Factor Views 4Q 2022
Themes from the quarterly Quantitative Solutions Research Summit
- Factors held up relatively well amid difficult macro conditions and continued to provide diversification benefits to a portfolio of traditional asset classes.
- Equity momentum was the top performer over the quarter, with valuations remaining attractive across equity factors in aggregate.
- The merger arbitrage factor benefited from high spread levels and finished in positive territory despite elevated market volatility.
- Macro factors were mixed after a strong start to the year, with losses across commodity factors offsetting gains in other asset classes.
- We maintain our positive outlook for equity factors, which appear cheap, and for merger arbitrage, which is underpinned by wide spreads. We believe that macro-based strategies also still have scope to perform well.
Traditional asset classes had another difficult quarter in 3Q 2022 amid concern over persistent high inflation, aggressive monetary policy and the potential for a global recession. The MSCI World Index of global equities finished the quarter down 6.2%, bringing year-to-date losses to 25.4%; the second half of the quarter was particularly challenging for equities as hopes of a soft landing and dovish policy pivot by the Federal Reserve were quashed by high inflation prints and hawkish central bank rhetoric. Fixed income offered limited diversification benefits as yields backed up near the end of the quarter. The FTSE World Government Bond Index (WGBI) of developed market government bonds finished Q3 down (in local currency terms) 4.2%, and down 13.2% year-to-date.
Commodity markets also declined: The Bloomberg Commodity Index was down 4.1% in 3Q 2022, partially reversing gains earlier in the year. The U.S. dollar is one of the few assets that has enjoyed consistently positive returns this year.
Despite this dour backdrop, the factors that we favor held up well over the quarter: Equity momentum, merger arbitrage and macro carry were all positive, and losses across other factors were relatively limited (Exhibit 1).
Factors were mixed over the quarter but held up relatively well amid difficult macro conditions
Exhibit 1: Quantitative Solutions long/short factor returns
Our macroeconomic outlook has become more pessimistic over the course of 2022; we expect difficult conditions to carry through to next year as central banks remain hawkish in the face of stubborn inflation. These conditions may continue to challenge traditional asset classes, especially equities, as corporate profit margins come under pressure.
However, our outlook for factors remains positive and is unchanged from last quarter. Equity factors in aggregate continue to appear very inexpensive, with value standing out; the quality factor offers a measure of defensiveness should the market downturn continue. The merger arbitrage factor remains supported by higher spreads, as are macro carry factors. Macro momentum factors appear well positioned for a continuation of the current market regime, with a sizable number of shorts in place across equity and fixed income markets.
Factors in focus
Equity factors: A choppy quarter, with momentum surprisingly resilient
Equity factors remained volatile over the quarter, albeit with volatility that was more two-sided than earlier in the year, when factor moves tended to be biased more to the upside than the downside.
The value factor recorded its first negative quarter since the end of 2020, when COVID-19 vaccine announcements sparked a long rally in value stocks across the globe. This lackluster quarter coincided with a continued increase in U.S. Treasury yields, calling into question—as we have historically—the perceived linkage between the value factor and interest rates. The relationship between the two weakened over the quarter, and value actually appeared more closely linked to oil prices than any other macro variables by the end of the quarter (Exhibit 2).
The value factor did not follow the rise in interest rates over the quarter
Exhibit 2: Value factor returns vs. macro variables
The quality factor also declined, partly due to what some market participants characterized as a short squeeze in August: Low quality stocks outperformed in a short-lived equity rally on hopes that central banks would pivot and moderate their hawkish stance. Notwithstanding this recent wobble, quality stocks have performed well, both year-to-date and longer term, yet they remain inexpensive, in our view.
Momentum performed well over the quarter and was surprisingly resilient amid macroeconomic and market volatility. Whereas momentum has at times traded as the inverse of the value factor,1 they have been positively correlated over the past two years, reflecting the broad rally in value stocks since the end of 2020.2 And while it is commonly believed that growth is the opposite of value, more recently stocks with high earnings growth have performed similarly to value stocks and their correlation has risen from zero into positive territory (Exhibit 3).
The value factor has aligned with earnings growth for much of 2021 and 2022
Exhibit 3: Value vs. earnings growth factor
The opportunity set for equity factors remains positive, supported by the inexpensiveness of the value factor. Globally, the value factor remains as cheap as it has been since the dot-com bubble, and in the U.S. market as cheap as we have ever observed, in data going back to 1990. The picture is mixed across the quality and momentum factors, with both very inexpensive in the U.S. market but neutral to expensive in certain other developed markets. Globally, in aggregate, equity factors appear as attractive as they have been since the dot-com bubble.
