Written by: Yazann Romahi , CIO of Quantitative Beta Strategies, J.P. Morgan Asset Management
Themes from the quarterly Quantitative Beta Research Summit
Policy as well as economic and fundamental data impacted pricing last quarter, and many of the factors that we favor were challenged, though there were pockets of strength (EXHIBIT 1). For much of 2017, the reflation/Trump trade from 4Q 2016 unwound, with yields and inflation expectations falling, the U.S. dollar declining and cyclical sectors and stocks underperforming. (High-tax company stocks have underperformed low-tax company stocks in 2017, a reversal of 4Q 2016, suggesting that politics likely played at least some role in these market dynamics). Conditions began to change in September. The Federal Reserve (Fed) signaled that it would hike rates once more this year, and the Trump administration unveiled a tax overhaul. Markets priced in a 78% probability of a rate increase toward the end of September, up from 31%; yields and the U.S. dollar reversed course; and cyclical sectors and stocks began to once again outperform.
Performance was uneven across factors as conditions reversed late in the quarter
Note: Equity and event-driven factors represented as 100% long notional exposure, macro factors as aggregation of 5% volatility subcomponents.
Equity factors: Continued reversals
Factors reversed course late in the third quarter, and while the moves were not as pronounced as those experienced in 4Q 2016, they were directionally similar. Equity momentum gave back gains in September after leading performance for much of the quarter as price trends extended beyond a subset of the market and drove performance more broadly. Value continued to struggle across sectors and regions over much of the quarter before reversing course in the U.S. While value generally trades independently of the economic cycle, the factor has exhibited positive correlation to rates markets over the past two years, perhaps because the low interest rate environment has caused investors to focus on future growth more than on near-term earnings. Size was the strongest performing factor in September, particularly in the U.S., where lower corporate taxes would benefit domestically oriented small cap stocks. Quality, which has been flat for much of the past year, was modestly negative for the quarter.
The opportunity for the size factor remains attractive, with valuations for the smallest quartile of global developed stocks cheap relative to their larger cap counterparts vs. history dating back to 1990 (67th percentile) (EXHIBIT 2). Quality, on the other hand, appears rich (36th percentile). Value spreads are average, and any progress toward a congressional infrastructure package would likely boost cyclical value stocks. Additionally, a pickup in inflation expectations or disappointing earnings from growth companies could cause investors to refocus on earnings fundamentals, a shift that would favor value over growth.
So far this year, equity markets have been led by growth stocks, especially a small group of Internet companies with the market monikers BAT (Baidu, Alibaba and Tencent) and FANG (Facebook, Amazon, Netflix and Google). Some investors see a bubble forming here, drawing parallels with the extreme prices of many technology stocks in 1999. But on balance we are less concerned, given that these companies boast massive user bases, impressive growth rates and in many cases strong profitability as well. The recent rally has made them less attractive, but their valuations do not seem unreasonably high just yet. Potential regulation is the biggest risk.
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 size factor.
Event-driven factor challenge
Despite losses in August, merger arbitrage continued to collect the premium implied by announced merger deals. 1 Our expanded suite of event-driven factors, however, continued to suffer, primarily due to conglomerate discount arbitrage and share repurchases factors. Over the past year, the number of companies buying back a large proportion of their outstanding shares has dropped by 50% as low interest rates have led the market to reward companies spending capital over those repaying shareholders. As a result, investors who varied their allocation to the share repurchases factor based on the opportunity set would have experienced less of a drawdown than those who kept a constant exposure.
Corporate activity levels are below their long-term average, limiting the opportunity to gain exposure to event-driven factors without sacrificing diversification. However, greater certainty on U.S. tax policy (particularly around repatriation of overseas cash) or an easing of European macro and political uncertainty could increase the opportunity set. Merger arbitrage spreads remain healthy (8% to 10% on an annualized basis), and over 95% of deals are friendly, 2 supporting the prospects for performance going forward.
Macro factors: Mixed performance
Momentum factors were negative, with FX G10 momentum leading the way down and extending the past year’s losses. Unexpected monetary action was the primary culprit in the third quarter, as hawkish talk from the Norwegian central bank and the Bank of England hurt short positioning.
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, signaling a reduced opportunity to capture carry in those markets. Rate normalization, however, could improve the opportunity set. Dispersion in price moves across currencies and commodities improved, benefiting the prospects for the momentum factor.
Synchronized global economic growth continues to support equity markets, but uncertainty around the outcome of monetary and fiscal policy led to a mixed quarter across our range of factors. Especially in the current policy-driven environment, which presents several investment challenges, 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 capture 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.
1The difference between the target company’s stock price and the announced acquisition price.
2 On average, less than 10% of friendly deals fail, vs. over 50% for hostile deals
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