How the Economic Reboot May Revive the Long-struggling Value Style
Macro is back in the driver’s seat
In the decades since Paul Volcker crafted and set afloat for future Fed Chairs “The Great Moderation”, macro-economic volatility trended predictably lower. This environment allowed investors to focus on other considerations in decisions making. However, that all changed in 2020. As the U.S. economy recovers from the hard hit of COVID-19, interest rates have been on a rising path at an unanticipated pace not seen for years with heightened uncertainty. Taken together with simmering inflation concerns dominating the headlines, the outlook for economic recovery and policymakers’ actions has become a key risk factor for market participants. Public discussion on the potential impact of macro factors on financial assets and how to position portfolios accordingly has become widespread.
Indeed, going beyond asset allocation, macroeconomic factors are increasingly influencing stock selection decisions of equity managers as well. Figure 1a shows how the average stock’s excess return variation (over the broader market) explained by interest rate changes has been steadily rising over recent years, indicating that interest rates have been an increasingly important driver of equity returns. Furthermore, in Figure 1b - which shows the average interest rate sensitivity for the most and least interest-rate sensitive quintile groups over time - we can see that the dispersions in stocks’ interest rate sensitivity have significantly widened, suggesting that rates have a profound effect on winners and losers cross-section ally in the stock market. This supports the popular view that the surge in interest rates and inflation is the main catalyst for prominent sector and style factor rotations observed in recent months, including in Value stocks.
Figure 1a. Stocks have become increasingly sensitive to interest-rate movements
|Figure 1b. Interest rate sensitivity dispersions have widened|
Average % of excess return variation over the broader market explained by 10-year interest rate changes, normalized in z-scores
|Average stocks’ interest rate sensitivity within the top and bottom quintile groups sorted by interest rate sensitivity|
Source: Factset, FRED, Voya IM.
Source: Factset, FRED, Voya IM. *Stocks’ interest rate sensitivity is estimated by regressing stocks’ net-of-market residual returns on changes in 10-year treasury yields using 2-year moving weekly returns.
Diverging macro sensitivity has dictated factor positioning
In Figure 2, we show how Deep Value (book-to-price) has largely rebounded out of the well documented struggles* against the backdrop of a surging long-term yield. Indeed, many have argued that the struggle of Value in the last decade has been in part attributable to the low-rate environment, which tends to favor Growth over Value. The rate sensitivity of Value has drastically increased since the end of the Dot-com bubble, resulting in an increasingly synchronized performance with interest rate moves.
Figure 2. With the recent interest rate hike, Value finding footing in rates’ footsteps
Deep Value and 10-Year Treasury Yield are increasingly synchronized post-GFC
Source: FRED, Voya IM. *Deep Value is the long-short equally-weighted quintile returns of book-to-price factor, sourced from Axioma.
To provide wider context, we plot the style factors’ net breakeven inflation and real yield exposures in Figure 3. Consistent with our observations above, the current factors’ macro sensitivity exhibits much greater dispersions than the long-term average. In particular, Deep Value stands out in the top-right corner, and is poised to have positive interest rate sensitivity, indifferent to the driver thereof. This is consistent with the shiny performance of Deep Value amid the surging yield and expected inflation environment since the beginning of the year.
Meanwhile, Momentum has significantly shifted towards Value as a result of its recent rally, yielding a similar positive rate sensitivity that is far away from its long-term average. Small-caps are also benefiting from the economic recovery as cyclicals/reflation trades are dominating. Less cyclical value stocks (characterized by high earnings yield) also have positive rate sensitivity but tilt more towards the real yields side. By contrast, Growth, Low Volatility and Low Beta – which are long duration in nature - stand in the very opposite corner. Given the stretched dispersions in style factors’ macro sensitivity, macro is playing an increasingly important role in dictating factor returns as well as the performance of active quant investing.
