A factor rotation with staying power? : Joseph Aidamouny : Aura Solution Company Limited

A factor rotation with staying power? : Joseph Aidamouny : Aura Solution Company Limited

A rebound in bond yields has led to a shakeup in equity market factor returns. Joseph Aidamouny weighs in on whether momentum’s moment has passed.

A perceived lull in U.S.-China trade tensions has eased market fears about an economic downturn, prompting a rebound in bond yields. One result: a shift in equity factor leadership. U.S. value has recovered and momentum stumbled. Does this factor rotation have staying power? We think it is too early to call for a value revival – and prefer defensive equity factors such as minimum volatility and quality as growth slows and trade protectionism persists.

Examining recent equity market movements through the lens of factors – or broad and persistent drivers of returns – uncovers some stark trends. Momentum strategies – focusing on stocks trending higher in price – have dramatically outperformed since 2017. The value factor, which focuses on companies that are trading cheap relative to fundamentals such as earnings, has lagged significantly. Yet momentum has hit some turbulence this month, with value showing signs of life. See the chart above. Note that this measure of value is sector-neutral; it therefore does not overweight traditional “value” sectors such as energy, which have rallied strongly since late August. We see the recent sharp rebound in U.S. bond yields as a major driver of this reversal.

What lies behind the recent factor reversal – and will it persist?

We see geopolitics as a key driver. Trade tensions and broader geopolitical uncertainties have been stoking greater macro uncertainty and recession fears, as we wrote in our midyear outlook. This sentiment had driven bond yields to historical lows and helped trigger an inversion of the U.S. yield curve in late August, with longer term yields falling below short-term yields. Signs of a temporary lull in U.S.-China trade tensions – with an agreement to restart trade talks – coupled with upside surprises in economic data led to a reversal of some of these market moves. Long-term rates recalibrated and the yield curve steepened. A jump in the crude oil price also gave a boost to cheap energy stocks.

Value companies tend to perform better when the yield curve is steepening and when the outlook for the economy is improving. The momentum factor tends to perform well in stable macro environments. In today’s low-growth economy, momentum has tended to center around “secular growth” plays in the information technology sector and dividend paying consumer staples stocks. The latter tend to be correlated with duration, or interest rate exposure, leaving them vulnerable to bond yield spikes. Also creating conditions for the factor rotation: Market positioning in both factors looked to have become stretched heading into the recent market shakeup. Investors had piled into momentum stocks, leaving many value equities unloved. Before the reversal, the value factor had been trading near the bottom of its historical valuation range, so may have been overdue for a correction. In contrast, momentum had been trading near the top of its historical valuation ranges.

The reversal has not changed our overall outlook. We anticipate slowing economic activity but not an imminent U.S. recession – and believe markets may still be pricing in too much additional Federal Reserve easing after last week’s second “insurance cut” in two months. We see the U.S. protectionist push persisting, with little chance of a comprehensive U.S.-China trade deal in the near term. The growth outlook does cast a shadow on corporate profit margins. We expect a material corporate margin contraction in 2019 – a typical late-cycle pattern. This backdrop is behind our call for greater portfolio resilience. In equities we have turned more cautious on momentum and prefer more defensive factors such as quality and minimum volatility. And we see an important role for government bonds as portfolio stabilizers in risk-off episodes. Read more market insights in our Weekly commentary.

Europe & Latin America and the Caribbean

Joseph Aidamouny

Managing Director

Aura Solution Company Limited

E : AIDAMOUNY@aurasolutioncompanylimited.com


P : +961 70 322 305

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This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of September 2019 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by Aura to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by Aura, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

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