Equity market complacency is over; choose a Quality strategy
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|ETF Investment Strategist|
The surprise uptick in US inflation in February has led global stocks to correct sharply and volatility to rise. We believe the sell-off partly reflected profit taking after a strong bull market at the end of last year but also a higher risk of inflation as the global economy recovers. Despite improving global economic conditions, higher volatility and rising interest rates may have mixed consequences for equities.
The February sell-off ended market complacency and highlighted serious challenges ahead for equity investors
A period of stronger economic growth is generally a positive driver for equities, but inflation can erode corporate profits. While the unexpected acceleration of US wage growth in January was not sustained in February, it reminded investors that the risk of inflation is rising as the spare capacity in the economy is absorbed. As a result, the Federal Reserve could decide to act proactively with regards to inflation by increasing interest rates more aggressively than currently anticipated.
In addition, drivers other than inflation and Federal Reserve policy have the potential to push US yields higher. The US tax reform is expected to widen the US government deficit by US$1.5tn over the next decade, which in turn will require an increase in government funding. The resulting additional supply of US Treasury bonds coupled with a reduced demand from central banks, as they simultaneously prepare for unwinding quantitative easing, will also add upward pressure on bond yields.
The rise of interest rates is likely to negatively impact equity valuations (equity prices typically decline when bond yields rise). The S&P 500 Index valuations are currently slightly above their long-term historical average for periods of interest rates hovering around 2.5%, as illustrated in the graph below.
Looking ahead, we expect higher volatility in US inflation figures and yields to translate into short-term drawdowns as investors reassess earnings outlook and reprice higher yields into equity valuations.
Quality as a defensive equity strategy
The yield gap between the S&P 500 dividend yield and the 2yr US Treasury bond yield has turned negative since the beginning of the year. In other words, the risk-free short-term government bond yield has surpassed the ‘risk asset’ yield. As a solution for this predicament, investors can benefit from the combination of Quality and Dividend Yield factors through a systematic investment style to capture the excess returns of high-quality stocks over low-quality stocks while avoiding the yield trap. What is more, the chosen stocks in the MSCI USA Select Quality Yield Index continue to provide a positive yield differential over the US short-term risk free rate.
Higher rates will place pressure on borrowers, namely governments and corporates, as the cost of debt increases. Quality companies are less vulnerable to rising interest rates as they usually exhibit low leverage (debt-to-equity ratio), but also because their superior profitability and lower earnings variability suggest they are aptly managed and can quickly adapt to changes. Over the last two decades, the MSCI USA Select Quality Yield (SQY) Index has offered a decent annualised return (7.5%) and the lowest annualised volatility (12.7%) compared to other factor investing, such as Value and Momentum. While the Momentum strategy has outperformed Value and Quality strategies, it also exhibited the highest annualised volatility (16%), and can be more susceptible to market downturns. For instance, during the Global Financial Crisis, the MSCI USA Momentum Index lost 52% from October 2007 to February 2009, compared with 48% for the broad market (S&P 500 Index) and 39% for SQY Index.
Quality companies tend to outperform a pure Value strategy in market downturns and periods of high volatility.
Quality provides diversification for multi-factor portfolios
In the table below, we have illustrated the relationships between various pure factor portfolios over the long-term. The returns of two Quality-based portfolios, namely profitability and low earnings variability, have exhibited a low or negative relationship with Value and Momentum strategies.
Source: BMO Global Asset Management, Bloomberg, Correlations of daily Returns (31.12.1999 to 05.03.2018).
The quality screening has been successful to increase yield and dampen volatility when added to other factor portfolios. The graph below illustrates the risk-adjusted return profiles of a pure Quality, pure Value and multi-factor equity portfolio.
Market volatility is likely to persist in 2018 across all asset classes. We believe companies with sound fundamentals will be less vulnerable to market shocks, acting as a defensive diversifier in a multi-factor equity portfolio.
BMO MSCI Income Leaders Equity ETFs track the MSCI Select Quality Yield Indices which focus on the three abovementioned criteria to capture quality; namely profitability, leverage and earnings’ quality. The BMO MSCI UK and USA Income Leaders Equity ETFs have strongly outperformed their peers* since the beginning of last year.