Figure 3. Style factors’ net expected inflation and real yield betas are more stretched than they used to be
Style Factors’ Net Macro Sensitivity
Source: Axioma, FRED, Factset, Voya IM. Style factors are based on equally-weighted long-short quintile portfolios; the long-term average is over 1986-2021. Deep Value is based on book-to-price; Value is based on earnings yield. We use predicted breakeven inflation rates based on survey-based inflation forecasts for the pre-2003 period when TIPS yields were not available. Stocks’ macro sensitivity is estimated by regressing stocks’ net-of-market residual returns on changes in 10-year breakeven inflation and real yields respectively, based on 2-year weekly returns. Prior to 2005, macro betas are estimated using 3-year monthly returns. Macro betas are normalized in z-scores.
Where is the tipping point for ‘bad’ inflation?
Recent surging inflation has raised concerns of continuing inflation risks to the upside, and whether investors should expect a more persistent inflation overshoot, an environment not seen since the 1970s and early 1980s. We conducted a long-history analysis with the Fama-French factor data to shed light on the historical relationship between inflation and equity factor returns. We gauged the CPI year-on-year change to define four inflation regimes, i.e. deflation (below 0), moderate inflation (between 0 and 3%), high inflation (between 3% and 5%) and extreme inflation (above 5%) periods over 1926-2021.
Figure 4 summarizes the average returns for the three Fama-French factors, i.e. excess returns on the market (“Mkt-Rf”), book-to-price (high-minus-low, “HML”) and small-caps (small-minus-large, “SML”). We can see that the market excess returns shrink alongside higher levels of inflation, accompanied by a significant shift in the sensitivity to inflation changes. In contrast, Deep Value (HML) and Small-caps (SML) are more resilient to the level of inflation rate. In particular, Deep Value earns a higher return premium during the high and even the extreme inflation periods. Even after a ‘tipping point’ has been reached such that high inflation becomes a headwind for the market, Deep Value consistently reacts more positively to rising than falling inflation in all regimes. This result lends credence to the belief that Deep Value benefits from higher inflation and typically holds up well to offer protection.
Figure 4. Average monthly factor returns in different inflation regimes (July 1926 - April 2021); Deep Value reacts more positively to rising inflation in all regimes
Source: French factor library, FRED, Factset, Voya IM. *Mkt-RF, HML and SML refer to Fama-French factors of excess returns on the market, book-to-market and size of firms, respectively. **Inflation is measured as year-on-year change of the monthly Consumer Price Index
Implications for style investing and asset allocation
We have seen how after decades of “moderation” the macroeconomic backdrop has become relevant again, both for asset allocation as well as security selection. The recent rise in interest rates appears primarily driven by increased inflation expectations, while the real interest rate remains underwhelming. When it comes to style investing, Deep Value strategies that have historically done well in this environment. Macro timing is difficult, and neutralizing macro risk by being sector-neutral versus the benchmark has historically boosted risk-adjusted returns of factors.1 However, for those with concerns about cyclical or even structural inflation, history suggests Value equities may offer protection. Even if inflation were to reach a tipping point where it might hurt equities, a situation last seen in the 1970s and by few investors active today, historical evidence points to Value stocks holding up relatively well in such an environment. The recent surge in macro volatility should remind investors how macro matters: investment styles such as Value essentially provide a short-hand for the fundamentals of a company’s business, while the macroeconomic outlook affects the prospects and proper valuation thereof.
1 For example, see Daniel, K., L. Mota, S. Rottke and T. Santos (2020) “The Cross-Section of Risk and Returns”, The Review of Financial Studies 33(5), May 2020, 1927-1979, and Herskovic, Bernard and Moreira, Alan and Muir, Tyler, “Hedging Risk Factors” (January 14, 2019). Available at SSRN: https://ssrn.com/abstract=3148693.
Past performance does not guarantee future results. This commentary has been prepared by Voya Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) interest rate levels, (4) increasing levels of loan defaults, (5) changes in laws and regulations, and (6) changes in the policies of governments and/or regulatory authorities