Overview

Factors’ and traditional asset classes’ performance varied by geography in the fourth quarter as U.S. markets diverged from most other markets around the globe, driven by geopolitics, macroeconomic data and investor sentiment. 

The election of Donald Trump to a second term as president had a meaningful impact. The prospect of further tax cuts, expansionary fiscal policy and a more nationalist trade policy boosted U.S. equity markets at the expense of other countries and regions. Exuberance about the new Trump administration also influenced U.S. equity factors, as investors’ preference for expensive, low-quality companies challenged the U.S. equity value and quality factors and pushed equity factors more broadly into negative territory (Exhibit 1).

U.S. economic data remained strong, while recession fears weighed on Europe. Political concerns (even instability) also weighed on markets in several countries in a quarter that saw Germany’s governing coalition collapse, France’s prime minister suffer a no-confidence vote, South Korea’s president spark a martial law crisis and the UK government’s fiscal policies become a cause for concern. While global equity markets finished the quarter lower, driven by declines in emerging and developed stock markets ex-U.S., international equity factors were positive and helped counter losses from their U.S. counterparts.

Against this backdrop, fixed income volatility remained high. All major developed markets’ government bond yields rose, with U.S. Treasuries rising highest, challenging fixed income factors. The U.S. dollar appreciated as FX markets priced in a solid U.S. economy and fewer interest rate cuts. Dispersion in emerging market (EM) currencies’ performance played out in a manner that benefited the FX EM carry factor. Commodities finished Q4 higher despite the dollar’s strength, with commodity factors ending the quarter particularly well.

Our outlook for traditional risk assets, especially U.S. risk assets, remains upbeat. Looking ahead, we expect attractive valuations, and a potential broadening out of earnings, to be supportive of the U.S. equity value factor and the (already strong) U.S. equity momentum factor. We have a more neutral view on international equity factors and macro factors. We emphasize, however, that a “neutral” view implies positive returns, and that we favor diversification in an uncertain environment.

Factors in focus

Equity factors stumbled in the U.S., although they continued to perform well in other regions

Following six consecutive quarters of gains, global equity factors finally took a downturn, in aggregate, experiencing their toughest stretch since before the COVID-19 vaccine arrived and heralded the post-pandemic economic recovery. All the Q4 pain came within U.S. equity factor markets: Value, quality and momentum ended the quarter negative; international developed and emerging market factors finished positive.

The U.S. value factor was the most challenged. Using our sector-neutral long/short lens, value fell more than 10% over the quarter—its second-worst quarter in our records, dating back to 1990 (eclipsed only by the quarter the pandemic broke out). Smaller cap value companies performed worst.¹ The U.S. quality factor was down sharply, as well, its sixth-worst quarter in our records. Taken together, these declines in two fundamentally oriented factors points to investors’ preference for the more speculative segments of the U.S. equity market. ² 

In international markets, momentum performed best across developed markets and quality performed best across emerging markets. These regions’ factor performance diverged meaningfully from U.S. factors—breaking from the pattern of Q3 2024 (Exhibits 2A and 2B). 

Looking back at the year overall, 2024 was the third best year in our data (to 1990) for international (ex-U.S.) developed market factors, which last performed this well in 2002 when the dot-com bubble burst. The 2024 story wasn’t quite as robust for emerging market factors but it was a better-than-average year. By contrast, U.S. factors’ 2024 ranked in the bottom third of years in our history. 

As U.S. equity factors diverge from other regions’, so, too, is our outlook (Exhibits 3A and 3B). 

U.S. equity factors: At one-standard deviation inexpen-sive relative to their long-term history, they are nearly as attractive as they were at the peak of the dot-com bubble. Still, they are more expensive than during the post-COVID bubble when an extreme preference for speculative growth stocks challenged the value and quality factors. In addition, U.S. equity factor valuations are more attractive now than last quarter, following Q4’s weak performance.³

The value factor is the most attractive of U.S. equity factors, at more than one-standard deviation inexpensive relative to its long-term history. The U.S. quality factor also continues to be inexpensive relative to its long-term history but is less attractive than last quarter, and certainly less than it was at the market’s nadir during COVID-19 when factors sold off. The quality factor is starting to become expensive among larger cap stocks but we note that this is to be expected in a mid- to late-cycle market environment.⁴   

Developed market factors: International developed market factors have become less attractive at current valuations, which are now around their long-term averages. International developed value is still inexpensive but less so. International developed quality moved into expensive territory in Q4 (one standard deviation expensive, relative to its long-term history). After international developed factors’ exceptionally strong run from 2021–24 in absolute terms and relative to their U.S. counterparts, it seems reasonable to expect a reversion to normal returns befitting compensated factors. 

