Local Inflation, Foreign Currency, and the Cyclicality of Equity Styles: July 2025 Factor Performance Report

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Source: Venn by Two Sigma. The median and percentile columns measure the performance of each factor in the Two Sigma Factor Lens relative to the entire history of the factor in USD, using monthly data for the period August 1998 - July 2025

Local Inflation Factor: This factor is residualized against our Equity, Interest Rates, Credit, and Commodities factors and measures if a local inflation hedge is providing value. 

Despite U.S. CPI continuing to be in-line with expectations, market pricing for future inflation rose in July as measured by the 10-year break even (Exhibit 2). This may have been due to a flurry of tariff headlines increasing the average effective tariff rate from 15.8% on July 1st to 16.6% by the end of the month, as measured by The Budget Lab at Yale.¹

Exhibit 2: Local Inflation Factor Cumulative Return and 10-Year Break Even in July

Source: Venn by Two Sigma and the St.Louis Fed.

Foreign Currency Factor: This factor is residualized against our Equity, Interest Rates, Credit, and Commodities factors and has had a historic start to the year, up 14.88% from January to June. This indicates that investors with exposure to our Foreign Currency factor have been rewarded as the USD has broadly depreciated. Conversely, July was a bounce-back month for the USD, leading to our Foreign Currency factor dropping 2.15%.

In the current environment, currency moves are among the most correlated they have been with macro factors such as Equity and Interest Rates on a rolling 3-Year basis. This is evidenced in Exhibit 3, where we show:

• Correlation of Venn’s raw FX factor input (before residualization) with Equity and Interest Rates factors (Top Row). 

• Correlation of Venn Foreign Currency Factor (after residualization) with Equity and Interest Rates factors (Bottom Row).

• Note: the Y-Axis of each chart is not in the same scale.

Exhibit 3: Rolling 3-Year Correlation of Equity and Interest Rates Factors with our FX Factor Input and Foreign Currency Factor

Source: Venn by Two Sigma.

Higher FX correlations with these macro factors makes it increasingly difficult for investors to truly understand what's driving their portfolio risk and return. Consequently, it puts greater importance on taking an intentional approach to separate and understand these risks, such as Venn’s Foreign Currency factor aims to help investors do. 

Equity Styles Factors: Venn’s Equity Styles are long/short market neutral portfolios. In July, Crowding, Quality, and Low Risk captured historically negative performance. 

While each Equity Style independently targets a zero beta to global equity markets over time, it is interesting to think about what negative performance implies about current market conditions. This is especially true when combining this intuition across multiple factors, as this different dimension may have a more tangible link with business cycles or equity markets than each individual Equity Style.

For example, negative performance for each can be interpreted as:

• Low Risk: Higher Risk Stocks Outperforming
• Momentum: Relative Underperformers Now Outperforming
• Quality: Lower Quality Stocks Outperforming
• Value: More Expensive Stocks Outperforming
• Small Cap: Larger Stocks Outperforming
• Crowding: More Highly Shorted Stocks Outperforming

To dive deeper into this line of thinking, we measured the average rolling 6-month performance of our Equity factor over periods when two Equity styles are negative over those same 6 months. To be clear, each analysis in Exhibit 4 is independent and only considers two equity styles at a time. 

Exhibit 4: Average Rolling 6-Month Equity Performance When a Pair of Equity Styles Are Both Negative

Source: Venn by TwoSigma. Data from 8/7/1998–8/4/2025 when analyzing a pair without the Crowding Factor. Pairs including the Crowding Factor use data back to 7/6/2006.

We found that:

• Periods when lower quality and higher risk stocks outperformed have historically coincided with the strongest average 6-month returns for our Equity factor (8.68%). 
  
  Visualizing this timing in Exhibit 5, it seems that these two equity styles are often both negative toward the second half of an Equity factor rally. This might suggest a tendency for rallies to be more speculative and to broaden out to lower quality companies as they mature. 

Exhibit 5: Rolling 6-Month Equity Factor Return During Periods When Higher Risk and Lower Quality Stocks Outperformed

Source: Venn by Two Sigma. Period from 8/7/1998–8/4/2025.

• Conversely, when both highly shorted and larger cap securities outperformed, the Equity factor tended to deliver its weakest average 6-month return (-6.89%). 
  
  Exhibit 6 shows that when Crowding and Small Cap have been both negative, various crisis periods such as the global financial crisis, or the Covid Crash were occurring. This is likely as investors were being forced to cover their shorts and showed a preference for larger and more stable companies. 
  
  Importantly, there have also been sell offs, such as in 2022, where highly shorted and larger cap stocks didn’t outperform. This highlights that market stress can manifest through different investor behaviors and risk preferences.
  

Exhibit 6: Rolling 6-Month Equity Factor Return During Periods When Higher Short Interest and Larger Companies Outperformed

Source: Venn by Two Sigma. Note that the time period is different from Exhibit 5 due to more limited data for the Crowding factor. Period from 7/6/206–8/4/2025.

References

^{1https://budgetlab.yale.edu/research/state-us-tariffs-august-1-2025}

Exposure to risk factors is not a guarantee of increased performance or decreased risk. 

References to the Two Sigma Factor Lens and other Venn methodologies are qualified in their entirety by the applicable documentation on Venn.

This article is not an endorsement by Two Sigma Investor Solutions, LP or any of its affiliates (collectively, “Two Sigma”) of the topics discussed. The views expressed above reflect those of the authors and are not necessarily the views of Two Sigma. This article (i) is only for informational and educational purposes, (ii) is not intended to provide, and should not be relied upon, for investment, accounting, legal or tax advice, and (iii) is not a recommendation as to any portfolio, allocation, strategy or investment. This article is not an offer to sell or the solicitation of an offer to buy any securities or other instruments. This article is current as of the date of issuance (or any earlier date as referenced herein) and is subject to change without notice. The analytics or other services available on Venn change frequently and the content of this article should be expected to become outdated and less accurate over time. Two Sigma has no obligation to update the article nor does Two Sigma make any express or implied warranties or representations as to its completeness or accuracy. This material uses some trademarks owned by entities other than Two Sigma purely for identification and comment as fair nominative use. That use does not imply any association with or endorsement of the other company by Two Sigma, or vice versa. See the end of the document for other important disclaimers and disclosures. Click here for other important disclaimers and disclosures.