By Mark Barnes, PhD, and Christine Haggerty, Global Investment Research
While still a source of outperformance this year, the global rotation into Value struggled for traction in Q3, thwarted by a summer rally in long-time laggard Quality.
As highlighted in our latest Equity Factor Insights report, in most markets, Value performed modestly worse than the broad-market benchmarks in the global Q3 rout, while Quality did modestly better.
Regional Value returns relative to benchmarks (LC, rebased)
Source: FTSE Russell. Data as of September 30, 2022. Past performance is no guarantee to future results. Please see the end for important disclosures.
This performance was a striking about-face from the trends prevailing in the previous quarters, as illustrated below by the relative factor returns averaged across the six regions we analyzed. Despite recent setbacks, Value, Yield and Low Vol have retained their 12-month leadership.
Factor returns relative to benchmark (LC %) – Average across regions*
Source: FTSE Russell.*Combined average of factor performance across FTSE USA, FTSE UK, FTSE Europe ex UK, FTSE Japan, FTSE Developed Asia Pacific ex Japan and FTSE Emerging indexes. Data as of September 30, 20222. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
Interest rates drive the action
Both Value and Quality have been hostage to the extreme shifts in interest-rate expectations over the past several months.
Bond yields eased in the early months of the quarter amid investor hopes that rapidly deteriorating economic indicators would prompt an earlier end to central bank tightening policies. The pullback paved the way for a strong relief rally in growth stocks, which dominate the Quality factor.
But those hopes and the Quality rebound were soon quashed as central banks, led by the US Fed, remained steadfast in their anti-inflation efforts, fueling a renewed surge in bond yields and a brutal equity-market selloff in September. Nonetheless, Quality maintained a modest lead in most markets for the quarter as a whole.
US Treasury bond yields (%)
Source: FTSE Russell / Refinitiv. Data through September 30, 2022. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
The recent back-and-forth between Value and Quality reflects their compositional differences and the differing ways they typically respond to macroeconomic shifts.
Growth-dominant Quality typically suffers in rising-rate environments. That is because the factor’s main constituents tend to be valued largely on their earnings prospects far into the future. When rates rise, the present value of those future earnings declines.
By contrast, Value stocks are more weighted to Financials and to cyclically sensitive stocks valued on their more immediate earnings streams and, thus, tend to perform better than Quality in rising-rate environments, particularly those resulting from improving economic and profit outlooks.
But that is not what has been happening this year. The surge in bond yields this year has come largely in reaction to persistently high inflation and the increasingly aggressive central bank efforts to tame it. Increases in short-dated US Treasury bond yields have outpaced those of long-dated equivalents since June, causing the yield curve to become deeply inverted.
US Treasury yield spreads (%)
Source: FTSE Russell / Refinitiv. Data through September 30, 2022. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
Yield curve inversion – a game-changer for Value
The steady flattening of the US yield curve this year has been a headwind for Value, which has long been positively correlated to shifts in the slope of the US yield curve in most equity markets and has grown even more so recently. An inverted yield curve is a classic market signal of an impending recession and of deep investor pessimism − hardly a backdrop conducive to risk-taking in general and bargain-hunting in particular.
24-month correlations of Value returns to shifts in the slope of the US Treasury yield curve (10yr − 2yr)
Source: FTSE Russell / Refinitiv. Data through September 30, 2022. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
This analysis is particularly relevant to the performances of Financial stocks. Much of the perceived benefits of rising rates for these firms, particularly banks, assume a positive sloping yield curve, as these institutions borrow money at lower short-term rates and lend at higher long-term rates. But an inverted yield curve turns that profit equation on its head, diminishing the typically favorable impact of rising rates on Financial stock returns and, thus, on Value generally.
For more on global equity factor performance, see our October Equity Factor Insights report or Subscribe to our blog.
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