FACTOR INVESTING - Combining quality and value: the winning solution

What is the most important factor at this point of the cycle?

This year was a year of robust global growth that has now reached its peak. The major global economies are growing faster than their potential and central banks are tightening their monetary policies, led by the Fed. This trend is poised to continue in 2019, and the debate will eventually focus on the level of the “neutral rate” in the US, which is always tricky to predict. The investment cycle is mature; it is still in phase ii¹ of our road map (left chart), but some indicators, and especially risk indicators (volatility, IG spreads, corporate margins, industrial commodity prices, emerging markets) suggest that the cycle is already slightly more mature than this. As far as factors go, this phase still favours quality, according to our roadmap. But we can also start looking at styles that will benefit from the next phase, namely high dividends and minimum volatility. Both styles, which are more defensive, are nevertheless negatively sensitive to interest rates and will become more relevant once long rates have peaked.

Let’s now take a snapshot of the current reality

The vertical axis of the other map (right chart) shows market momentum; if the factor is positioned high, it outperforms the MSCI World (in US dollars) and vice versa if it is positioned low. The horizontal axis depicts earnings momentum. The size of the circle refers to its relative valuation (the bigger it is, the more expensive it is). As the markets anticipate earnings dynamics, the natural direction is clockwise. The colour code highlights three types of factors: value-growth, large-mid-small, and other styles.

Conclusion

The growth/value ratio, which has been excessively high in 2018, has begun to ease but without completely reversing the trend for now. Small caps, which shone for a large part of 2018, have also ended up losing their grip. They had benefited greatly from domestic dominance in the US thanks in large part to the fiscal stimulus and, in relative terms, the trade war. In Europe, small caps served as growth stocks. The spike in volatility and likely peak in margins just ahead (wage hike) are now working against them. They are only at neutral on our map (in the centre). However, both these parameters are supportive for the quality factor (sustainable growth without leverage), which took the high ground in 2018. This is still a good compromise for 2019, provided investors do not overpay for it. The quality-value combination steers clear of the value traps laid by the value-only style as defined, for example, by MSCI. The next two styles investors should look at are high dividends (high and sustainable) and minimum volatility. They have already benefited from the October selloff and proved their merit in a portfolio (relative downtrend halted, particularly for high dividends in the Eurozone and minimum volatility in the US). We believe these factors will gain appeal once long rates have peaked.