The coronavirus outbreak has altered market dynamics since late January – including in the space of equity style factors. One example, Quality has posted more muted gains after strong outperformance in late 2019. We stand by our tactical views on factors for now, including a modest overweight on quality. These are anchored by our expectation for a global growth uptick to resume once the outbreak recedes, although the depth and width of the eventual V-shaped recovery are uncertain.
The performance of equity style factors – broad, persistent drivers of return – has historically ebbed and flowed as the economy goes through different phases of a cycle. The quality factor (companies with sound balance sheets) has tended to do well during late-cycle periods – such as where we stand now. Living up to this expectation, quality posted outsized returns in the fourth quarter in risk-adjusted terms, outpacing other style factors. That outperformance has faded since the coronavirus outbreak – alongside improving performance of momentum (stocks with rising prices) and further weakness in value (cheap stocks relative to fundamentals). See the chart above. For now, we still see room for our factor views to play out over six to 12 months.
What could explain the shifting dynamics behind factor returns since the coronavirus outbreak? We had expected quality to perform well over our tactical horizon of six to 12 months, as the factor has tended to be resilient in late-cycle periods and includes global firms that stand to benefit from a pause in trade tensions. The spread of the virus – and the containment measures imposed by the Chinese authorities – have triggered global supply chain disruptions and a hit to global growth, making such global firms vulnerable. We still see the outbreak delaying – but not derailing – the global growth uptick that we have been expecting to take root in 2020. As a result, we still favor quality on a tactical basis.
Momentum’s outperformance in early 2020 has come as a surprise. We had expected a steepening of yield curves and overhang of growing regulatory risk in the tech sector to weigh on the factor – but coronavirus risks have caused investors to rotate back into these tried-and-true exposures. Momentum has a relatively high exposure to the information technology sector (21% of the MSCI World Momentum Index), which has been the leading global sector performer so far this year. Momentum is also populated with “bond proxies,” or dividend-paying companies in healthcare and consumer staples. Today’s historically low rates means that any small change in rates could have outsized repercussions for these stocks. Momentum has shown a meaningful negative correlation with the 10-year Treasury yield over the past year, our research shows. We see an eventual yield curve steepening and regulatory scrutiny around U.S. election as risks for the factor.
The negative correlation between momentum and value has strengthened in recent weeks. We maintain our neutral call on value as its pro-cyclical nature could benefit once the pickup in growth – and yield curve steepening – resume later this year as risks associated with the coronavirus ultimately recede. Declining global trade tensions, which also underpin our expectation for a stable dollar, are another potential support for value.
Risk assets have performed well since late 2019, thanks to a pause in trade tensions and improved global growth prospects. Yet uncertainties abound – from the impact of the coronavirus outbreak to the result of the U.S. election later this year. This reinforces our call for raising portfolio resilience. We maintain our moderate tactical overweight to quality, and are reviewing our overall risk orientation and tactical views in light of the coronavirus outbreak.