Emerging market factors: The emerging market story resembles what we see in the U.S.: inexpensive in aggregate (although not to the same extent as during the pandemic-era extremes), with value and quality the most inexpensive factors. 

Macro factors: Carry, currency and commodity factors lead the way 

FX and commodity factors were remarkably resilient in a quarter of geopolitical and macro surprises. Gains for FX and commodity factors offset losses in fixed income factors arising from reversals across government bond markets during the quarter.

The commodity momentum factor was the top performing macro factor, powered by shortfalls in cocoa and coffee, markets that continued to rally on supply-side concerns. Drought and crop disease in West Africa have created a shortage in cocoa supply, while drought and wildfires in Brazil, and the impact of a typhoon in Vietnam, have challenged coffee production. The commodity carry factor rose due to long positioning across cocoa and coffee futures—albeit positioning flipped to slightly short cocoa by the end of the quarter. 

The performance of FX factors, measured across G10 currencies, was positive but muted over the fourth quarter. Much of the activity was concentrated in the U.S. dollar’s strengthening vs. other currencies: Long positioning in the U.S. dollar was beneficial, yet because other currencies’ pair-wise movement was very minimal, there were fewer opportunities than usual in FX G10 factors. In contrast, EM currency markets saw more movement. The FX EM carry factor performed very well when implemented in the dollar-neutral fashion that we favor: long positioning in EM currencies with high rates (high carry) and short positioning in low-carry EM currencies, with no net U.S. dollar exposure.

The U.S. dollar strengthened against all EM currencies, although not uniformly. Lower carry currencies performed poorly over the quarter, including the Korean won (neg-atively impacted by the martial law crisis); Czech koruna (hindered by economic headwinds domestically and in  Germany, a key trading partner) and Chilean peso (hit by  resurgent inflation and China’s weaker demand for copper). Higher-carry currencies had a relatively better quarter.

Fixed income factors, on the other hand, were challenged. Fixed income carry, expressed based on real yield, suffered from long positioning in Treasuries and UK Gilts, the two developed market government bonds that rose the most. Fiscal concerns were one of several reasons. Short positioning in other markets (such as Japanese government bonds and European Bunds, whose yields rose only modestly) were less fruitful. The fixed income time-series momentum factor was challenged by the rise in government bond yields, after the factor entered Q4 positioned long duration across all traded markets.

Equity time-series momentum factors declined, too, as long positioning across a range of international equity markets suffered declines over the quarter.

Looking ahead, we take a neutral view of macro factors. We have downgraded macro carry from positive to neutral, primarily because commodity carry spreads tightened in Q4. The underlying reasons included declines in implied carry on cocoa futures and seasonality impacting natural gas markets.

FX carry spreads remain at the highest level since the global financial crisis (GFC): a 3.4% annualized spread, vs. 2.5% post-GFC. FX carry spreads, on average, are neutral on a longer-term basis since, through our factor lens, the U.S. dollar is no longer a favored market. We also rate the fixed income carry factor a neutral; real yield spreads are above their post-GFC average (1.9% now vs. 1.6% then) but the factor has tightened quarter-over-quarter. And fixed income carry remains below 2022’s highs.

We have downgraded our macro momentum factors to neutral. FX market dispersion remains low and commodity market dispersion is tighter (no longer one standard deviation wider than average). As for time-series or trend-following momentum factors, signals are now mixed. The government bond market reversals flipped positioning from long duration to slightly short (despite being five months into a global rate-easing cycle); meanwhile, softness across international equity factors began to be reflected as positioning became more neutral.

Concluding remarks

We continue to see generally attractive prospects for a range of factors. The equity value factor may offer the strongest prospects for above-average returns, supported by attractive valuations. Other factors appear more neutrally valued—following a continued normalization in international equity factor valuations and a downgrade to our outlook for macro carry and macro momentum. At a time when many investors are positioned long traditional risk assets, we continue to see factors as attractive opportunities for diversifying sources of return.

¹ When measured across a large/mid-cap universe of U.S. stocks rather than an all-cap universe, the U.S. value factor was down 7%, which was its 10th worst quarter in our records dating back to 1990, highlighting that small-cap value stocks were challenged in particular within U.S. markets.

² Last quarter we suggested that strong U.S. equity factor performance in Q3 2024 may have been a sign 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, but this battle is clearly not over.

³ U.S. factors experiencing their third worst quarter in our records, dating to 1990—despite being very inexpensive as the quarter began—is a good reminder that valuations are not a reliable signal over the short term.

⁴ In the U.S. large- and mid-cap space, high quality stocks are more expensive than their lower quality counterparts about 45% of the time.

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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