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. The factor is currently mired in its second-worst drawdown dating back to 1990.

Merger arbitrage delivered gains; however, our suite of event-driven factors was negative on losses from spinoff and share repurchase factors.

Macro factors broadly declined on global divergences and trade war tensions.

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 negative in a quarter marked by global divergences and episodic trade tensions (EXHIBIT 1). The U.S. market continued to experience a late-cycle melt-up, as strong economic growth and robust earnings data drove large cap equities to their best quarter since 2013. The U.S. dollar strengthened, consumer confidence reached its highest level since 2000, and wage growth surprised on the upside, leading the market to price in the possibility of a more hawkish Federal Reserve (Fed). On the other hand, international and emerging markets bore the brunt of generally worsening economic fundamentals, political uncertainty and trade tensions that afflicted certain end markets. Emerging market (EM) currencies in particular suffered; the declines were led by the Turkish lira, which experienced a sharp fall in August, with the sell-off spreading across countries with large current account deficits and high external debt. The rising U.S. dollar and concerns about international trade also impacted a range of commodity markets. Against this backdrop, equity value extended its drawdown, while macro factors generally underperformed.

Factors were generally negative in a quarter marked by global divergences and episodic trade tensions

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

Source: J.P. Morgan Asset Management; data as of September 30, 2018. 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 sell-off in value

The value factor was down for a seventh consecutive quarter, with losses of over 16% in a drawdown that began at the start of 2017 (EXHIBIT 2). While momentum was positive, the magnitude of gains was once again less than that of the losses for value. This is a historical anomaly: When value has suffered drawdowns greater than 10%, momentum has been up over 30%, on aver¬age. Since the beginning of 2017, however, momentum was only up about 7%. Elsewhere, quality was flat, with gains coming from our minimum volatility descriptor in particular, while the size factor reversed and sold off sharply in September.

The value factor extended its drawdown

EXHIBIT 2: VALUE FACTOR DRAWDOWN (GLOBAL)

Source: J.P. Morgan Asset Management; data as of September 30, 2018.

The opportunity set for the value factor continues to improve (EXHIBIT 3). While value stocks are by definition cheaper than their counterparts, the gap in valuation is elevated (89th percentile) relative to history dating back to 1990, which should point to above-average returns going forward. On average, the value factor has returned around 5% on an annualized basis (net of assumed transaction costs). Historically, when the factor has been this cheap it has delivered average returns of 12% over the next 12 months and been positive more than 70% 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.

The opportunity set for the value factor continues to expand

EXHIBIT 3: VALUE FACTOR VALUATION SPREAD (GLOBAL)

Source: J.P. Morgan Asset Management; data as of September 30, 2018.

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.

While the timing of a value rebound cannot be known, a deeper examination of the characteristics of cheap vs. expensive stocks is telling. Within the top quartile of value stocks (the cheapest names in the universe), 30% of the companies rank high in quality while 20% rank low in quality. Within the bottom quartile of value stocks (the most expensive stocks in the universe), on the other hand, 35% of the companies rank low in quality vs. 23% that rank high. In other words, the value factor is currently biased toward higher quality companies, while expensive/growth stocks are biased toward the lowest quality names (EXHIBIT 4). In recent quarters, investors have rewarded companies that have borrowed to fuel growth, but that trend is likely unsustainable-particularly if borrowing costs continue to rise and debt has to be rolled over at higher rates. Higher rates may also spark a re-pricing of value stocks from another perspective, as higher discount rates lower the valuation of future earnings growth, a significant driver of the value of growth stocks. While nominal interest rates have begun to rise, borrowing costs and discount rates applied to fundamental valuation models take both credit spreads and nominal rates into account, and credit spreads remain low relative to their history. Should markets continue to progress from late cycle into end cycle, we may see rising credit spreads serve as a catalyst for the value factor.

The value factor is currently biased toward higher quality companies, while expensive/growth stocks are biased toward the lowest quality names

EXHIBIT 4: VALUE AND QUALITY FACTOR OVERLAP

Source: J.P. Morgan Asset Management; data as of September 30, 2018.

Mixed performance across event-driven factors

The merger arbitrage factor continued to climb higher and was positive in each month over the quarter as sentiment remained strong in the M&A space. In addition, the merger arbitrage factor benefited from the auction of Sky News, the culmination of a bidding war between Comcast and 21st Century Fox that had been brewing since the end of 2016. Elsewhere, our expanded suite of event-driven factors was negative, reversing gains from earlier in the year as both the spinoff and share repurchase factors declined.

We see a positive outlook for event-driven factors. Corporate activity levels for non-merger arbitrage factors have improved, and we continue to expect an increase in activity on the back of corporate tax changes in the U.S. Further, merger spreads1 are healthy and more than 90% of deals are friendly, supporting the prospects for performance going forward.

The value factor is currently biased toward higher quality companies, while expensive/growth stocks are biased toward the lowest quality names

A challenging quarter for macro factors

Last quarter, we discussed how divergences in economic growth and central bank policy across the globe have led to a difficult environment for macro factors. That environment has persisted; indeed, it has been exacerbated by trade war tensions and episodic political uncertainty. Both carry and momentum factors declined this quarter, with carry suffering in particular across currency and commodity markets. FX EM carry was negatively impacted by sell-offs across a range of currencies, including the Turkish lira, the South African rand and the Brazilian real, while commodity carry was hit by a fall in lean hog prices after China imposed tariffs on U.S. pork sales.

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 premiums across government bonds. Although this suggests a diminished potential to capture carry in those markets, rate normalization could improve the opportunity set. Regarding momentum factors, dispersion in price moves across currencies and commodities was below average, while the number of significantly trending levels fell slightly as positioning flattened out in fixed income and equity markets and moved negative across commodity markets.

CONCLUDING REMARKS

Overall, a number of factors suffered during the third quarter. That said, 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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