Overview

Factors and traditional asset classes generally ended the third quarter in positive territory, though they did not follow a straight line up as investors navigated a few key events.

Risks assets continued to climb as equity and credit markets performed well, overcoming spikes in volatility in late July and early August when a weaker than expected jobs report spooked investors and an unwind of the Japanese yen carry trade reverberated globally.¹ By the end of the quarter, the S&P 500 was up 5.5%, boosted by the Federal Reserve’s 50 basis point (bps) rate cut as U.S. policymakers joined other central banks in beginning an expected rate-cutting cycle.

China’s announcement of its largest stimulus since 2015 also spurred positive investor sentiment, particularly in developed and emerging market equities, Chinese markets in particular. In fixed income, corporate credit markets continued to climb and government bond markets also rallied.

Factors were challenged at times by the equity market reversals and the unwind of the Japanese yen carry trade; however, they still experienced a positive third quarter (Exhibit 1). Equity factors led the way, especially U.S. equity factors, though the gains were smaller than previous quarters’. The FX carry and FX momentum factors had a tough quarter, while commodity factors performed well.

The outlook for risk assets remains strong. At a time when positive and broadening earnings growth is expected, along with a soft landing and additional interest rate cuts, we see factors as an equally attractive opportunity, supported by attractive equity valuations, greater differences in carry across the commodities market and stronger trends across macro markets.

Factors in focus

Equity factors extended their gains, powered by the quality factor in particular.

The strong run for equity factors continued in the third quarter. A blend of our value, quality and momentum factors reached a new all-time high on a global basis.

Within U.S. markets, the value, quality and momentum factors each moved higher (Exhibit 2). The U.S. momentum factor led the way, as it has throughout the year, despite a marked yet fleeting reversal in July when small cap stocks bucked the trend and outperformed large caps.² The U.S. value factor rebounded in July following a tough June, although it underperformed during the rest of the quarter, when measured on a sector-neutral basis.³ The U.S. quality factor logged a solid yet unspectacular quarter.

Outside of the U.S., the quality factor was up everywhere in Q3 except the U.K. The value and momentum factors rose almost everywhere except Japan, where they struggled, pushing the EAFE⁴ value and EAFE momentum factors into negative territory over the quarter (Exhibit 3).

Following yet another positive quarter for equity factors, we again must ask how long the exceptional post-COVID run is likely to last. Last quarter, we posited that supportive valuations and broadening earnings growth might be enough to lift U.S. equity factors above any challenges brought on by investors’ enthusiasm for a handful of AI-fueled stocks. U.S. equity factors’ strong performance was a step in that direction.

The U.S. value factor may no longer be dislocated, as value stocks’ strong performance has made the value factor more expensive. However, the U.S. value factor is still roughly one standard deviation inexpensive, relative to its long-term average (across all market caps) and is at levels eclipsed only during the dotcom and post-COVID bubbles.

The U.S. quality factor’s story is similar. It is no longer dislocated but remains attractive, relative to its long-term history, at levels eclipsed only during the dotcom and post-COVID bubbles.⁵

Internationally, the value factor is still less inexpensive than it has been historically in all but a few periods, but it is no longer one standard deviation inexpensive relative to its long-term average. The international quality factor has actually become slightly expensive. Less attractive valuations for international value and international quality temper our outlook for international value factors.

It is important to note, however, that compensated factors—such as value, quality and momentum—would be expected to generate positive returns even when they are neutrally valued, so we may expect positive performance from international equity factors and above average returns from U.S. equity factors.

Macro factors: Headwinds from the unwind of the yen carry trade

While risk assets and equity factors generally ended higher in Q3, macro factors faced challenges as investors unwound the Japanese yen carry trade in early August. The unwind caused volatility that directly impacted the FX carry factor, with spillover effects on other macro factors. Yet despite a challenging quarter, macro factors are up over the past year, supported most notably by gains in carry and commodity carry factors.

