Cross-country risk pricing is normalising, undermining Australian momentum performance

In recent articles, we have argued that momentum investing – a strategy that buys yesterday’s winners and sells yesterday’s losers – is a low reward-to-risk strategy in the foreseeable future, both in global markets and domestically. Here, we add to this argument by pointing to a normalisation of equity risk pricing across U.S. and emerging markets (EMs), signalling reduced anxiety about the “loss of U.S. exceptionalism”.

Historically, EM equities have been riskier than U.S. equities. Investors typically use volatility gauges from options pricing to assess riskiness of securities and markets. As it turns out, it is possible to observe the implied volatility of EM equity exchange traded funds (ETFs), denominated in USDs (VXEEM). This indicator is directly comparable to the implied volatility of U.S. equities (VIX). For most of the available history of the two series, VXEEM has sat above VIX. But post-Liberation Day, we note that the order flipped for an extended period of time, as investors became nervous about the U.S. losing exceptionalism in the global monetary architecture.

VIX and XVEEM

Such changes in the natural order of risk pricing should have profound implications for asset allocation and global style rotation. Investors concerned about the US reallocate to the rest of the world (RoW), purely on risk, rather than expected return considerations. When they reallocate, they typically do so at market capitalisation weights, much like a passive investor. It would not surprise us, in such circumstances to see momentum and size factors do well in the RoW – certainly better than their counterparts in the U.S. Indeed, history suggests that this is broadly the case. When VXEEM undershoots the VIX, we tend to see EM momentum factors outperform U.S. momentum factors in the subsequent period.

EM-U.S. relative momentum factor performance and VXEEM-VIX spread

EM-U.S. relative momentum factor performance and VXEEM-VIX spread

The relevance for Australia is that it sits in between the EM complex and the U.S. More importantly, there are reasons why investors might have viewed Australian markets as exceptional in their own right, as discussed in a previous article. Australia is a natural beneficiary of rotation out of the U.S., especially as policy makers have many levers to pull to stabilise the economy, meaning that the economy is not at the extremely high-risk end of the RoW basket. Further, Australia is a natural beneficiary of any rotation out of China, because it is viewed as a regional safe haven. One would expect a reallocation of funds towards Australia (and away from the U.S. or China) to push up Australian momentum and size factor performance, while movements back into the U.S. (and away from Australia and China) should contribute to Australian momentum and size factor underperformance.

The return of VXEEM to levels above VIX suggests to us that the RoW safe haven trade versus the U.S., and by implication, a portion of the Australian momentum trade, is likely to unwind a little, just on fund flows. Further, if global investors arrive at the view that China is investable again (e.g. noting that U.S. officials are now allowing NVIDIA (NASDAQ: NVDA) is allowed to export chips to China again), we could see further unwinding of Australian regional safehaven and momentum trades.