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.