In brief

• Factor performance was mixed, on balance, with some factors recovering from losses in the first quarter while others continued along their recent trajectories.
  
  
• Equity factor volatility remained high: Size experienced its best quarter since 2009 while value suffered its second-worst quarter in 30 years (exceeded only by losses in Q1).
  
  
• Merger arbitrage bounced back over the quarter; however, other event-driven factors were broadly negative.
  
  
• Macro factors declined as historically sharp market reversals upended both time-series momentum and relative value momentum positioning across asset classes.
  
  
• We continue to see the outlook for equity value as attractive; additionally, we have upgraded our view for equity quality because of the emergence of the most compelling valuation spread since the dot-com bubble.

Factors in focus

Equity factors: Opportunity for the quality factor continues to improve

Performance was mixed over the quarter across equity factors and geographies. One constant was the underperformance of value, which in May experienced its second-worst month in about 30 years (exceeded only by losses right before the dotcom bubble peak in March 2000) and its second-worst quarter (exceeded only by Q1).¹ Size, on the other hand, recovered sharply from Q1 losses to enjoy its best quarter since 2009 as fears of liquidity risk and distress risk faded (at least temporarily). Momentum was up on a global basis and positive in most markets; however, it was flat in the U.S. as market leadership shifted in April from high quality to low quality names.

This reversal also impacted the quality factor in the U.S., which posted negative returns and continued to lag other regions (Exhibit 2). The quality factor continued to underperform in the small cap segment of the market—particularly in the U.S. (Exhibit 3), where investors have tended to favor either mega cap names presumed to be secular growers or low quality small cap stocks that received a lifeline from government stimulus. We view the spread of underperformance from value to quality as a signal of sentiment’s dominance over fundamentals; it is also a sign of investor preferences that we expect will meanrevert over time.

Quality has underperformed in the U.S., in particular across smaller cap stocks

Exhibit 2: Quality factor performance                                     Exhibit 3: U.S. quality factor                                                                  by region                                                                                         performance by market cap

Source: J.P. Morgan Asset Management; data as of June 30, 2020.                                            Source: J.P. Morgan Asset Management; data as of June 30, 2020.

The quality factor (Exhibit 4) has been on our radar in recent quarters and has become increasingly attractive.² The difference in fundamentals between high quality and low quality companies (e.g., profitability or financial risk metrics) has continued to grow; however, the market is no longer rewarding high quality companies’ valuations to the degree that it once was. In fact, a dislocation has recently emerged: High quality companies are now historically cheap relative to their low quality counterparts at the same time that they are exhibiting relatively strong fundamentals. This scenario is rare. However, the last two times it occurred—during the dot-com bubble peak in March 2000 and following the global financial crisis dash-to-trash rally in 2009— the quality factor went on to outperform by 34.9% and 2.4%, respectively, highlighting the potential for tailwinds (although that is, of course, far from a guaranteed outcome).

The quality factor has become increasingly attractive

Exhibit 4: Quality factor valuation spread (global)

Source: J.P. Morgan Asset Management; data as of June 30, 2020.
Note: Valuation spread is a z-score between the median P/E ratio of top-quartile stocks and bottom-quartile stocks as ranked by the value factor.

Event-driven factors mixed over the quarter

Following an extremely challenging March, event-driven factors were mixed over the quarter. The merger arbitrage factor was up and is once again positive over the past year; it benefited from the attractive spread levels we noted in our Q2 Factor Views and suffered relatively few deal failures due to COVID-19. However, other event-driven factors—such as share buybacks, spinoffs and activist factors—continued to languish in a drawdown that has accelerated over the past 14 months.

We maintain a positive outlook for the merger arbitrage factor, where we still consider spreads (the difference between the stock price of a company targeted for acquisition and the announced acquisition price) to be attractive. We have a more tempered view on other event-driven factors, though, given that we expect a decline in corporate activity levels, which would limit the ability to capture these factors while also remaining diversified.

Macro factors suffer from sharp reversals across asset classes

Momentum factors experienced a challenging quarter as historically sharp reversals upended positioning across asset classes. Heading into the quarter, time-series momentum signals were biased negative across equity and commodity markets. Relative value momentum signals were bearish on energy commodities and commodity-linked currencies (e.g., AUD and NOK) compared with precious metals, agricultural commodities and safe haven currencies (e.g., USD and CHF). Of course, this positioning proved to be painful over the subsequent months. Carry factors, on the other hand, were positive in aggregate. In particular, they were led by gains from FX carry, which rebounded after a difficult Q1 (providing valuable diversification benefits when paired with FX momentum).

Carry spreads are generally below long-term averages, particularly across G10 government bonds and FX markets. This suggests a diminished potential to capture carry in those markets. Among momentum factors, dispersion in price moves was average across currencies and commodities. The number of significantly trending assets was somewhat neutral in aggregate, as short-term (e.g., three-month) and longer-term (e.g., 12-month) signals conflicted across a number of markets.

Factor Opportunity Set

The table below summarizes our outlook for each of the factors accessed by the Quantitative Beta 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:

Source: J.P. Morgan Asset Management; for illustrative purposes only. 
*Other: Conglomerate discount arbitrage, share repurchases, equity index arbitrage, post-reorganization equities and activism.

Our framework for evaluating factor outlooks is centered on the concepts of dispersion, valuation and the opportunity for diversification. For equity factors, we measure dispersion and valuation spreads between top-quartile and bottom-quartile stocks on a market, region and sector-neutral basis. For event-driven factors, we measure implied carry and the level of corporate activity as indicative of the ability to minimize idiosyncratic stock risk. For macro factors, we measure the dispersion or spread between top-ranked and bottom-ranked markets as well as the number of significantly trending markets.