Each quarter, our Global Equities' senior investors, led by Paul Quinsee, meet to discuss current trends, best opportunities, and key risks in global equity markets. Our 3Q 2017 Global Equity represent the output of this meeting.

IN BRIEF

• Equity factors generated mixed performance over the quarter, with the momentum factor continuing to perform well while value and size once again struggled.

• Merger arbitrage delivered steady returns, but our broader set of event-driven factors continued to suffer.

• Macro carry factors were mixed, with gains in commodity momentum offset by losses in FX carry.

• With opportunities present across a range of compensated factors, we believe in a diversified approach that minimizes exposure to uncompensated risks.


OVERVIEW

Themes established in 2017 across a wide range of markets and factors continued to resonate through the fourth quarter. Economic growth was strong and supportive of equity markets across the globe, a range of volatility measures reached all-time lows, and business and consumer sentiment remained elevated. Even so, inflation pressures continued to be muted and major central banks kept their policy projections relatively accommodative. After difficult and at times frantic negotiations, the U.S. Congress passed a tax overhaul in December that will, among other provisions, cut corporate tax rates from 35% to 21%. Still, analyst earnings estimates were largely unchanged and the U.S. dollar continued to decline.

Factor performance, though mixed, was directionally consistent with what was experienced earlier in the year (EXHIBIT 1). As 2018 gets underway, much has been made of the possibility of a “melt-up” across stock markets and risk assets. While economic growth is expected to stay above trend through the first half of the year and monetary policy is likely to remain accommodative, we see potential for shifting currents at the factor level and opportunities across a range of factors due to tentative signs of increasing equity factor dispersion, a pickup in corporate activity, and the pricing in of eventual interest rate normalization.

Performance across factors was generally consistent with themes experienced earlier in 2017

EXHIBIT 1: QUANTITATIVE BETA STRATEGIES FACTOR RETURNS (LONG/SHORT)

Source: J.P. Morgan Asset Management. Note: Factors presented are long/short in nature. Equity factors represented as 100% long notional exposure, macro factors as aggregation of 5% vol sub-components.

FACTORS IN FOCUS

An improving equity factor outlook

Despite a temporary setback in September, broader trends re-emerged across equity factors. Momentum continued to perform well in the fourth quarter while value and size once again suffered. Size was the worst performing factor over the quarter, experiencing its steepest losses in the U.S., despite the passage of tax reforms that are expected to benefit the small cap stocks that have faced higher effective corporate tax rates than their larger, multinational peers. Value remains in the midst of its fourth worst drawdown since 1990, though it did show signs of recovering with strong performance in December. As discussed in last quarter’s report, value generally trades independently of the economic cycle. However, the factor has shown an increasing linkage to rates markets in recent periods as historically low yields have led investors to favor future earnings over current cash flows. In fact, over the past two years correlations with the 10-year U.S. Treasury yield have reached extreme levels (92nd percentile). On the other hand, quality performed well in the fourth quarter and continues to be led by the factor’s low volatility sub-component.

Size remains an attractive opportunity, with valuations for the smallest quartile of global developed market stocks cheap relative to their larger-cap counterparts vs. history dating back to 1990 (71st percentile) and a potential catalyst in the form of analyst earnings revisions following U.S. tax reform. We focus this quarter, however, on the opportunity for the value factor. As measured by both factor valuation and factor dispersion, value cheapened in 2H 2017 and now appears fairly priced. These metrics, however, obscure two important points.

First, the value factor has returned around 5% on an annualized basis (net of assumed transaction costs) dating back to 1990, so it may be poised for similar performance now that valuation metrics have returned to neutral levels. Second, our definition of valuation incorporates forward earnings estimates, which are elevated for growth stocks. Rising interest rates or disappointing earnings from growth companies shift performance in favor of value over growth beyond historical averages.

Our measure of opportunity for the size factor remains elevated

EXHIBIT 2: SIZE FACTOR VALUATION SPREAD (GLOBAL)

Source: J.P. Morgan Asset Management. Note: Valuation spread is a z-score between the median P/E ratio of top quartile stocks and bottom quartile stocks as ranked by the size factor.

