Bilal’s Macroscope: Equity Performance Split By ‘Rate Sensitive’ and ‘Rate Agnostic’
- By Bilal Hafeez and Viresh Kanabar
Summary
- Momentum, growth, and quality have all outperformed the market in the last six months due to exposure to companies with strong earnings growth and profitability.
- These factors have also exhibited the least sensitivity to changes in bond yields recently, as the market gives more importance to higher cash flows than the discount rate.
Market Implications
- Quality as a factor looks crowded following its strong run in the last six months. Given its strong breadth and elevated valuations, we could have seen wider flows into the factor. These could unwind going forward.
- In contrast, both small cap and low volatility look attractive. Small caps should benefit as US growth remains robust. Investors could consider a barbell with growth and small caps on either side.
Equity Markets Rebound as Fed Pivots
Below we introduce our equity factor dashboard, a standardised set of charts and tables highlighting factor returns and fundamentals. For this analysis, we use the MSCI factor indices for consistency.
During the last six months, all eight factors we track have shown positive performance as the equity market rebounded. This rebound was driven by lower-than-expected inflation, which raised the prospect of faster interest rate cuts. From an equity perspective, the dual themes of AI and the GLP-1 (diabetes and weight-loss) drugs have also boosted bottoms-up earnings forecasts (Chart 3).
However, relative to the index, returns have shown significant dispersion as just three factors – momentum, growth, and quality have outperformed over the last six months. Consistent with this, both the growth and quality factors have seen positive earnings revisions relative to the index, and we can also see that gap widening (Chart 4).
Unsurprisingly, the largest holdings within the quality and growth factors contain a number of the key AI and GLP-1 drug beneficiaries, such as Nvidia, Microsoft, Meta, and Eli Lilly.
Following this run, how do these factors look fundamentally?
- Quality Looks Expensive:
While quality is still delivering faster earnings growth, and greater profitability relative to the index, both metrics are within historic norms. However, its next 12 months (NTM) P/E of 24 or 3 turns is higher than the index and is elevated on a z-score basis. Therefore, you now pay more to gain access to quality companies while getting little extra for it (Tables 1 and 2).
- Growth Is Not Yet Stretched:
Growth’s characteristics are similar to quality. It provides access to companies with superior profitability and lower leverage relative to the market. Yet despite growth’s strong performance, its NTM P/E of 29.2 is no higher versus the index than it has been over the last five years. Meanwhile, the extra growth of 27% it is set to deliver versus 10% for the index is also within historic norms. So despite strong performance, much of this has been driven by fundamentals rather than just multiple expansion.
- Low Volatility and Small Caps Could Be Attractive
Low volatility’s forward P/E of 18 means it is much cheaper relative to the index than it has been historically with similar levels of profitability. Investors are receiving lower earnings growth relative to the index – but no lower than you would typically expect. Small caps follow a similar pattern but would likely offer better exposure to a scenario where economic growth stays strong – typically where low volatility has underperformed.
- Value, Not Offering Enough:
Lastly, despite steep underperformance, the value factor is currently no cheaper relative to the index than historically. Meanwhile, its relative quality metrics have deteriorated. Given the value factor’s current exposures, it would likely require a period of higher energy and commodity prices to outperform.
- Momentum Goes All-In On Growth:
Rather than looking at momentum on a fundamental basis, we like to observe its correlation with other factors – particularly value and growth. Typically, momentum’s correlation with value tends to be around 0.4, while its correlation with growth is much higher at 0.7. More recently, this relationship has widened to historical extremes, with momentum’s correlation with value dropping to 0 over the last 12 weeks (lowest since July 2021), while its correlation with growth has risen to 1. We also find that just 10% of value constituents currently reside in the MSCI US momentum basket, showing the extent to which the market has piled into recent winners.
Rising Profitability Helps Market Shrug Off Changes in Treasury Yields
More recently, the market has differentiated between ‘rate sensitive’ and ‘rate agnostic’ stocks. Rate agnostic includes momentum, quality, and growth, where the impact of stronger earnings growth has superseded that of higher rates (Chart 5).
In contrast, the equal weight and value factors have shown the strongest correlation to changes in bond yields. What do both have in common? Mainly an overweight in financials and an underweight to the technology sector.
Finally, the low correlation to rates has led to both quality and growth displaying the strongest breadth among its constituents. Currently, over 80% of stocks within the quality factor are in an uptrend (above their 200-day moving average) versus just 60% for small caps (Chart 6). One reason could be broad flows into the quality factor as a whole, rather than discriminating among various stocks. Potential crowding could also explain the elevated valuation as well. We are also wary of crowding within momentum too.
Another way to show how the market has favoured companies with quality traits is by breaking down recent performance by these metrics.
Factors with the highest ROE have performed the best over the last six months, which was also a key driver of the low correlation versus bonds. Equity factors with the lowest ROE have performed the worst. Except for small cap, the factors with the highest ROE have also been the least correlated to bonds.
Similarly, the market is also rewarding rising profitability. Outside quality, which has seen no increase in profitability in the last six months, factors with the largest increases in ROE have seen the strongest returns.
This tells us that, to some extent, the equity market remains rational for now. The companies exposed to mega-trends such as AI and GLP-1 are highly profitable, but they have also increased their profitability and been rewarded accordingly. Meanwhile, profitability remains flat to down for the rest of the market, which has impacted returns.
What Next for Factor Allocation?
A wide array of literature discusses how certain factors perform best during different phases of an economic cycle. For instance, small cap value typically performs best exiting a recession, quality performs best when growth slows at the end of a cycle, while low volatility does best during a recession.
However, since 2022, the trajectory of interest rates and commodities has had a larger impact on factor performance than in the past. So we must consider this when allocating. We lay out three scenarios and allocations investors should consider along with a secular allocation to growth, which ensures exposure to mega-theme beneficiaries.
Scenario 1: Inflation Keeps Cooling, Growth Remains Robust
This scenario would be a continuation of events since Q3 last year. Here, we think the stock-bond correlation should weaken. This will allow investors to increase allocation to small caps which typically benefit amid strong growth – particularly if industry rebounds (i.e. ISM higher). There would also be a valuation tailwind.
Scenario 2: Inflation Re-Accelerates
In this scenario, the Fed must walk back its guidance for interest rate cuts this year. The cause might be an energy shock, forcing bond yields higher and increasing the correlation between stocks and bonds. Here, having exposure to value and commodity-sensitive sectors will be beneficial – particularly as both quality and growth are still negatively correlated with oil prices.
Scenario 3: Growth Slows, Fed Must Cut
Finally, should we see the labour market deteriorate and signs of an impending recession, we think stocks and bonds would again be negatively correlated as stocks sell off due to growth risks. Low volatility should offer protection due to its exposure to more defensive companies, while its valuation remains attractive relative to history.
For now, we think scenario 1 is the most likely: disinflation continues, allowing the Fed to enact their first cut in June.
Bilal Hafeez is the CEO and Editor of Macro Hive. He spent over twenty years doing research at big banks – JPMorgan, Deutsche Bank, and Nomura, where he had various “Global Head” roles and did FX, rates and cross-markets research.
Viresh Kanabar is an investment strategist with 8+ years of experience, notably contributing to portfolio construction and risk management at CCLA Investment Management, a £12 billion fund. Viresh was also a voting member of the Investment Committee and ran the private asset valuation process.