Overview

Investor sentiment and market conditions have swung and shifted this year. Fears about what the fastest pace of rate hikes in a generation could mean for markets and the economy, and concern about a potential “hard landing,” gave way to expectations that a surprisingly resilient U.S. economy might well manage a “soft landing.” More recently, investors have focused on the implications of a potentially “higher for longer” interest rate environment.

Last quarter, we noted that the one constant had been equity market gains, but that changed this quarter as stock markets faltered in August and September when interest rates rose sharply.

Despite these shifting regimes and changing market conditions, factors enjoyed another strong quarter (Exhibit 1). The equity value and equity quality factors rallied, signaling that investors were more focused on company fundamentals than earlier in the year when euphoria over artificial intelligence boosted a subset of the market—and also, perhaps, indicating a bit more fear in Q3 about the economy’s near-term prospects.¹ The merger arbitrage and macro carry factors also fared particularly well.

Factors continued to perform well in aggregate, with a few rising significantly

Looking ahead, our base case sees both inflation and economic growth moderating, but also acknowledges the underlying resilience of the U.S. economy. We continue to see considerable potential for relative value opportunities within asset classes at the factor level, and we retain a positive outlook across the equity value, equity quality and macro carry factors more broadly.

Factors in focus

Equity factors: A strong quarter for fundamental factors as market regimes shifted

Both the equity value and quality factors were positive in a quarter when sentiment shifted and broad markets faltered after a strong first half of the year.

The value factor—which we measure at the stock level and on a sector-neutral basis²—was positive over each month during the quarter and in each country and region that we evaluate. These stock-driven results stand out compared to a typical “style-box” value approach, which largely reflects the relative performance of sectors vs. a growth index. Value is now slightly positive year-to-date in the U.S. all cap universe, and up significantly across most international markets. In the U.S. large/mid cap universe, value is still down for the year (Exhibit 2).³

Equity value rose globally in Q3 but year-to-date has performed better outside the U.S.

High quality stocks also outperformed over the quarter, particularly in August and September, when companies with strong cash flows fared best.⁴

We continue to see some normalization of equity factors when we assess their risks and prospects, albeit not a full reversal from pandemic-era dislocations. Factor volatility, which was in the 90th percentile in aggregate earlier in 2023, decreased over Q3 but remains high: in the 79th percentile.⁵

Factor valuations also continued to normalize but they remain attractive. Valuations are now, in aggregate, 1 standard deviation below their long-term averages. The value factor remains inexpensive across global markets. The quality factor remains cheap in the U.S., especially among small cap stocks (Exhibit 3).

Value remains inexpensive across the globe; quality is inexpensive in the U.S.

The quality factor story strikes us as particularly interesting at this point in the economic cycle, when macro uncertainty hangs over markets.

High quality stocks may offer the potential for asymmetric returns without requiring a precise tactical call on markets and the economy because of certain features: These stocks are significantly less expensive than they would typically be in a late-cycle environment⁶ and they tend to outperform during most market regimes—the exception being the early phase of an earnings growth cycle, which we do not believe is near (Exhibit 4).

Equity quality tends to perform well except at the start of an earnings growth cycle

Credit factors: Value had another positive quarter; momentum and quality underperformed

Credit markets were generally range-bound during Q3. U.S. high yield spreads reached 12-month lows in early September before widening to end the quarter almost unchanged at 396 basis points (bps).

Within high yield markets, credit value continued to perform very well for another quarter. It has delivered positive returns in seven of the last eight quarters. Elsewhere in credit, both the momentum and quality factors underperformed during Q3. Credit momentum particularly struggled—it has underperformed in three of the last four quarters. Credit quality’s performance has been flat.

Our outlook is positive for the value credit factor and neutral for credit quality and momentum. Valuations for all three credit factors are close to fair value, relative to long-term levels. On price dispersion, the momentum and quality factors are neutral while the value factor looks attractive.

Merger arbitrage: Strong performance supported by regulatory decisions

The merger arbitrage factor enjoyed its best quarter since 2009, rallying nearly 4% in Q3 following positive regulatory developments.

We have discussed previously how concerns about an increasingly aggressive Federal Trade Commission (FTC) drove merger arbitrage spreads wider, to quite attractive levels, as investors required compensation for elevated odds of deal failure. In Q3 2023, however, a federal judge approved Microsoft’s acquisition of Activision and the FTC allowed Amgen to acquire Horizon Therapeutic. These decisions boosted the merger arbitrage factor’s performance, tightening spreads. (The FTC had previously stood against these mergers on anti-competitive grounds.)

