Factor Views Q2 2021
Themes from the quarterly Quantitative Solutions Research Summit
- Factors generally performed well and have seemingly found their footing after a volatile 2020.
- Equity value exhibited its strongest performance in around 20 years while small cap stocks continued to extend relative gains over much of the quarter.
- The merger arbitrage factor continued to perform well, extending gains to new all-time highs.
- Directional macro factors benefited from the continuation of trends across asset classes.
- We continue to see an attractive outlook for equity, despite the recent rally, and note strong directionality among time-series momentum factors that may lift both their risk and their return potential.
Reflation and reopening themes pervaded markets over the first quarter of 2021. Trends that began to emerge late in 2020 were boosted by additional fiscal stimulus and the rollout of vaccines across the globe. Risk assets moved higher, led again by cyclical segments of markets as global equities pushed to new all-time highs. At the same, time U.S. Treasuries experienced their worst quarter in over 30 years as yields rose on the back of expectations for above-trend economic growth and potential inflation. The factors that we favor by and large followed suit, with equity value and equity size up significantly, and merger arbitrage and trend factors extending recent gains (EXHIBIT 1).
We expect a prolonged period of above-trend global economic growth and remain optimistic in our outlook for the equity value factor, where valuations remain supportive and where companies may benefit from a pickup in earnings growth. We continue to see equity quality as cheap (although the factor may lag if a risk-on environment persists), and we are more optimistic across macro factors than we have been in recent quarters.
Equity factors were generally positive as themes from 2020 extended in Q1
EXHIBIT 1: QUANTITATIVE SOLUTIONS LONG/SHORT FACTOR RETURNS*
Factors in focus
Equity factors: Another historic quarter
The equity value factor posted its third best quarter in our data history, going back to 1990 (it was only exceeded by the bursting of the dot-com bubble). The gains reflect a shift in market leadership (EXHIBIT 2), sparked by vaccine announcements in November and sustained by strengthening growth, a gradual reopening of the economy and additional fiscal stimulus. Cyclicals again outperformed defensive companies, and small cap stocks again outperformed large caps as lower quality companies continued to dominate the rally over much of the quarter. While we saw high performance dispersion across sectors, and the energy and financials sectors led the way, value vs. growth dynamics were actually more prevalent within sectors than across sectors (EXHIBIT 3). Value stocks outperformed within each sector, whereas sector leadership was driven more by cyclicals vs. defensives than value vs. growth (e.g., as certain value-oriented yet defensive sectors, such as utilities, lagged).
Value stocks rallied on the back of vaccine announcements, while factor fundamentals generally held up over 2020
(VS. RUSSELL 1000 INDEX SINCE 2019)
(VS. RUSSELL 1000, 1Q 2021)
The value and size factors have made up considerable ground in recent months, though value remains underwater relative to pre-pandemic levels and has only just begun to climb out of its worst drawdown across our records.1,2 We continue to see value as an attractive opportunity. Relative valuations of value vs. expensive/growth stocks remain historically cheap (97th percentile dating back to 1990), which continues to affirm our view that the value drawdown had been driven primarily by investor sentiment (and even exuberance) rather than by underlying fundamentals. In addition, value actually cheapened over the quarter, despite the run-up in price, highlighting strengthening fundamentals across value companies and the continuing opportunity.
An important dynamic regarding the outlook for equity factors relates to shifting factor correlations and what these could imply across a range of economic and market scenarios. While the value, quality and momentum factors have historically exhibited low correlation to one another, these relationships do vary over time, particularly for momentum, which changes shape by its very definition. Although the performance of momentum stocks has been diametrically opposed to value in recent years, momentum is becoming more “value-like” in its composition amid the recent reversal in market leadership. In fact, from a holdings-based perspective, the correlation of stock-level value and momentum scores has become less and less negative as the reflation rally has taken hold. The average correlation between value and momentum increased from -0.41 in August 2020 to -0.15 in March 2021. Earnings revision momentum, a subcomponent of momentum that moves faster than our 12-month definition of price momentum, has already flipped to aligning with value — with score correlations moving from -0.17 in August 2020 to 0.14 in March 2021. Should the current market regime/market leadership persist, value and momentum may increasingly align. This would in turn affect the potential of portfolios with exposure to multiple factors, as outlined for three potential scenarios below:
Overheating: If stimulus efforts prove excessive, value stocks will likely continue to benefit from both valuation adjustments and earnings growth. Momentum, which will likely align with value as market trends are amplified, should also perform well. Quality stocks may be left behind in this scenario, though any eventual response from central banks to tighten policy may shift markets back to favoring more defensive/higher quality names.
