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.
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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.
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