The merger arbitrage factor has now produced positive returns for 14 consecutive quarters. The last loss was at the onset of the COVID-19 pandemic when merger arbitrage spreads widened significantly.

Despite the recent positive developments, merger activity remains low (nearly 1 standard deviation below its long-term average). Regulatory uncertainty remains high, the macroeconomic outlook is uncertain and potentially structural changes in interest rates and financing conditions are keeping companies from pursuing new transactions.

The risk-return opportunity for the merger arbitrage factor remains attractive nonetheless. Merger spreads have tightened from the last quarter but are still above historical averages, and the proportion of friendly deals (which are more likely to close than hostile deals) remains high.

Macro factors: Carry steered through a volatile quarter, while market reversals upended momentum

Macro carry factors continued a recent run of strong performance in an improved carry spread environment, something we discussed in our last two quarterly reports. The performance was notable considering the volatility in the fixed income market as yields shot higher during the summer.

Currency carry was the top-performing factor for a second consecutive quarter. Gains were balanced across developed and emerging markets. The surprising resilience of the U.S. economy helped the currency carry factor, as participants in the G10 FX market took long positions in USD. High carry emerging markets (e.g., the Mexican peso) held up better than low-carry markets (e.g., the Hungarian forint).

Commodity carry also performed well, supported by positioning across energy and soft commodity markets. Long positions gained with rallies in the prices of crude oil, lean hogs and soybeans. Short positions benefited from price declines in natural gas and wheat. Fixed income carry performance was close to neutral, despite the elevated fixed income market volatility, as both longs and shorts navigated rising yields globally.

Macro momentum factors, on the other hand, gave back last quarter’s gains on reversals in the FX, equity and commodity markets. The equity trend factor also flipped over the quarter when signals across equity indices changed from generally bullish to generally bearish.

We continue to see potential for the carry factor to continue its strong performance, given attractive spread levels. Real yield differentials remain greater than 200bps across countries, elevated relative to history, though slightly lower than last quarter.

Commodity carry spreads are also attractive on a long-term basis, ranking in the 82nd percentile of our data going back to 1990. Currency carry spreads remain neutral relative to their long-term history but are nearing 400bps for the first time since the 2008 global financial crisis, making them attractive compared to the past 15 years. However, regime changes can be challenging for the carry factor: it tends to benefit when prices are stable and carry is earned over time. Our outlook remains positive, though slightly tempered from prior quarters.

The outlook for macro momentum is mixed. Higher-for-longer interest rates may prove beneficial, as we are now positioned short equities, short fixed income and mixed across commodity markets—although markets may whipsaw as the macro landscape continues to evolve. In addition, dispersion decreased within FX markets but increased within commodity markets during the quarter.

Concluding remarks

We continue to see generally attractive prospects for a range of factors: equity value, equity quality in the U.S. market and credit value. We also maintain our positive outlook on merger arbitrage and macro carry. In an environment of continuing macro and market uncertainty that may challenge traditional asset classes, we believe that factors can play an important complementary role in portfolio construction.

¹ The worst quartile of value and quality stocks (i.e., most expensive and lowest quality) were each down more than 11% in August through September, highlighting investors’ preference for reducing exposure to these pockets of the market amid a more challenging macro and market backdrop.

² Assessing which stocks are expensive vs. inexpensive within a given sector and constructing the factor without any sector biases.

³ This underperformance within the U.S. mid to large cap universe does not result from a binary view, or positioning across mega cap technology stocks at large, although a few notable companies currently rank in the most expensive quartile (e.g., Apple, Amazon, NVIDIA and Tesla).

⁴ Our profitability metrics (cash flow return on investment [CFROI] and free cash flow to sales) and our financial risk metrics (free cash flow to current liabilities and cash flow to debt) outperformed other quality metrics.

⁵ According to our records dating back to 1990. Factor correlations remain extremely elevated and are in the 100th percentile of our records dating back to 1990—which has implications for the diversification benefits available within multi-factor investing strategies.

⁶ In a late-cycle environment, the quality factor typically becomes as much as 1 standard deviation rich.

Glossary

• Credit value: Long/short U.S. high yield corporate bonds based on default-adjusted spread and spread to long-term sustainable debt ratio; sector and market neutral
• Credit quality: Long/short U.S. high yield corporate bonds based on profitability, coverage ratios and market leverage; sector and market neutral
• Credit momentum: Long/short U.S. high yield corporate bonds based on equity and bond price changes; sector and market neutral
• 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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