The challenges to macro factors began in mid July when the Japanese yen began to rally from its weakest levels since 1986—strengthening by nearly 11% by the first week of August.⁶ This sharp move was driven by the Bank of Japan’s decision to raise interest rates and reduce bond purchases at the end of July. Coupled with investor concern about the strength of U.S. economic growth, investors who had borrowed in low interest rate yen to invest in higher yielding assets elsewhere unwound this carry trade.⁷ Naturally, the FX G10 carry factor declined as a result.

Short positioning in the Japanese yen and the Swiss franc both took losses. The FX G10 momentum factor also deteriorated, as positioning had become correlated with FX carry following gains over the course of 2024. The FX emerging market carry factor also declined, as high interest currencies, such as the Mexican peso, sold off.

The time-series momentum factor also declined over Q3—in August, especially—as the TOPIX (Tokyo Stock Price Index) fell when the Japanese yen rallied, and the Nasdaq, recently a high-momentum market, reversed as well. Commodity factors proved immune to these events. Commodity momentum rallied in each month of the quarter, serving as a diversifier to other macro factors as upwards trends in gold, silver, coffee and cocoa prices continued, as did downward trends in soybean prices.

Looking ahead, we see a healthy opportunity for macro factors. We have upgraded macro carry from neutral to positive now that commodity carry spreads are one standard deviation above their long-term average. Supply-demand imbalances are high for coffee (positive carry) and natural gas (negative carry).

While we classify FX carry spreads as neutral, they remain at the highest level since the global financial crisis (GFC): a 3.4% annualized spread vs. 2.5% post-GFC, on average. The fixed income carry factor is also a neutral; however, real yield spreads are above their post-GFC average (2.0% now vs. a 1.6% average then). Although fixed income carry is below 2022’s highs, yield curve differentials are in line with their long-term average.

We have also upgraded the macro momentum factors. While FX market dispersion remains low, commodity market dispersion has reached more than one-standard deviation wider than average. Precious metals, industrial metals and certain soft commodities (e.g., coffee and cocoa) continue pushing higher, while energy commodities continue to sell off—opening significant momentum opportunities for investors without their having to take an outright bet on commodities.

As for time-series or trend-following momentum factors, bullish trends remain in place across nearly all equity markets we trade (TOPIX is a notable exception). Bullish trends are also forming across government bond markets as a global rate-easing cycle begins. In all, we see a supportive backdrop for trend-following momentum factors across equity, fixed income and commodity markets.

Concluding remarks

We continue to see generally attractive prospects for a range of factors. Equity value appears best positioned from a valuation perspective. Equity quality is now neutral on a global basis but attractive in the smaller cap U.S. market. We have a more constructive view of macro factors, having upgraded both the macro carry and macro momentum factors. While macro conditions have evolved in line with our call for a soft landing, and generally support a risk-on posture across traditional asset classes, we continue to see factors as attractive for investors looking for diversifying sources of return.

¹ The Nikkei experienced its largest one day drop since 1987 in a spillover from the unwind. 

² Small caps outperformed during this brief period by the fifth widest margin in our data’s history, which dates to 1990. Over the whole Q3, about two-thirds of S&P 500 stocks outperformed the S&P 500 over the quarter, reflecting a broadening out of performance beyond just the mega-cap Magnificent 7.

³ We evaluate the value factor on a sector neutral basis, considering the richness/inexpensiveness of stocks relative to their sector peers (e.g. the valuation of an IT company vs. other IT companies) rather than leaning into sectors that may be cheaper than other sectors.

⁴ Europe, Australasia and the far east (East Asia)

⁵ The U.S. quality factor has become slightly expensive when measured across large and mid-cap stocks only.

⁶ Prior to these moves, the Japanese yen had wakened by over 20% since the end of 2022.

⁷ The interest rate differential is the “carry.” In an unwind, investors buy back lower interest rate assets (here, the yen) and sell higher yielding assets to close the trade.

Glossary

• 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 momentum: Long/short global developed stocks based on price change and earnings revisions; sector and region neutral
• Equity size: Long/short global developed stocks based on market capitalization; sector and region neutral
• 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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