May began with the failure of First Republic bank, the second largest bank failure in U.S. history.1 While this made headlines, markets moved on rather quickly when J.P. Morgan swooped in to acquire First Republic's assets from the FDIC.2 A more persistent headline affecting markets was the raising of the U.S. debt ceiling, which had an uncertain future until May 27th when President Biden and Speaker of the House Mccarthy agreed on a deal to go through Congress.
The global fight against inflation also continued in May with sticky inflation data seen across various regions. Per a Reuters report, “All six of the central banks overseeing one of the 10 most heavily traded currencies and that met in May hiked rates. Central banks in Australia, New Zealand and Norway joined the European Central Bank, the Bank of England and the Federal Reserve in lifting benchmark rates last month by 25 basis points each, for a cumulative 150 bps.”3
Nvidia’s positive performance of 36.3% also made headlines in May as it benefited from a revenue forecast of $11 billion versus the analyst consensus of $7.2 billion.4 This was in part driven by their intention to increase the supply of products that power artificial intelligence applications to meet demand.4 This further fueled an already strong trend in AI and cloud computing throughout markets.
Against a backdrop that included the debt ceiling, rising rates, and AI, May was an interesting month for risk factor performance in the Two Sigma Factor Lens.
Exhibit 1: May Performance of the Two Sigma Factor Lens
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 March 1995 - May 2023
- Interest Rates: Rates around the world rose as countries continued to fend off sticky inflation, leading to negative performance of this factor. When looking at 3-month and 10-year Treasury yields of major countries, all ended the month higher than they started with the lone exception of the German 10-year bond. The U.S. 3-Month Treasury rose meaningfully more than the U.S. 10-year amid debt ceiling talks, an occurrence likely due to investors requiring additional compensation for short-term default risk.
- Credit: Our credit factor began to struggle in March of this year, coinciding with the first instance of bank failure news and the resulting credit tightening. It began trending downward again in late April/early May as First Republic began making headlines. This downward trend continued late into May as U.S. debt ceiling talk increased default risks in markets.
Exhibit 2: Cumulative Performance of Venn’s Credit Factor Since Bank Failure News in March 2023
Source: Venn by Two Sigma
- Local Equity: Positive performance for this factor indicates the outperformance of the U.S. equity market over global markets. Part of this may have been due to a relative technology sector overweight in U.S. markets, a sector that took off in May on the back of positive performance in AI and cloud computing stocks.5
Macro Style Factors
- Equity Short Volatility: YTD Equity Short Volatility is among the best performing factors, typically benefitting when implied equity volatility for the S&P 500 falls. Notably, it is designed to be orthogonal to our Equity Factor via residualization. Despite spikes in volatility around bank failures and the U.S. debt ceiling, implied volatility has been generally decreasing in between these isolated events. Unlike Credit, where tighter credit conditions have been an ongoing concern, the negative effects of these events do not appear to have lingered in equity volatility markets.
Exhibit 3: CBOE Volatility Index (VIX) Levels Since Bank Failure News in March 2023
Source: CBOE, VIX historical data.
Beta Neutral Equity Style Factors
- Value: Value struggled in May as expensive stocks outperformed those that are cheaper. Much like Local Equity, part of this may have been driven by the AI craze sweeping through markets, a theme associated with growth more than value companies.
Also of note is that of the various value component portfolios,6 dividend yield was down the most at -4.96% as rates rose globally. This supports a “bond proxy” narrative for higher dividend yield securities, suggesting they may be hurt when rates rise and benefit when rates fall. Dividend yield is the only value input that has had a positive correlation with our Interest Rates Factor (0.12) going back to March 1995.
Exhibit 4: Correlation of Value Inputs Since March 1995
Source: Venn by Two Sigma
- Low Risk: Low Risk considers risk via beta and residual volatility, capturing low risk in both a systematic and idiosyncratic manner. Portfolios measuring both of these components were down in May, however, the residual volatility measure was down just -0.74% versus the beta portfolio down -5.88%. This suggests that high beta stocks outperformed low beta stocks after allocating more capital to the low beta portfolio to neutralize equity risk.
- Quality: Underperformance of Quality implies that junkier stocks outperformed those of higher quality in May. While Quality was down for the month, it has been one of the best performing factors year-to-date, likely in part due to short bank exposure.
- Crowding: Negative performance for Crowding implies that a short position in companies that are heavily shorted underperformed a long position in those not heavily shorted. Historically, Crowding has had a slightly positive correlation with both our Quality and Low Risk factor at 0.11 and 0.30, respectively. With both Quality and Low Risk Factors exhibiting negative performance in May, it may be the case that positive performance in some of their anti-factor securities hurt the short positions of our Crowding factor.
5 For example, the Robo Global Artificial Intelligence ETF (THNQ), the WisdomTree Cloud Computing ETF (WCLD), and State Street’s Technology Select Sector SPDR Fund (XLK) were up 11.7%, 14.3%, and 8.8% in May, respectively. At the index level, MSCI USA had 29.13% weight in the Technology sector as of 4/28/2023, whereas MSCI ACWI had 22.05%.
6 Various portfolios include Earnings Yield, Dividend Yield, Long-Term Reversal, and Book to Price.
References to the Two Sigma Factor Lens and other Venn methodologies are qualified in their entirety by the applicable documentation on Venn.
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