Q1 2018 Factor Views
Written by: Yazann Romahi, Garrett Norman
Themes from the quarterly Quantitative Beta Research Summit
- Equity factors generated mixed performance over the quarter, with the momentum factor continuing to perform well while value and size once again struggled.
- Merger arbitrage delivered steady returns, but our broader set of event-driven factors continued to suffer.
- Macro carry factors were mixed, with gains in commodity momentum offset by losses in FX carry.
- With opportunities present across a range of compensated factors, we believe in a diversified approach that minimizes exposure to uncompensated risks.
Themes established in 2017 across a wide range of markets and factors continued to resonate through the fourth quarter. Economic growth was strong and supportive of equity markets across the globe, a range of volatility measures reached all-time lows, and business and consumer sentiment remained elevated. Even so, inflation pressures continued to be muted and major central banks kept their policy projections relatively accommodative. After difficult and at times frantic negotiations, the U.S. Congress passed a tax overhaul in December that will, among other provisions, cut corporate tax rates from 35% to 21%. Still, analyst earnings estimates were largely unchanged and the U.S. dollar continued to decline.
Factor performance, though mixed, was directionally consistent with what was experienced earlier in the year (EXHIBIT 1). As 2018 gets underway, much has been made of the possibility of a “melt-up” across stock markets and risk assets. While economic growth is expected to stay above trend through the first half of the year and monetary policy is likely to remain accommodative, we see potential for shifting currents at the factor level and opportunities across a range of factors due to tentative signs of increasing equity factor dispersion, a pickup in corporate activity, and the pricing in of eventual interest rate normalization.
Performance across factors was generally consistent with themes experienced earlier in 2017
EXHIBIT 1: QUANTITATIVE BETA STRATEGIES FACTOR RETURNS (LONG/SHORT)
Source: J.P. Morgan Asset Management.
Note: Factors presented are long/short in nature. Equity factors represented as 100% long notional exposure, macro factors as aggregation of 5% vol sub-components.
FACTORS IN FOCUS
An improving equity factor outlook
Despite a temporary setback in September, broader trends re-emerged across equity factors. Momentum continued to perform well in the fourth quarter while value and size once again suffered. Size was the worst performing factor over the quarter, experiencing its steepest losses in the U.S., despite the passage of tax reforms that are expected to benefit the small cap stocks that have faced higher effective corporate tax rates than their larger, multinational peers. Value remains in the midst of its fourth worst drawdown since 1990, though it did show signs of recovering with strong performance in December. As discussed in last quarter’s report, value generally trades independently of the economic cycle. However, the factor has shown an increasing linkage to rates markets in recent periods as historically low yields have led investors to favor future earnings over current cash flows. In fact, over the past two years correlations with the 10-year U.S. Treasury yield have reached extreme levels (92nd percentile). On the other hand, quality performed well in the fourth quarter and continues to be led by the factor’s low volatility sub-component.
Size remains an attractive opportunity, with valuations for the smallest quartile of global developed market stocks cheap relative to their larger-cap counterparts vs. history dating back to 1990 (71st percentile) and a potential catalyst in the form of analyst earnings revisions following U.S. tax reform. We focus this quarter, however, on the opportunity for the value factor. As measured by both factor valuation and factor dispersion, value cheapened in 2H 2017 and now appears fairly priced. These metrics, however, obscure two important points.
First, the value factor has returned around 5% on an annualized basis (net of assumed transaction costs) dating back to 1990, so it may be poised for similar performance now that valuation metrics have returned to neutral levels. Second, our definition of valuation incorporates forward earnings estimates, which are elevated for growth stocks. Rising interest rates or disappointing earnings from growth companies shift performance in favor of value over growth beyond historical averages.
Our measure of opportunity for the size factor remains elevated
EXHIBIT 2: SIZE FACTOR VALUATION SPREAD (GLOBAL)
Source: J.P. Morgan Asset Management. Note: Valuation spread is a z-score between the median P/E ratio of top quartile stocks and bottom quartile stocks as ranked by the value factor.
Event-driven factor challenge
Merger arbitrage continued to collect the premium implied by announced merger deals1. Our expanded suite of event-driven factors, however, detracted for a fifth consecutive quarter. Conglomerate discount arbitrage was the worst performing event-driven factor as multiple companies announced changes to announced spin-off plans. The factor is suffering its second worst drawdown since 1998. In a reversal from Q3, share repurchases were positive and began to retrace losses from earlier in the year.
