Overview

The second quarter confounded many market participants. Fears of a banking crisis, a debt ceiling crisis and an imminent recession abated as economic growth remained resilient and risk assets thrived. In March, amid several high profile bank failures, markets priced in multiple Federal Reserve (Fed) policy rate cuts, but investors now expect additional rate hikes by year-end. A constant through the quarter: equity market gains. Global stocks jumped 6.2% in Q2 and are up 13.9% year-to-date and 25.7% from mid-October lows. What had been a bear market is now apparently a bull market.

Factors generally performed well over the quarter (Exhibit 1), despite some twists and turns. They were led by strength in macro factors and macro carry in particular, which mitigated the effects of a choppy quarter for equity factors in the U.S.

Factors rose in aggregate over the quarter, led by strength in macro carry

Looking ahead, we see greater two-way risks around macroeconomic outcomes, which may set a difficult course for investors looking to take directional market views. However, we see considerable potential for relative value opportunities within asset classes – e.g., at the factor level – and retain a positive outlook across the majority of our favored factors over the medium to long term.

Factors in focus

Equity factors: A choppy quarter ends with a gain

Following a challenging start to the year, equity factors finished the second quarter in positive territory in aggregate. It was a choppy quarter, however, marked by disparate performance from region to region, factor to factor and month to month. Equity markets sought to navigate an uncertain economic environment. Markets were led by a handful of U.S. mega cap names that have benefited from widespread enthusiasm about the potential for artificial intelligence (AI), resulting in an exceptionally narrow market for much of the quarter before other stocks rallied in June.

Factor performance was generally stronger internationally than in the U.S., and toward the end of the quarter vs. the beginning. Regional differences were strongest for the value factor (May was an especially challenging month in U.S. markets). Those differences led to a quarter that was negative for U.S. value but positive for EAFE value and emerging market (EM) value (Exhibit 2A).

Recently value has performed better in ex-U.S. markets relative to the U.S.

Regional divergence for the value factor is a recent development. From the end of 2019 to early in 2Q 2023, value performed similarly across developed markets. But in the past few months, value has begun to struggle in the U.S. and in U.S. large cap stocks in particular (Exhibit 2B).¹

The underperformance of value in the U.S. and the outperformance of U.S. large cap stocks reflect general excitement about the growth prospects for artificial intelligence and the broader technology ecosystem but begs the question of whether the excitement is speculative or justified by fundamentals. It’s too soon to say. But in our view, current valuations appear supportive of the value and quality factors, particularly in the U.S., where both factors appear inexpensive, albeit slightly less so than in prior quarters.²

In the U.S., value and quality look cheap on a relative rather than an absolute basis (Exhibit 3). In other words, when we rank stocks based on their valuation, the most expensive quartile of stocks trade nearly 75% more expensive than their long-term history (a current P/E of 47.3x vs. a long-term average of 27.1x), whereas the cheapest quartile of stocks is only 12% cheaper than their long-term history (a current P/E of 10.5x vs.12x).³

Expensive/growth and low quality names have become particularly expense vs. their long-term average

A similar relationship holds for the quality factor, with low quality stocks more expensive than high quality stocks are cheap. Given this backdrop and the potential for mean reversion of valuations, we see opportunity over the medium to long term in factor strategies that underweight or short expensive, low quality stocks and favor cheaper, high quality names. However, we acknowledge risk over the near term should market euphoria build.

Credit factors: A general tightening

Value reversed its negative Q1 performance in high yield markets, while quality and momentum were flat.

Credit markets generally tightened over the quarter, with U.S. high yield spreads decreasing from 455 basis points (bps) to 390bps and testing their prior 12-month lows. Most of the spread compression occurred in June after a rangebound start to the quarter.

Within high yield markets, credit value gained, reversing its negative performance amid March’s market turbulence. Elsewhere, credit quality performance was flat in Q2 after four consecutive strong quarters. Credit momentum was also flat following a strong Q1.