We have historically observed a linkage between starting factor valuations and subsequent factor returns that strengthens with longer time horizons. We see the current spreads indicating the potential for continued strong performance across equity factors—the value factor in particular. However, ecent returns have been accompanied by elevated factor volatility, and investors should expect short-term reversals in factor , given the uncertainties in the macro and market environments.
We also note risks and opportunities created by factor positioning and correlation. On the one hand, factors’ alignment suggests the potential for a broad factor rally and an above-average environment for factor investing—particularly multi-factor investing—until a regime shift. On the other hand, diversification opportunities may be limited than they have been historically.
Merger arbitrage factor resumed its climb
Despite market volatility, the merger arbitrage factor resumed its climb over the quarter, its performance buoyed by the attractive spread levels that we flagged last quarter.3 Positive returns spanned both friendly and hostile deals in a quarter where deal failure rates remained below the long-term average.
The merger arbitrage factor typically exhibits some level of positive correlation to equities during sharp market declines, which makes its resiliency and low volatility over both the quarter and the past two years notable. Since the fall of 2020, the factor has exhibited an equity beta of only 0.02 vs. a long-term average of 0.13, and volatility of only 2.8% vs. a long-term average of 4.8%.
Deal activity remained roughly unchanged, with the number of deals below both the long-term average and the level heading into 2022, as macro uncertainty kept companies from engaging in new transactions. Yet spread levels remain attractive—even though they are slightly below the end of Q2—and support the prospects for returns.
Macro factor: Mixed across asset classes, with commodity losses offsetting gains elsewhere
After a strong start to the year, macro factors were mixed in 3Q 2022. Gains from positioning across fixed income and foreign exchange markets were offset by losses across commodity markets.
Fixed income carry benefited from relative value positioning that was short UK Gilts. While government bond markets across the world were down over the quarter, losses in Gilts were particularly acute and historic, the result of proposed fiscal policies that sparked panic—and ultimately dysfunction—in markets and forced the central bank to intervene.
Currency factors were also positive, with both carry and momentum contributing over the quarter as positioning generally favored the U.S. dollar and was against the euro and yen. The strength of the U.S. dollar has been a notable trend throughout 2022; the U.S. dollar is at its highest level in over 20 years vs. other major currencies, supported by the relative resiliency of the U.S. economy and a hawkish Federal Reserve.
Commodity factors were the weak spot as both carry and momentum declined over the quarter amid a reversal that saw many commodity markets give back gains from earlier in the year. Positioning in crude oil futures was hit hardest, though losses were spread across other markets, including a range of soft commodities, such as cattle feed, cotton and corn, where positioning remained long.
After enjoying significant gains in the first half of the year, cross-asset momentum (or trend) factors were flat as losses from long commodity positioning offset gains from short equity and fixed income positions.
Looking ahead, carry spreads remain attractive across fixed income markets, where they are generally at least 1 standard deviation higher than the long-term average; they are also above average in currency markets. It is worth noting that macro factors have less conviction in commodity markets, with carry levels less attractive than they had been earlier in the year. Momentum positioning is mixed, with longs in soft commodity markets offset by shorts in precious metals, industrial metals and energy markets.
Factor performance remains strong year-to-date, particularly in light of volatile macroeconomic conditions and one of the worst starts to the year for traditional asset classes. Our outlook is unchanged across factors: We continue to see generally attractive pros-pects for a wide range of factors; equity value remains especially attractive, as do equity quality and equity momentum in U.S. markets, and we retain a positive outlook on merger arbitrage and macro carry.
We expect the environment for traditional asset class exposures to remain uncertain and believe that factors can play an important complementary role in a broader portfolio context.
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. Momentum exhibits a negative correlation of -0.56 on monthly data going back to 1990, based on research by J.P. Morgan Asset Management’s Quantitative Solutions team.
2. FactSet, J.P. Morgan Asset Management. Historically stocks with the strongest momentum have exhibited a forward P/E of 17.4x vs. 15.1x for those in the weakest quartile. However, today the P/E of the strongest momentum stocks is lower than that of the weakest momentum stocks (13.8x vs. 14.9x, respectively).
3. Yazann Romahi and Garrett Norman et al., “Factor Views: Themes from the quarterly Quantitative Solutions Research Summit,” J.P. Morgan Asset Management, 2Q 2022.
- 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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