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 value continued to sell off and is currently mired in its second worst drawdown since 1990.

Merger arbitrage fully recovered losses experienced in February and March, while our expanded suite of event-driven factors was led by strong performance of the share buyback factor.

Macro momentum factors once again suffered from market reversals; however, carry factors were mixed with gains in FX G10 and commodity markets and losses in fixed income markets.

We believe in diversifying across a broad range of compensated factors while minimizing exposure to uncompensated risks, especially as we move through the latter part of the economic cycle.


OVERVIEW

The factors that we favor were generally mixed in a quarter in which equity markets recovered and volatility subsided—despite a more hawkish Federal Reserve (Fed), escalating trade tensions and a rise in geopolitical risk. While event-driven factors recovered losses experienced earlier in the year, the equity value factor extended its drawdown and equity momentum reversed recent gains, selling off sharply in June (Exhibit 1). On the macroeconomic front, economic growth diverged as U.S. fundamentals remained strong while economic data in Europe, Japan, China and emerging markets broadly disappointed. Against this backdrop, the U.S. dollar rose nearly 5% and certain emerging market currencies plummeted. While our macro factors were largely resilient, the quarter reminded us of the importance of diversification and the need to take ancillary risks into consideration.

Factors were generally positive, though equity momentum joined equity value in negative territory

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

Equity factors: Continued headwinds for the value factor

Since the beginning of 2017, the value factor has posted losses of nearly 15%; 2Q was the second worst quarter since 1990, and the factor is now mired in the second worst drawdown since 1990 (eclipsed only by the dot-com bubble, Exhibit 2). While the sell-off may feel like a strictly U.S. or technology sector event, the factor has suffered across regions and sectors. Indeed, the current drawdown is worse in Europe (-20%) and Japan (-21%) than it is in the U.S. (-17%). In our view, this underscores that we are experiencing a natural sell-off of a factor whose performance is always cyclical. Elsewhere, the size factor continued to rebound and is now positive for the year, though it is worth noting that gains are concentrated in the U.S. and that the performance of other factors has recently been worse in smaller cap stocks than large cap names. Quality was flat to positive over the quarter, driven by gains from earnings quality-related measures of the factor, while momentum experienced a sharp reversal in June.

The value factor has suffered its second worst drawdown since 1990

EXHIBIT 2: VALUE FACTOR DRAWDOWN (GLOBAL)

Source: J.P. Morgan Asset Management.

The opportunity set for the value factor continued to improve alongside the sell-off, as is typically the case for a mean-reverting factor such as value (Exhibit 3). While value stocks are by definition cheaper than their more expensive counterparts, the gap in valuation is elevated relative to history (79th percentile dating back to 1990), which should point to above-average returns going forward. Historically, when the factor has been this cheap it has delivered average returns of 12% over the next 12 months and been positive 75% of the time. Further, gains in the value factor have tended to occur in batches—in fact, the top 20 months of performance account for 76% of the value factor’s gains since 1990. Given the above-average opportunity set and the potential for disappointing earnings from growth companies (bottom-up Q2 2018 EPS estimates for the S&P 500 rose by the second largest amount since Q2 2010 and currently stand at 20.0%), prospects for the value factor look particularly attractive at this point. Continued increases in interest rates may also serve as a catalyst for the value factor, particularly if growth companies begin to have difficulty rolling over debt or investors alter discount rate assumptions.

The opportunity set for the value factor continues to increase

EXHIBIT 3: VALUE 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 value factor.

Strong performance across event-driven factors

The merger arbitrage factor rebounded strongly over the quarter and more than recouped losses experienced earlier in the year. A few prominent, and at times challenged, merger deals closed over the quarter after winning regulatory approval (for example, Bayer-Monsanto and AT&T-Time Warner), boosting sentiment across the M&A space and leading to a recycling of investor capital into remaining outstanding deals. In addition, bidding wars in the media space further improved returns for the merger arbitrage factor. Elsewhere, our expanded suite of event-driven factors was positive for a second consecutive quarter, again led by the share repurchases factor, which has benefited from the enactment of tax reform last year.

Corporate activity levels remain broadly below their long-term average; however, this year we have seen an increase for certain non-merger arbitrage factors (share repurchases and spin-offs), and we continue to expect an increase in activity on the back of corporate tax changes in the U.S. (particularly around repatriation of overseas cash). In addition, recent regulatory approval of challenged merger deals may create the potential for a rise in M&A activity. Merger spreads1 have tightened but remain attractive, and more than 90% of deals are friendly, supporting the prospects for performance going forward.

Mixed performance across macro factors

Given divergences in economic growth around the globe, the transition away from accommodative policy has occurred at differing paces across central banks, leading to a difficult environment for momentum factors. FX momentum has been hurt by long positioning in the British pound (reflecting dovish commentary from the Bank of England) and the Norwegian krone (subdued inflation), while time-series momentum has been affected by whipsawing fixed income markets. Carry factors, on the other hand, experienced mixed performance, with gains in FX G10 and commodity markets and losses in fixed income markets.

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. Although this suggests diminished prospects to capture carry in those markets, rate normalization could improve the opportunity set. Additionally, the difference in roll yield between high-carry and low-carry commodities is above average. Regarding momentum factors, dispersion in price moves across currencies and commodities is below average. However, the number of significantly trending markets stayed at healthy levels, with positioning generally long across equity markets and short across fixed income markets.

CONCLUDING REMARKS

Overall, a number of factors recovered during the second quarter as volatility by and large subsided. We see potential catalysts in place across the equity, event-driven and macro spaces. As always, we believe in diversifying across a broad range of compensated factors while minimizing exposure to uncompensated risks.

FACTOR OPPORTUNITY SET

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.

FACTOR VIEWS

Source: J.P. Morgan Asset Management; for illustrative purposes only.
*Other: Conglomerate discount arbitrage, share repurchases, equity index arbitrage, post-reorganization equities and activism.
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 on a market, region and sector-neutral basis. For event-driven factors, we measure implied carry and the level of corporate activity as indicative of the ability to minimize 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.




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

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




Important Disclaimer

The views contained herein are not to be taken as an advice or a recommendation to buy or sell any investment in any jurisdiction, nor is it a commitment from J.P. Morgan Asset Management or any of its subsidiaries to participate in any of the transactions mentioned herein. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own professional advisers, if any investment mentioned herein is believed to be suitable to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yield may not be a reliable guide to future performance.
Copyright 2018 JPMorgan Chase & Co. All rights reserved.

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Yazann Romahi

 








Chief Investment Officer, Quantitative Beta Strategies




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