Factor Views Q3 2021
Themes from the quarterly Quantitative Solutions Research Summit
- Factors were generally positive, though volatility was elevated beneath the surface.
- Equity value, quality and momentum all performed well early in the quarter but fell in June as market leadership shifted.
- The merger arbitrage factor continued to extend all-time highs.
- Directional macro factors benefited from the continuous rise across equity markets. However, reversals across fixed income markets and within currency and commodity markets negatively impacted momentum exposures.
- We continue to see an attractive outlook for equity factors, though we acknowledge tension across a range of factors as investors try to discern the lasting impacts of the pandemic.
Risk assets continued their climb over the quarter, despite a rise in U.S. inflation, a hawkish surprise by the Federal Reserve (Fed) and a move from early to mid-cycle for the U.S. economy. While global equities extended all-time highs, crosscurrents within equity markets shifted, with the reflation trade reversing toward the end of the quarter. Rates markets experienced a sharp bear flattening, while commodities rallied over much of the quarter and the U.S. dollar fell (despite a recovery in June). The factors that we favor were generally positive, though volatility remained high beneath the surface—particularly across equity factors, with market leadership shifting back in favor of growth stocks (Exhibit 1).
We continue to expect a prolonged period of above-trend global economic growth and do not see recent developments as changing our core factor views in any material way. We remain optimistic about the equity value factor, where valuations are supportive and where companies may benefit from a pickup in earnings growth. Once again, we support the equity quality factor, which remains extremely cheap and may be bolstered by a move to a mid-cycle environment where the factor’s lower risk profile will serve as less of a headwind.
Factors were generally positive in Q2 2021, with performance hiding intra-quarter volatility across equity factors
Exhibit 1: Quantitative Solutions long/short factor returns
Factors in focus
Equity factors: A breather or a reversal?
The equity value and size factors both gave up ground over the quarter, after delivering strong performance since the summer of 2020 (Exhibit 2). June was a particularly difficult month for the value factor, which fell amid the Fed’s hawkish surprise and a sharp bear flattening of the yield curve. This raises the question of whether this is the beginning of a shift back to an environment in which growth stocks carry the torch for equity markets, or is instead a technically driven and temporary shakeout. In attempting to answer this question, much has been made about the link between value vs. growth dynamics and interest rates—and the hypothesis that value will underperform if interest rates remain low over the long run (which the bond market appears to be signaling). Despite a clear rise in correlations between value performance and interest rates in recent years, we think it is important to put the impact of this relationship into context. The majority of the variability of the value factor is not explained by changes in the U.S. 10-year Treasury yield, even in recent years (Exhibit 3). Other forces must hold the key to value’s future.
Equity value fell alongside longer-term interest rates, though the majority of variability cannot be explained by rates
Last quarter, we presented three potential scenarios for the economy and markets and included our view on the potential impact of each across equity factors. The scenarios: overheating, which would favor value and momentum over quality; a smooth handoff from stimulus to economic growth, which would also favor value and momentum over quality; and a recession/double-dip recession, whether sparked by variants or other concerns, which would favor quality over value and momentum.
While we did not offer a view of the relative probability of these scenarios, we think a shift in the global economic backdrop toward the end of last quarter can help us explain recent factor dynamics. The U.S. economy moved from early to mid-cycle, and Fed rhetoric along with concerns about coronavirus variants and political gridlock shrank the right tail risk in terms of potential reflationary outcomes. This lower probability of the overheating scenario corresponds with a tougher short-term environment for value and momentum1 but does not diminish our optimism about return prospects over the longer term.
In our view, the potential for markets to overreact to sentiment and positioning changes is extraordinarily high. That mainly reflects the difficulties in distinguishing signal from noise as the ramifications of the pandemic impact both economic and company-specific data. We think the story for value will be driven both by valuation support (Exhibit 4) and a continued recovery in earnings, which we believe should matter more to value performance in the medium to longer term. Relative valuations of value vs. expensive/growth stocks remain historically cheap (96th percentile dating back to 1990), which reaffirms our view that the value drawdown has been driven primarily by investor sentiment (and even exuberance) rather than underlying fundamentals. Earnings revisions are as supportive of value as they have ever been, with recent data pointing to a step change from what we have seen in the past 30-plus years (Exhibit 5). While we will keep a keen eye on this quarter’s earnings cycle, a continuation of this trend would bolster the case for value and move momentum further in favor of value.