Corporate activity levels remain below their long-term average, limiting the opportunity to gain exposure to event- driven factors without sacrificing diversification. There was, however, a pickup in activity in December (led by the share repurchase factor) and greater certainty on U.S. tax policy (particularly around repatriation of overseas cash) is expected to lead to a continued increase in activity. Merger arbitrage spreads remain healthy (8%–10% on an annualized basis), and over 90% of deals are friendly, supporting the prospects for performance.
Macro factors: Mixed performance
Carry factors detracted over the quarter, particularly in FX markets where investors suffered losses across both G10 and emerging markets (EM). Weakness in two commodity currencies, which had benefited from the rise of oil earlier in the year (the Australian dollar and Canadian dollar) hurt long positioning in the FX G10 carry factor. Geopolitical tension and rising inflation (impacting the Turkish lira) and worsening government financials (affecting the South African rand) hurt long positioning in the FX EM carry factor.
Momentum factors delivered positive performance, particularly in commodity markets, where price dispersion across agricultural commodities benefited momentum positioning (long livestock, short grains and softs).
The spread between high-yielding and low-yielding currencies remains below its long-term average (particularly for G10 currencies), as does the difference in term premium across government bonds. These trends signal a reduced potential to capture carry in those markets. Rate normalization, however, could bolster the opportunity set. Dispersion in price moves across currencies and commodities improved intra-quarter before falling back to low levels. At the same time the number of significantly trending markets increased quarter-over-quarter, particularly across equity and fixed income markets.
Related: Who Gets Sick When the U.S. Sneezes?
While risk assets again posted strong gains, performance was mixed across factors. Looking ahead, we recognize the potential for positive catalysts across equity, event-driven, and macro factors. As always, we believe in diversifying across a broad range of compensated factors while minimizing exposure to uncompensated risks.
The table below summarizes our outlook for each of the factors accessed by the Quantitative Beta Strategies platform. 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. For event-driven factors, we measure implied carry and the level of corporate activity as indicative of the ability to cap¬ture opportunities while minimizing 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.
Source: J.P. Morgan Asset Management; for illustrative purposes only. *Other: Conglomerate discount arbitrage, share repurchases, equity index arbitrage, post-reorganization equities and activism.
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1The difference between the target company’s stock price and the announced acquisition price.
The views contained herein are not to be taken as an advice or a recommendation to buy or sell any investment in any jurisdiction, nor is it a commitment from J.P. Morgan Asset Management or any of its subsidiaries to participate in any of the transactions mentioned herein. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own professional advisers, if any investment mentioned herein is believed to be suitable to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yield may not be a reliable guide to future performance.
This Is the Best We Can Get With a Booming Job Market? Something Just Isn’t Right
While big job gains are making all the headlines, we see credit card delinquencies at a level last seen in the depths of the Financial Crisis and retail sales contracting over the past three months. This is the best we can get with a booming job market? Something here just isn’t adding up.
The week started off strong out of the gate on Monday in the wake of Friday’s post-payroll rally, but the momentum quickly faded, leaving the S&P 500 down four consecutive days as of Thursday’s close. If it closes in the red again Friday, it will be the longest losing streak in over 16 months going back October 31st, 2016. We dug into the details of the recent data and in this week’s edition, we point out some things that are just not adding up.
Wednesday the Industrials sector fell below its 50-day moving average with Boeing (BA) leading the decline as the weakest performer in the Dow, also falling below its 50-day moving average. In the Materials sector Century Aluminum (CENX) fell below its 50-day moving average to lead metals lower. DowDupont (DWDP) also failed to rise above its 50-day moving average. Thursday the Dow Transports sector followed Industrials, falling below its 50-day moving average and finding resistance at its late February peak.
The strongest performing S&P 500 sector over the past five days has been Utilities, followed by Real Estate – not exactly typical bull market leaders. After having experienced one of the strongest starts to a year, the S&P 500 is up less than 3% from December’s close and ended Thursday below its 50-day moving average. Technology has been the only sector to reach a new record high, but its technical indicators are starting to weaken, so this one looks to be over-extended. By Thursday’s open the percent of stocks in the S&P 500 trading above their 50-day moving average was down to 43% with over 22% of stocks in oversold territory and 21% in overbought.
