Investors Should Think Risk Factors, Not Asset Classes

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.