed the MSCI World benchmark during slowdown. Since quality, growth and value delivered more than min vol, you may wonder about what motivates our preference for min vol. It's got to do with the volatility of returns, and thus risk-adjusted metrics.

As Figure 3 shows, the annualized standard deviation for min vol stocks is 11.1%, compared to 14%-16% for other strategies, including the benchmark. These results suggest that certain strategies cater to different investor profiles, with min vol being particularly attractive for risk-averse investors. This is especially true as some portfolio hedges, such as long-duration bonds, have failed to protect portfolios this year amid tariff announcements and Europe's shift away from fiscal austerity, which has triggered higher inflation expectations and rising yields.

With European tariffs likely to be announced on April 2, the min vol factor may have room to outperform further in the coming weeks. Therefore, min vol remains a crucial factor that we continue to have exposure to in our portfolios.