US 10-year Treasury yield broke above its 100-month moving average in November of last year for the first time since July 2007 and hasn’t looked back. That being said, while the yield for the 10-year recently peaked on February 21st at just shy of 3% and has fallen roughly 12 basis points since then, the S&P 500 hasn’t been able to make much progress.
Meanwhile, no one seems to be talking about how we are seeing flattening in the yield curve.
February Retail Sales were weaker than expected, declining for the third consecutive month, the longest such streak in three years. Then again, the month-over-month change in average hourly earnings for all employees has been either flat or negative in 6 of the past 7 months and in the fourth quarter of 2017, consumers racked up credit card debt at the fastest pace in 30 years - bad for consumer spending, but rather confirming for our Cash-strapped Consumer investing theme. Most concerning is that credit card delinquencies at smaller banks have reach levels not seen since the depths of the Great Recession.
Homebuilder sentiment, after reaching the highest level since 1999 this past December, has now declined for 3 consecutive months, but even so, it still remains at nearly the highest levels since the financial crisis. Meanwhile, the NAHB Housing Market Index has fallen 17% from the January 22nd high and its most recent report found a significant downturn in traffic, perhaps due to rising mortgage rates as the 30-year fixed rate has reached the highest level in over 4 years. Perhaps the weakness has something to do with the aforementioned lack of wage growth as the ratio of the average new home price to per capita income has again reached the prior peak of 7.5x – people just can’t afford it.
We’ve been warning of the dangers of exuberant expectations for a while here at Tematica. The General Business Conditions Average for manufacturing from the Philadelphia & New York Fed this week illustrated just why we have. The two saw a small uptick in March after having been weakening in recent months. However, the outlook portion, which had been looking better in the past is now showing some weakness. For example, CapEx expectations 6-months out fell in March from the highest levels on record in February. Expectations around Shipments also dropped, having been at the second-highest levels of the current expansion. After having reached extreme levels in November, New Order expectations also declined. When sentiment expectations reach new highs, tough to continue to rise significantly from there.
While Friday’s job report got the markets all excited, perhaps the reason that enthusiasm has cooled is folks are realizing that the 50k gain in retail jobs isn’t syncing up with the -4.4% SAAR decline in retail sales over the past three months. Then there is what we are hearing from the horses’ mouth. Walmart (WMT) and Target (TGT) both issued weak guidance, as did Kroger (KR) who also suffered from shrinking margins. A tight and tightening job market is unlikely to help with that. Costco (COST) missed on EPS, as did Dollar Tree Stores (DLTR), who also missed on EPS and gave weaker guidance. Big Lots (BIG) saw a decline in same-store sales. At the other end of the spectrum, the 70k gain in construction is in conflict with rising mortgage rates, traffic and declining pending home sales, while the 31k gain in manufacturing has to face a dollar that is no longer declining, high costs on tariff-related goods and potentially some sort of trade war.
As I mentioned above, while real retail sales fell -4.4% SAAR over the past three months, Core Consumer Prices rose 3.1% SAAR and Wednesday’s Producer Price Index (PPI) report from the Bureau of Labor Statistics also showed rising inflation pressures. Core PPI (yoy) has reached its highest levels since 2011 with the annualized 3-month trend having gone from 1.5% last summer, to 2.7% at the end of 2017 to 3.4% based on the latest data.
Import prices for February rose 0.4%, taking the year-over-year trend up to 3.5% from 3.4%. Recall that last summer this was around 1%. Ex-fuel the pace rose to 2.1% from 1.8% previously and 0.8% over the summer.
The bottom line this week is that we are no longer in the easy peasy 2017 world of hyper-low volatility and relentlessly rising indices with a VIX that has found a new normal more than 50% above last year’s average. The wind up is the major market indices haven’t been able to commit to a sustained direction. The hope and promises of 2017 have been priced in, leaving us with a, “So now what?” which is reflected in the Atlanta Fed’s GDPNow forecast falling from 5.4% on February 1st to a measly 1.8% on March 16th – talk about a serious fade.
What has us really concerned is that at a time when big job gains are making all the headlines we see credit card delinquencies at the level last seen in the depths of the Financial Crisis and retail sales contracting at a 4.4% annual rate over the past three months. This is the best we can get with a booming job market? Something here just isn’t right
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