Interestingly, credit value continues to push higher in the investment grade market as well, and in the banking sector in particular, where momentum and quality have also performed well. This year’s strong performance was first seen in March 2023 (Exhibit 4), when volatility in the banking sector and dispersion across issuers provided a strong opportunity for credit factors, and through the second quarter.

In the IG banking sector, March volatility set the stage for strong performance

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

Merger arbitrage: Flat through a period of regulatory uncertainty

The merger arbitrage factor was flat for a second consecutive quarter, selling off sharply in May before recovering in June. Indeed, May losses were the worst seen since the outbreak of COVID-19 and one of the worst ever outside of recessionary periods. Investors reacted aversely to the Federal Trade Commission’s lawsuit to block Amgen’s takeover of Horizon Therapeutics – the latest forceful move by FTC chief Lina Khan. That said, with high spread levels come the potential for high returns, and performance was quite strong in June.

Once again, merger activity remains below its long-term average (at the end of Q2 by roughly 1 standard deviation). Uncertainty about the regulatory and macro environments, coupled with structural changes in interest rates and financing conditions, is keeping companies from pursuing new transactions. Spread levels, however, remain attractive, now up to the 94th percentile relative to their longer-term history. Higher nominal rates and the broader market uncertainty likely account for some of the spread moves.

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

Macro carry factors in aggregate enjoyed their second strongest quarter in the post-GFC era, taking advantage of the improved carry spread environment that we discussed last quarter. Gains were widespread across currency, commodity and fixed income markets. Currency carry ranked as the top performer amid strong results in emerging markets – and in particular Latin American currencies (e.g., Colombian peso, Brazilian real and Mexican peso), which outperformed lower carry peers. Macro momentum factors delivered positive performance following several difficult quarters. Strong gains from commodity momentum and trend factors offset weakness in currency momentum.

We expect the carry factor’s recent strong performance will likely continue, backed by spreads at attractive levels. On a long-term basis, spreads look high in fixed income markets, where real yield differentials, north of 200bps across countries, are over 1 standard deviation above their long-term average and in the 86th percentile of their long-term history.⁴ Commodity carry spreads are also attractive on a long-term basis, ranking in the 82nd percentile. And while currency carry spreads remain neutral relative to their long-term history, they are attractive on a post-GFC basis, with spreads nearing 400bps for the first time since 2008.

The backdrop for momentum factors has improved somewhat since last quarter, as dispersion has picked up within FX G10 and commodity markets – albeit not to significant levels relative to long-term history. Trend positioning is similar to where it was last quarter: long across equity markets in aggregate (with long positioning strongest in European, Japanese and U.S. large cap stocks), slightly short in fixed income markets (driven by shorts on U.S. Treasuries, German Bunds and UK Gilts) and neutral across commodities (longs on soft commodities offset by shorts across industrial metals, precious metals and energy commodities).

Concluding remarks

We continue to see generally attractive prospects for a wide range of factors: equity value, especially, across the globe; equity quality in the U.S. market; and credit quality. We also maintain our positive outlook on merger arbitrage and macro carry. Expecting continued uncertainty in the macro and market environments for traditional asset classes, we believe that factors can play an important complementary role in portfolio construction.

¹ The U.S. value factor is down 5.3% year-to-date when defined within an all-cap stock universe and down 7.8% amid a large/mid cap universe.

² The value factor is also cheap in international developed and emerging markets, but not to the extremes that it is within the U.S. The quality factor appears neutrally priced within international developed markets, and while it is cheap within emerging markets, it is similarly not as cheap as it is within the U.S.

³ The overall U.S. market appears slightly expensive, with a current P/E of 18.0x that is around 7% higher than the long-term average of 16.8x for this universe of stocks, dating back to 1995.

⁴ Yield curve spreads are more attractive than they have been for most of the past decade, although close to their long-term average. Attractiveness is driven solely by inversions on the “short leg” of a long/short trade in contrast to flat curves in markets that would compose the “long leg.”

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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