The Style Cycle: Equity Factors and Macro Data Diverge

The divergence between recent bullish factor performance and weaker economic fundamentals should give investors pause.

The performance of equity factors such as value, quality and low risk tends to track the economic cycle, and their recent behavior has eased concerns among many investors that the economy is slowing. Yet we believe investors should be cautious.

The value factor, which historically tends to perform well in expansions, has outperformed the more defensive quality and low-risk factors so far this year, after having lagged those factors in the second half of 2018 as recession fears grew.

The sudden reversal in these factors was widely attributed to reasons including oversold conditions, optimism about trade talks between China and the U.S., and a dovish shift in Fed policymakers’ tone.

But the rebound in equity market sentiment indicated by the recent outperformance of the value factor doesn’t match current macroeconomic conditions.

Our December Cyclical Outlook, Synching Lower,” forecasts a synchronized global slowdown this year, and reliable indicators of the economic cycle, such as global purchasing managers’ indices, suggest that growth is decelerating. The IHS Markit Global Purchasing Managers Index stood at 50.6 in February, below the nine-month average of 51.9.

Furthermore, earnings growth estimates continue to be revised downward, on average and across sectors.

We think the divergence between recent bullish factor performance and weaker economic fundamentals should give investors pause and, at the very least, suggests that investors should aim for a factor mix that has the potential to perform well in all macroeconomic environments.

Constructing quality, low-risk and value portfolios

A quality portfolio holds long positions in stocks with high profitability, measured by return on equity (ROE), return on assets (ROA), gross margin, or stable earnings. It also takes short positions in stocks with low measures of profitability.

Quality portfolios are typically expected to do well when the economy is slowing and investors seek sources of what is believed to be dependable, stable returns amid increasing uncertainty. They are expected to do less well during expansions, as investors find cheaper, higher-operating-leverage investments to profit from during the upswing in cyclical growth.

Low-risk portfolios are also typically expected to perform well in periods of higher economic uncertainty. They are long stocks with lower market beta and volatility and short stocks with higher market beta and volatility.

Value stocks, conversely, tend to do poorly during slowdowns and are expected to outperform during periods of recovery and expansion. Their price-to-book ratio, Tobin’s Q, and other measures of market prices to asset values tend to favor firms with an element of distress risk that would make them vulnerable to worsening economic conditions.

Figure 1 shows the average annualized returns for the quality, low-risk and value equity factors during the economic expansion/recovery and slowdown phases from 1995 through February 2019. Note that the second half of 2018 appeared to conform to the pattern observed for slowdowns, while the returns in January and February 2019 seemed consistent with expansions and recoveries.

Investment implications

Ideally, we desire a factor mix that has the potential to perform well in all macroeconomic environments. This is a tall order, although a diversified portfolio of factors (like value, low risk and quality) can reduce the potential for capital losses.

In practice, we suggest a mix of factors that can perform well in the stage of the economic cycle that matches likely conditions.

In addition, investors should be prepared for mismatches between equity factors and economic indicators and be ready to test their thesis about the economy versus what the market is saying.

For detailed insights into our views across asset classes together with investment ideas, please read our 2019 Asset Allocation Outlook, “Late Cycle vs. End Cycle Investing.


The Author

Wesley Chan

Bill Smith

Portfolio Manager, Global Equities



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All investments contain risk and may lose value. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Factor investing is the process of constructing portfolios with exposure to factors that help explain the differences in returns between securities. Quality: Companies exhibiting "high quality" metrics such as high earnings, ROE, strong profitability, stable cash flows, tend to outperform lower quality stocks over time. Value: Tendency of cheap stocks to outperform expensive stocks over time. Low Risk: Captures excess returns to stocks with lower than average volatility, beta, or idiosyncratic risk. Derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice. Investors should consult their investment professional prior to making an investment decision.