Relative valuations of value vs. expensive/growth stocks remain historically cheap
Exhibit 4: Value and quality factor valuation spreads (Global)
Earnings revisions are as supportive of value as they have ever been
Exhibit 5: Global earnings revision valuation spread
Turning to the quality factor, we continue to see extremely strong valuation support. Setting aside the difficultly in mapping factor performance to the business cycle,2 we tend to see quality perform better as cycles extend and, in particular, after we move past early-cycle (and sometimes speculative) dynamics. These elements should serve as key tailwinds for the quality factor. Finally, the quality factor again outperformed the minimum volatility (min vol) factor, which we see as only one input into a broader definition of quality. While the three scenarios we have described would suggest that both quality and min vol exposures can serve as important ballast in portfolios, we prefer a broad capture of quality, which considers insights from related measures such as profitability or earnings quality in addition to metrics related to financial risk, such as historical volatility.
Merger arbitrage factor again extends all-time highs
The merger arbitrage factor continued to march higher over the quarter—its fifth consecutive quarter of strong performance in what has been a steady climb since the onset of the pandemic. The factor is now up 5% since March 2020.
In an outlook that is unchanged from last quarter, the opportunity set for the merger arbitrage factor remains attractive, bolstered by a stream of new deal activity. Indeed, the number of new deals has risen materially from 2020 lows to a level last seen in 2018 (and now slightly above the average over the past 10 years). With capital markets open and financial conditions relatively easy, further increases in activity levels could improve the outlook for the merger arbitrage factor. Meanwhile, median “capturable” deal premia look healthy in the context of the nonstressed backdrop, while a steady incidence of counterbids or improved offers could add to further upside.
Macro momentum factors upended in June but positive year-to-date
Macro factors performed well in April and May before they were caught offsides by shifts in fixed income, currency and commodity markets. Time-series momentum detracted across fixed income markets as short positioning was hurt by the late quarter move lower in interest rates—with losses most acute in the U.S. Choppiness in the performance of a range of currencies—most notably, the Norwegian krone, Swiss franc and Canadian dollar—hurt currency momentum positioning (and, to some extent, currency carry). At the same time, declines in lean hog, gold and copper pricing toward the end of the quarter and a rise in natural gas pricing negatively impacted commodity positioning.
On a forward-looking basis, positioning across time-series momentum factors remains pro-risk. While short fixed income positioning has been pared back slightly, these factors remain susceptible to mid-cycle bouts of volatility. The environment for carry-based macro factors has improved, with increased spread widening across fixed income markets, bolstering the potential for future gains.
The factors that we favor performed well in the second quarter by and large, and continue to appear attractive.
The equity factor space looks to be the most interesting opportunity set, with spreads historically wide for both equity value and equity quality. While we remain most optimistic about the prospects for equity factors, we believe, as always, in diversifying across a broad range of compensated factors while minimizing exposure to uncompensated risks.
Factor opportunity set
The table below summarizes our outlook for each of the factors accessed by the Quantitative Solutions platform. It does not constitute a recommendation but, rather, indicates our estimate of the attractiveness of factors in the current market environment.
Factor Views Vs. Last quarter:
1 As momentum continues to lean further toward the value factor on the back of general value outperformance since the summer of 2020.
2 Yazann Romahi, Joe Staines and Garrett Norman, “Factor Crowding, Timing and the Future of Factor Investing,” J.P. Morgan Asset Management, April, 2018.
- Equity momentum: Long/short global developed stocks based on price change and earnings revisions; sector and region neutral
- Equity value: Long/short global developed stocks based on book-to-price, earnings yield, dividend yield, cash flow yield; sector and region neutral
- Equity quality: Long/short global developed stocks based on financial risk, profitability and earnings quality; sector and region neutral
- Equity size: Long/short global developed stocks based on market capitalization; sector and region neutral
- Merger arb: Long target company and short acquirer (when offer involves stock component) in announced merger deals across global developed markets
- Event-driven (other): Conglomerate discount arbitrage, share repurchases, equity index arbitrage, post-reorganization equities and shareholder activism
- Macro carry: FX G10 carry, FX emerging market carry, fixed income term premium, fixed income real yield, commodity carry
- Macro momentum: FX cross-sectional momentum, commodity cross-sectional momentum and time-series momentum across equity, fixed income and commodity markets
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