In brief
- Factors posted a positive second quarter, on average, extending a strong run alongside risk assets’ stellar performance as sentiment improved over the quarter.
- Equity momentum stood out among equity factors, as momentum trading helped drive equity markets higher despite challenging conditions for value and quality.
- Macro factors gained, led by carry factors and FX and commodity carry. Momentum factors were also positive, in aggregate.
- We maintain our positive outlook for factors overall. Equity value and equity quality are now historically inexpensive and equity momentum could continue its run, although with heightened risk. We recommend diversification among and across factors now more than ever, given the potential for market disruption and elevated factor volatility.
Overview
Risk assets enjoyed a very strong second quarter, with many markets bouncing back from a challenging March on generally reduced—if still high—tensions in the Middle East and rising optimism around rising capex by the beneficiaries of artificial intelligence (AI). In aggregate, factors enjoyed a positive quarter (Exhibit 1).
Equity markets were fueled by “momentum winners,” the stocks that have performed best over the past 12 months. The cohort of stocks exhibiting momentum has changed over the past year, (from the hyperscalers in 2024 to memory chip makers this year-to-date), propelling the momentum factor’s continued very strong run. Many investors are questioning how long this environment can continue.
Macro factors performed positively, in aggregate, in Q2 despite market participants’ changing their outlook on inflation, and shifts in the fixed income and commodity markets broadly. The time-series momentum factor increased its exposure to equities over the quarter, perhaps signaling more a reflationary than a stagflationary environment ahead. Carry factors also gained.
Our outlook for factors remains positive overall. Equity value and equity quality are now significantly inexpensive, and we expect better-than-average long-term returns for both factors. Equity momentum could continue its run, albeit with elevated risk. Macro spreads are generally neutral, but we emphasize that even a neutral view implies positive returns.
Factors in focus
Equity momentum became the story
The momentum factor’s continuing strength evolved from an important story within the factor landscape to the central story for equity markets at large, as the beneficiaries of AI capex (“momentum winners”) continued to power markets higher. Global equity markets rose about 15% over the quarter—their strongest since the COVID-19 recovery in 2020—and roughly two-thirds of those gains came from the tech sector. (Some leading semiconductor vendors and memory chip makers saw meteoric gains of 100%–200% in Q2.
Momentum’s supersized gains raise questions: How long can the momentum rally last? Is a reversal likely to take down the broader equity markets? And what are the implications for other factors, such as value and quality?
Equity momentum: Again the top performing factor, it extended its best multi-year run since the dot-com bubble this quarter and was the only factor to deliver positive performance across all global developed and emerging markets. Gains were strongest in the Asian and emerging markets central to the AI and semiconductor supply chain. As investors price AI’s impact, momentum factor leadership has shifted to memory chip makers and AI capex beneficiaries and away from software firms. Market pricing appears to be the dominant signal as investors debate which stocks’ fundamentals the AI revolution will disrupt next.
We monitor the momentum factor through factor valuations, factor dispersion and factor volatility and are developing a proprietary Momentum Fragility Index that incorporates options market data and other statistical inputs to assess the likelihood the run will continue.
Momentum winners have generally demonstrated earnings acceleration sufficient to justify their stock price increases (i.e., factor valuations are benign). Yet the magnitude of difference in performance between market winners and losers (factor dispersion) is high, relative to history, raising the risk of a momentum reversal. We have also observed volatility in the momentum factor rising to six-year highs, and our Momentum Fragility Index indicates an elevated risk of a momentum crash.
We recommend investors trim momentum overweights but not abandon the factor. Momentum still offers important diversification benefits vs. the value and quality factors, as we will discuss.
Equity value: The factor stumbled globally following three positive quarters—declining in international markets particularly, on a sector-neutral basis.1 Value’s returns year-to-date are negative, except in the U.S. This turn for value, alongside the quality factor’s challenges, suggests a more speculative, perhaps euphoric, market tone.
The global value factor appears nearly one standard deviation inexpensive vs. history, on a sector-neutral basis. In the U.S., value is more than one standard deviation inexpensive, near a record low outside of the dot-com bubble and post-COVID-19 speculative bubble (Exhibit 3).
When and how might valuations normalize? In two ways:
- Value stocks’ prices and returns outperform expensive counterparts, which would correspond with strong value factor performance.
- Value companies’ earnings deteriorate, turning apparently attractive stocks into value traps, pricing in weak fundamentals.
Value factor investors clearly prefer the first path— and historically, it’s been the more common pattern: Wide valuation spreads have often been a precursor to better-than-average performance. However, the chorus arguing that this time is different—given how revolutionary AI appears to be— is particularly loud right now.
We stay humble (this time, may in fact, be different). The cushion of elevated valuation leaves us comfortable, however, maintaining exposure to the value factor. But we are not as overweight as valuation spreads alone would suggest.
Equity quality posted yet another weak quarter—continuing its worst stretch since the post-COVID-19 speculative bubble and one of the worst in history. It declined across all major regions except the UK and Japan. This may be another sign of markets potentially becoming more speculative.
The quality factor is now one standard deviation inexpensive globally vs. history, and more inexpensive than that within U.S. markets (Exhibit 4).
Healthy levels of fundamental dispersion remain; that is, the fundamentals (e.g., return on equity) differ between high and low quality businesses globally. That implies an opportunity to favor high quality stocks vs. their low quality counterparts. The dispersion of profitability metrics within the U.S.—a core input into how we measure the quality factor—is now more than one standard deviation wider than long-term history. Such elevated dispersion in profitability may paradoxically be making high quality companies targets for AI-related disruption, given the potential to displace them and earn those profits. As a result, market participants have discounted many high quality stocks’ prices.