Event-driven factor challenges

Merger arbitrage continued to collect the premium implied by announced merger deals1. Our expanded suite of event-driven factors, however, detracted for a fifth consecutive quarter. Conglomerate discount arbitrage was the worst performing event-driven factor as multiple companies announced changes to announced spin-off plans. The factor is suffering its second worst drawdown since 1998. In a reversal from Q3, share repurchases were positive and began to retrace losses from earlier in the year.

Corporate activity levels remain below their long-term average, limiting the opportunity to gain exposure to event- driven factors without sacrificing diversification. There was, however, a pickup in activity in December (led by the share repurchase factor) and greater certainty on U.S. tax policy (particularly around repatriation of overseas cash) is expected to lead to a continued increase in activity. Merger arbitrage spreads remain healthy (8%–10% on an annualized basis), and over 90% of deals are friendly, supporting the prospects for performance.

Macro factors: Mixed performance

Carry factors detracted over the quarter, particularly in FX markets where investors suffered losses across both G10 and emerging markets (EM). Weakness in two commodity curren¬cies, which had benefited from the rise of oil earlier in the year (the Australian dollar and Canadian dollar) hurt long position¬ing in the FX G10 carry factor. Geopolitical tension and rising inflation (impacting the Turkish lira) and worsening govern-ment financials (affecting the South African rand) hurt long positioning in the FX EM carry factor.

Momentum factors delivered positive performance, particularly in commodity markets, where price dispersion across agricultural commodities benefited momentum positioning (long livestock, short grains and softs).

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. These trends signal a reduced potential to capture carry in those markets. Rate normalization, however, could bolster the opportunity set. Dispersion in price moves across currencies and commodities improved intra-quarter before falling back to low levels. At the same time the number of significantly trending markets increased quarter-over-quarter, particularly across equity and fixed income markets.

CONCLUDING REMARKS

While risk assets again posted strong gains, performance was mixed across factors. Looking ahead, we recognize the potential for positive catalysts across equity, event-driven, and macro factors. As always, we believe in diversifying across a broad range of compensated factors while minimizing exposure to uncompensated risks.

FACTOR VIEWS

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.

Our framework for evaluating factor outlooks is centered on the concepts of dispersion, valuation and the opportunity for diversification. For equity factors, we measure dispersion and valuation spreads between top-quartile and bottom-quartile stocks. For event-driven factors, we measure implied carry and the level of corporate activity as indicative of the ability to cap¬ture opportunities while minimizing idiosyncratic stock risk. For macro factors, we measure the dispersion or spread between top-ranked and bottom-ranked markets, as well as the number of significantly trending markets.

Source: J.P. Morgan Asset Management; for illustrative purposes only. *Other: Conglomerate discount arbitrage, share repurchases, equity index arbitrage, post-reorganization equities and activism.




1The difference between the target company’s stock price and the announced acquisition price.


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GLOSSARY

• Equity momentum: long/short global developed stocks, based on price change and earnings revisions; sector and region neutral

• Equity quality: long/short global developed stocks based on financial risk, profitability and earnings quality; sector and region neutral

• Equity size: long/short global developed stocks based on market capitalization; sector and region neutral

• Equity value: long /short global developed stocks based on book-to-price, earnings yield, dividend yield, cash flow yield; sector and region neutral

• Merger arb: long target company and short acquirer (when offer involves stock component) in announced merger deals across global developed markets

• Event-driven (other): conglomerate discount arbitrage, share repurchases, equity index arbitrage, post-reorganization equities and shareholder activism

• Macro carry: FX G10 carry, FX emerging market carry, fixed income term premium, fixed income real yield, commodity carry

• Macro momentum: FX cross-sectional momentum, commodity cross-sectional momentum and time series momentum across equity, fixed income and commodity markets




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Yazann Romahi

 








Chief Investment Officer, Quantitative Beta Strategies




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