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

Factor performance was negative, on balance, as risk assets rallied to close an exceptionally strong 2019.

Equity factors experienced a choppy end to the year, as technical moves were once again disruptive.

Event-driven factors were mixed, with merger arbitrage continuing to generate strong returns while the share buybacks factor fell for a third consecutive quarter.

Macro factors gave back a portion of year-to-date gains amid reversals across FX and commodity markets.

We believe in diversifying across a broad range of compensated factors while minimizing exposure to uncompensated risks, although we find the opportunity set particularly compelling for equity and event-driven factors.


Overview

Risk assets powered through a fourth-quarter rally, extending already strong year-to-date gains as economic data showed signs of bottoming, geopolitical uncertainty eased and global central banks continued to act dovishly. U.S. equities hit all-time highs, credit spreads continued to grind tighter, emerging markets outperformed developed markets and commodity prices reflated. The factors that we favor generally struggled to keep pace with traditional asset classes, lagging over both the quarter and a year in which a traditional 60/40 portfolio-despite lackluster economic growth-cleared 20% in total returns for the first time since 2009. While almost all traditional asset classes moved up in 2019, for the second consecutive calendar year fewer than 40% of our primary factors delivered positive performance. That’s well below a long-term average of 60%-70% of factors delivering positive performance. In addition, volatility for both equity and macro factors was elevated in 2019 (74th percentile) as a number of reversals and technical unwinds went against factor positioning.

Factor performance was broadly negative in Q4, despite a rally across risk assets

EXHIBIT 1: QUANTITATIVE BETA SOLUTIONS LONG/SHORT FACTOR RETURNS

Source: J.P. Morgan Asset Management; data as of December 31, 2019. 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. 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.

Factors in focus

Equity factors: A choppy close to the year

The equity momentum and quality factors both underperformed in the fourth quarter as sentiment shifted away from defensive/low volatility names that had been in favor earlier in the year and toward those that are cyclical/low quality. Value showed signs of life, particularly in the U.S. but ultimately finished the quarter flat and has yet to emerge from the sharp drawdown that began at the start of 2017. Size performed better than it has recently but similarly remained in negative territory on a year-to-date basis, struggling in a market environment that rewards concentration.

Looking forward, we still have strong conviction in our bullish out-look for the value factor. As we have highlighted since 3Q 2018, the factor remains cheap from a historical perspective (EXHIBIT 2).We acknowledge that valuations alone are not sufficient to catalyze performance, but we believe there will be a positive turn for value. While the factor has experienced its second-worst drawdowns in 30 years, exceeded only by the dot-com bubble, its underperformance has been driven primarily by multiple expansion and investor exuberance for growth companies; that enthusiasm is not fundamentally justified. In fact, expensive/growth companies carry an average forward P/E ratio that is 27% above their long-term average, while value stocks trade at a 14% discount to history. In addition, while expensive/growth companies typically exhibit higher net income growth than value companies, this gap has actually narrowed over the past few years-which, if anything, would support outperformance of the value factor (EXHIBIT 3). Further, we have observed that expensive/growth companies are currently prone to cash flow shocks (particularly across small cap names) and that value companies may be more defensively positioned for the next turn in the economic cycle. For example, less than 1% of value companies currently exhibit negative interest coverage ratios, compared with more than 12% of expensive/growth companies (EXHIBIT 4). It is hard to say exactly when a shock may hit credit markets and so- called zombie companies, but we remain confident that fundamentals will eventually matter and the value factor will rebound.

Interesting dynamics are at play for the quality factor. The difference in fundamentals (e.g., profitability or financial leverage) between high quality and low quality companies has widened; however, the difference in valuations remains moderate-suggesting that markets are not fully pricing in higher quality companies’ better fundamentals. Dating back to January 1990, the only other time the relationship between fundamentals and pricing was this extreme was in July 1999, when quality rallied 13% over the subsequent 12 months and 68% (cumulative) over the subsequent three years. (Value also performed well during this period.)

Value and momentum experienced sharp reversals

EXHIBIT 2: U.S. VALUE VS. U.S. MOMENTUM

Source: FactSet, J.P. Morgan Asset Management; data as of December 31, 2019.

EXHIBIT 3: THE DIFFERENTIAL IN NET INCOME GROWTH BETWEEN VALUE AND EXPENSIVE/GROWTH COMPANIES HAS ACTUALLY BEEN NARROWING

Source: FactSet, J.P. Morgan Asset Management; data as of September 30, 2019.

EXHIBIT 4: DISTRIBUTION OF INTEREST COVERAGE RATIOS BY VALUE SCORE HIGHLIGHTS DEFENSIVE NATURE OF VALUE

Source: J.P. Morgan Asset Management; data as of September 30, 2019.

Event-driven factors led by merger arbitrage

The merger arbitrage factor continued to earn a healthy carry, delivering positive performance for a seventh consecutive quarter and closing out the year with gains of over 4% (the strongest calendar-year returns since 2016). The share buybacks factor, on the other hand, was negative for a third consecutive quarter as it continued to suffer broad-based losses.1

We maintain a positive outlook for event-driven factors. Merger arbitrage spreads2 remain healthy, particularly in the context of a high proportion of deals characterized as friendly in nature, with such deals offering higher odds of completion than unfriendly deals and thus better prospects of earning investor returns. In addition, corporate activity levels rose over the quarter, expanding the opportunity set to access event-driven factors while remaining diversified.

Macro factors suffer from FX and commodity reversals

Carry and momentum factors were both negative in the fourth quarter, with losses primarily driven by reversals across FX and commodity markets. Short positioning in pound sterling detracted early in the quarter as the currency bounced back from midyear lows as markets priced in a win for Boris Johnson and his Conservative Party. In addition, short positioning in the Norwegian krone and Australian dollar detracted in December as both currencies followed the broad reflation trade across markets. A range of commodity positions detracted over the quarter (e.g., long nickel and zinc in November and short soy- beans and coffee in December) as factors were generally caught off guard by shifting supply-and-demand dynamics.

While carry has enjoyed a strong run over the past year (4Q 2019 notwithstanding), spreads are now below long-term aver- ages, particularly across G10 government bonds. This suggests a diminished potential to capture carry in those markets going forward. Among momentum factors, dispersion in price moves was average across currencies and below average across commodities. The number of significantly trending levels remains high, with equity markets trending positively across the globe while commodity markets are trending in a negative direction.

Concluding remarks

Although factors struggled to keep pace with risk assets in the fourth quarter, the opportunity set is more attractive than it has been since we began sharing our Factor Views, toward the end of 2017. The potential looks particularly strong across equity and event-driven factors; however, 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 Solutions 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 Over the course of 2019, the top 10 detractors for the share buybacks factor spanned seven different sectors.

2 The difference between the target company 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




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Yazann Romahi

 








Chief Investment Officer, Quantitative Beta Strategies




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