Written by: Yazann Romahi and Garrett Norman
Most of the factors that we favor suffered in a quarter singed by a violent shift in volatility regimes. Despite still-healthy economic growth, equity markets moved rapidly from a rally that was deemed both “euphoric” and a “melt-up” straight into correction territory. The shift occurred amid inflation fears and a technical sell-off that saw the CBOE Volatility Index (VIX) experience its largest-ever single-day spike. Additionally, U.S. Treasury yields increased by more than 50 basis points (bps) intra-quarter, reflecting both concerns about inflation and hawkish Federal Reserve rhetoric. Late in the quarter, those gains were reversed. A broad range of factors sold off over this period, across both asset classes and styles, with diversification providing limited benefits (Exhibit 1). On closer examination, however, the decline across factors was asynchronous and behavior was markedly different from that in earlier periods of factor crowding, such as the Quant Crisis of 2007. (We explore this subject in our March 2018 white paper, “Far from the Madding Crowd: Factor Investing Through the Cycle”.)
Broader trends from 2017 echoed in the first quarter despite the significant rise in equity market volatility. The value factor, in the midst of its fourth worst drawdown since 1990, extended its losses to over 10% from the beginning of 2017. Last quarter we noted the recent short-term increase in linkage between rates markets and value, which reached extreme levels by the end of 2017 (92nd percentile). In Q1 this relationship reverted to normal levels as earnings growth accelerated across growth/expensive stocks on the back of U.S. tax reform. The size factor again detracted, though there were signs of a recovery in March, particularly in the U.S., where 2017 losses were centered. Momentum was positive, despite the backlash against the technology sector and a subset of mega cap tech names in particular, as was quality. (Note: Our momentum factor is constructed on a sector neutral basis.)
Size remains an attractive opportunity, with valuations for the smallest quartile of global developed stocks looking cheap relative to their larger cap counterparts vs. history dating back to 1990 (76th percentile). Quality continues to appear rich from a factor valuation perspective; however, we saw increased dispersion, or difference, in profitability ratios across stocks in our universe, which historically signals a greater opportunity set for the quality factor. While the value factor appears only slightly cheap, it is important to note that value has returned around 5% on an annualized basis (net of assumed transaction costs) dating back to 1990, so it may be poised for similar (or better) performance now that valuation metrics have returned to slightly better than neutral levels. Since the beginning of 2017, expensive stocks have increased in price by 28% (vs. 18% for cheap stocks), while forward P/E ratios have risen by only 4% (from 25.8 to 26.8) (Exhibit 2). While earnings growth has justified a portion of the outperformance of growth stocks, forward earnings estimates are elevated for growth stocks when compared with their historical average (Exhibit 3). Rising interest rates or disappointing earnings from growth companies could shift performance in favor of value over growth beyond historical averages.
It was a very rocky quarter for the merger arbitrage factor. Spreads 1 widened as volatility surged at the beginning of February. No sooner had the factor begun to recover mid-month than a negative idiosyncratic event occurred toward the end of February. Merger arbitrage spreads continued to widen in March as a wave of protectionist and antitrust fears negatively impacted five deals in particular. However, after a difficult January, our expanded suite of event-driven factors delivered gains in March and ended the quarter close to positive territory, making up for some of the losses from merger arbitrage. Share repurchases in particular performed well, even though this factor is known to have a modest correlation to the value factor.
Corporate activity levels remained below their long-term average, limiting the opportunity to gain exposure to event-driven factors without sacrificing diversification. We had expected to observe an increase in activity on the back of corporate tax changes in the U.S. (particularly around repatriation of overseas cash), and, indeed, we are beginning to see that theme play out with respect to share repurchases. Although merger arbitrage activity has been fairly quiet, spreads are now 30% above their recent averages (up from 9% to 12% on an annualized basis); in addition, more than 90% of deals are friendly, supporting the prospects for performance going forward.
A transition away from accommodative policy by central banks has led to losses across macro factors. Time-series momentum especially suffered, due to long positioning across equity markets heading into the spike in volatility in February and a shift from long to short positioning across fixed income markets just as the rise in rates reversed. Carry factors were slightly positive, with gains in FX markets offset by losses in fixed income and commodity markets.
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. Although this suggests a diminished opportunity to capture carry in those markets, rate normalization could improve the opportunity set. Additionally, the difference in roll yield between high carry and low carry commodities increased. Regarding momentum factors, dispersion in price moves across currencies and commodities worsened. However, the number of significantly trending markets stayed at healthy lev-els and we saw a shift in positioning, from long to short across fixed income markets through February and from long to short across equity markets by the end of March.
When all is said and done, a volatile quarter largely improved the opportunity set for factors, with potential catalysts in place across the equity, event-driven and macro spaces. 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.