While we acknowledge the risk of disruption, we remain optimistic about the quality factor’s prospects globally. Certain companies will no doubt be impaired. But given the attractive valuation levels and strong fundamentals across a broad cohort of high quality stocks, we see no reason to abandon the quality factor at this time.
Macro factors: Carry continued to perform well, with momentum also positive
Macro factors posted positive returns over the quarter, despite some geopolitical and monetary policy gyrations, including U.S.-Iran ceasefires and escalations, and the Federal Reserve’s transition to a new chair, Kevin Warsh. Carry factors led the gains and momentum factors finished Q2 higher, in aggregate.
FX carry was again the top performer across macro carry and momentum factors, driven by long and short positioning in Group of 10 developed markets. High-carry currencies, such as the Australian dollar and the British pound, performed well, supported by aggressive monetary policy Down Under and stronger-than-anticipated UK economic growth. The low-carry Japanese yen reached a 40-year low. EM FX carry also performed well, led by the Colombian peso and Mexican peso. The weakest performance was the Korean won’s; despite historic equity market gains, foreign investors have been selling and withdrawing capital as they seek to lock in their gains.
Commodity carry was another strong performer, primarily in June, led by higher-carry livestock markets including live cattle (due to Mexico suspending cattle imports from the U.S. after cases of flesh-eating New World screwworm appeared in border states) and lean hogs (amid short covering). Negative-carry agricultural commodities posted weak performance, including corn and wheat due to favorable harvests, and sugar (as weak demand met a supply surplus).
Momentum factors generally recovered from a difficult March to post a positive quarter, although they ended June lower as a surprisingly hawkish press conference by the new Federal Reserve chair prompted technical disruptions across a range of markets. Commodity momentum also suffered from a range of idiosyncratic drivers.
Our aggregate outlook on macro factors is unchanged, at neutral, with targeted shifts in certain macro momentum factors in response to price dislocations driven by the war in Iran.
Carry: Our overall outlook is neutral, though in aggregate it is weaker than it was last quarter. FX carry spreads again edged up. They began the year at 2.9%, rose to 3.0% in Q1 and ended Q2 at 3.1%—wide relative to the average of 2.5% in the post-global financial crisis period2 but low over the longer term.3
Fixed income carry spreads remained tight, ending the quarter one standard deviations below their long-term average. Yield curve steepness differentials (between the steepest and flattest government bond markets) remain only around 0.5%. The real yield differential between high yielding and low yielding economies widened, but is only 1.1%. We keep our outlook negative.
Commodity spreads came down in Q2 and are now neutral. Recently steep oil backwardation, offering positive carry, offset the reduced carry available in other commodity futures markets, but oil then declined during a period of generally reduced tensions in the Middle East.
Macro momentum: Time-series momentum rebuilt positive exposure to equity markets over the quarter, after moving to neutral in March during a peak in the Middle East conflict. The average signal is now 0.5 (on a scale of -1 to 1). Time-series momentum is still short duration, in aggregate, though less so than at the end of Q1 (when the average signal was -0.2). It is now neutral, in aggregate, across commodities (the average signal is 0.0) after a positive Q1.
There were, however, strong signals, including longs on live cattle, natural gas and feeder cattle and shorts on corn, lean hogs and gold. Overall, despite some of these moves, time-series momentum factors remained positioned for a reflationary environment; only time will tell if those conditions persist.
The number of significant trending markets has declined, lessening opportunities in time-series momentum and moving positioning closer to neutral in equities (slightly long) and fixed income markets (slightly short), although still long across many commodities. This narrows the profit (or loss) potential until new trends emerge.
The dispersion of returns within commodity markets lessened over the quarter, but returns are at neutral levels overall. Dispersion in returns within FX markets remains neutral as well, signaling average opportunities for relative value momentum factors.
Concluding remarks
We continue to see generally attractive prospects for equity factors, led by attractive valuations for the value and quality factors; however, we see elevated risks for the momentum factor (and all equity factors) and favor diversification rather than any outsized positions.
We rate most macro factors neutral and there, too, favor diversification across and within a wide range of macro factors.
While we believe the global expansion remains intact and supportive of a pro-risk posture across traditional assets, we continue to see factors as an attractive opportunity for diversifying sources of return.
Factor opportunity set
The table below summarizes our outlook for each of the factors accessed across J.P. Morgan Asset Management. It does not constitute a recommendation, but rather indicates our estimate of the attractiveness of factors in the current market environment.
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.
1 By sector-neutral, we mean comparing technology stocks to technology stocks, energy stocks to energy stocks, etc. and not favoring one sector over the other in defining the factor. This is in contrast to a “style-box” definition of value. A style box is a visual 3 × 3 grid that classifies equity investments by size (large, mid, small cap) on one axis and style (value, growth) on the other. Style is determined by metrics including price-to-book, P/E and earnings growth.
2 And much wider than the COVID-era lows of 0.8%.
3 The overall average since the inception of our data in the early 1990s is 3.7%. The average for the period before the global financial crisis is 4.8%.
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 regional 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 G-10 carry, FX emerging market carry, fixed-income term premium, fixed-income real yield, commodity carry
- Macro momentum: FX cross-sectional momentum, commodity cross-section momentum and time series momentum across equity, fixed income and commodity markets
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