In short, value and momentum perform well and quality does not — until action is needed to rein in inflation.
Smooth handoff from stimulus to economic growth: If we progress through the business cycle at a more measured pace, value stocks will likely continue to benefit. Momentum will also likely align with value, though it may take longer than it would in an overheating scenario and may deliver slightly less favorable returns. Quality may lag until the end of the cycle if accessed on a long-only basis due to its lower beta, but should be cushioned by cheap valuations and perform well thereafter. In sum, value and momentum perform well, and quality does not — until the end of the cycle.
Recession/double-dip: If the economy faces another pandemic-related shock (for example, serious damage from coronavirus variants) or otherwise moves back into a recession, value stocks may give up recent gains and resume their prior trend. Momentum may not serve as a buffer in this scenario, particularly if it looks more “value-like” in nature. Quality would likely benefit, with a market shock triggering an unlocking of historically attractive valuations. Summary: Value and momentum perform poorly, and quality does well.
Overall, the outlook for equity factors, and in particular value, looks quite attractive, in our view (EXHIBIT 4). While the quality factor has fallen behind amid the market rebound that began toward the end of March 2020, it is at historically cheap levels (98th percentile dating back to 1990). And as the above scenarios suggest, quality can serve as important ballast in portfolios — whether or not they are factor-based.
Value and quality factors appear increasingly attractive
EXHIBIT 4: VALUE AND QUALITY FACTOR VALUATION SPREADS (GLOBAL)
Merger arbitrage factor continues to extend all-time highs
The merger arbitrage factor continued to climb over the quarter, extending gains after having fully recovered from pandemic induced losses last quarter. The factor is now up more than 13% over the past year, its strongest 12-month stretch since the recovery from the global financial crisis.
While recent performance has been strong, the opportunity set for the merger arbitrage factor remains attractive, bolstered by a steady stream of new deal activity. Indeed, the level of new deals has risen materially from 2020 lows to reach levels 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.3
Time-series momentum factors lead the way in the macro space
Time-series momentum factors delivered standout performance in the first quarter, benefiting from continued, broadly positive trends across equity and commodity markets. Equity time-series momentum signals were increasingly long headed into the quarter, which proved supportive in an environment that was generally positive for risk assets. Commodity time-series momentum similarly entered the period with a generally pro-risk stance, which fared well despite a reversal in performance in March. In contrast, time-series fixed income momentum positioning had already been fairly neutral entering the year; it turned short in time to benefit from the increase in government bond yields through February and March.
On a forward-looking basis, positioning across time-series momentum factors remains very consistent within asset classes, with a strong pro-risk tilt reflected in long equity exposures and short duration. Given a core expectation of positive economic momentum throughout the second quarter, this should prove beneficial. However, we do see a tail risk: Momentum could reverse significantly if there is a sustained uptick in virus cases that delays reopening, particularly in Europe.
The environment for carry-based macro factors was more challenged in Q1, largely because of the fixed income rates carry factor. Curve steepening disproportionately impacted high carry markets (Canada, Australia and New Zealand) in comparison with low carry markets (Germany, Denmark and the UK). On the positive side, these moves increased carry spreads relative to levels at the beginning of the year, and any subsequent catch-up by market laggards could support further gains.
The factors that we favor by and large performed well in the first quarter 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, as noted above. 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:
- 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 financial risk, profitability and earnings quality; 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
1 The value factor had declined by 42% in long/short terms since December 2016, with the current drawdown now at -34%, compared with losses of 28% during the dot-com bubble (May 1998–February 2000).
2 For more information on the drawdown of the value factor and our view on the cyclical nature of recent underperformance, see Yazann Romahi, Garrett Norman and Gareth Turner, “Why value investing is poised to make a comeback in the 2020s,” J.P. Morgan Asset Management, updated as of June 15, 2020, https://am.jpmorgan.com/nl/en/asset-management/institutional/insights/portfolio-insights/why-value-investing-is-poised-to-make-acomeback-in-the-2020s/ .
3 The current median positive deal premium is around 4%, compared with an average of 4.2% since 2018, excluding the stress period of March to May 2020.