By Waman Virgaonkar, Senior Associate, Core Equity Research, and Hitendra Varsani, Executive Director, Equity Core Research, MSCI.

Factors in focus: Will 2020 vision sharpen exposures?

As we begin 2020, there are a few things we can declare with certainty: It’s a leap year; it’s a Summer Olympics year; and the title of this blog will be neither the first nor the last “2020 vision” reference you’ll see.

On the other hand, the financial outlook for the year remained clouded by economic uncertainty, even before the recent flare-up with Iran.

In this edition of Factors in Focus, we reflect on the historical relationships between factor returns and macro cycles, which have provided useful information for investors looking to take an active stance on factor exposures based on their outlook. Before we do so, however, we highlight certain factor returns over the fourth quarter and full-year 2019.

Source: MSCI.

Most global equity markets posted strong performance over the fourth quarter of 2019. For example, the MSCI ACWI Index returned 9.1%, bringing the full-year return of the index to 27.3%.

Developed markets (DM) were positive for stocks with higher quality and value factors, while stocks with a high beta factor fared relatively better in the emerging markets. In the previous Factors in Focus, we highlighted how the valuation spread between momentum and value in DM was the highest since the tech bubble. In the fourth quarter, value outperformed momentum in most DM regions.

All-time highs masked much dispersion over 2019

Looking over the year as a whole, many global equity markets reached all-time highs and experienced limited bouts of volatility, but underneath the calm surface, we saw a high degree of dispersion among factors and sectors.

• During the “slowdown” phase (as measured by our composite macro indicators) from Q1 to Q3 2019, the quality and momentum factors outperformed similar to their historical patterns (see the exhibit below).
• At the end of August, the momentum factor had the highest valuations vs. the value factor since the tech bubble of the early 2000s.
• During the first two weeks of September — when some factors experienced sharp reversals — the value factor outperformed the momentum factor by nearly 7%.
• Information technology within the MSCI ACWI Index was the leading sector over 2019. Growth and quality factors were key drivers of IT-sector performance, while the underperforming energy sector had relatively low growth, momentum, and profitability factor characteristics.

Source: MSCI.

It’s clear from a 2019 full-year perspective that quality was the top factor, while value and low size factors were underappreciated. Quality’s advantage was largely driven by overweight exposure to technology-sector stocks — the best-performing sector in the MSCI ACWI Index — and an underweight to energy.

Source: MSCI.

Factor performance across economic cycles

Style factors have been key drivers of equity returns over the long run. However, factor premia have been time-varying and delivered their performance at different points in the macro cycle.

The exhibit below tabulates information ratios (IR) of the MSCI ACWI Factor Indexes over historical timeframes as well as macroeconomic cycles. As a proxy to measure macroeconomic cycles, the macro states reflect changes in and absolute levels of the US PMI, and we measure the subsequent performance of factors conditioned on the level of the indicator at the start of the holding period.

All MSCI ACWI Factor Indexes delivered positive IRs over the full analysis period of Dec. 31, 1998, to Dec. 31, 2019. Over shorter periods, however, distinct patterns emerge. During a “slowdown” phase, quality and momentum were lead performers, while size and value were laggards — consistent with the overall performance during 2019.

Source: MSCI.

Source: MSCI.

Looking at factor valuations using the MSCI Factor Indexes over the last 20 years, we found that the enhanced value factor had very low valuation, while the quality factor had the highest. The momentum factor, which we found was overvalued in the last Factors in Focus, has seemingly corrected since then (as shown by its z-score going down to 0.81 from 1.5).

Source: MSCI.

What about 2020? Will the value vs. momentum battle continue?

While we cannot predict what will happen in 2020, our research has shown factors have historically been sensitive to broad and changing market conditions, such as the macro environment, valuations, recent performance trends, and risk sentiment.

As of Dec. 31, 2019, our adaptive multi-factor model showed the following exposures across the four pillars:

• The macro cycle pillar indicated a mixed-signal between contraction and recovery and overweighted low volatility, quality, and value, based on the Chicago Fed National Activity Index, the Federal Reserve Bank of Philadelphia’s ADS Index, and the PMI.
• The valuation pillar overweighted value, low size, and yield, based on the valuation gap compared to an equal-weighted factor mix in the context of nearly 30 years of a factor’s history.
• The momentum pillar selected value, quality, and low size, based on the last three months’ relative performance.
• The market sentiment pillar showed a mild overweight to low size, momentum, and value, based on contained credit spreads and an upward-sloping Cboe Volatility Index (VIX) term structure at the time of reference.

Source: MSCI.

Overall, our adaptive multi-factor model observed an overweight to value, a mild overweight to low size, a mild underweight to momentum, low volatility, and yield, with quality being neutral relative to an equal-weighted mix. Despite quality having had high valuations, it was overweight from a macro and momentum perspective and resulted in an overall neutral exposure.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)