Economic Recovery and Factor Performance

As investors, we are rarely given the twin tailwinds of cheap valuations and a supportive economic environment. The current rotation out of growth into value securities is a sign of the recovering global economy, and one that every government and central bank would like to see continue for some time yet.

Based on our Asset Allocation Interactive, we would expect an Australian value portfolio to earn 8% per annum over the next five years. Over the same period, we would expect an investor in a broad US equity portfolio to tread water, if they are lucky, but a value-based portfolio should gain 5% p.a. Even better opportunities exist in the downtrodden UK market (10%) and the riskier emerging markets (11%).

We are definitely living in interesting times. Last year, 2020, was a shock. An unexpected health and economic crisis on a global scale was thrust upon us. As we globally vaccinate, our focus moves to the future, and in all areas of our lives we look to recover. Whilst 2020 may have been unprecedented, if we can separate the economy and the equity market, investors may find themselves on very familiar turf.

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We had a significant global recession in 2020, and we are well into a worldwide economic recovery. Likewise, broad economic markets plunged, and after broadly troughing in early 2020, markets have surged, in some places to record high levels. This is the story of many a recession throughout the modern financial era.
But, when we look deeper, we see some eddies that add significant context to our understanding of the current investment landscape. When we delve deep below the surface of the broad global equity market and draw historical parallels, we likely know more about the future than we credit ourselves. To tease out the patterns of these eddies, we need to take a quick sojourn into the relationship between factor investing and the economic cycle. 


The economy has very real implications in our daily lives. Our jobs, spending, and personal well-being are all tied to its ups and downs. When economic times are good, we feel good. When economic times are bad, it gets us down. The same is true of the capital markets. When economic times are good, it feels like the market has no bound on the upside. During tough economic times and during recessions, it seems everything piles up against the market, and returns suffer. Simply, the state of the economy matters. It has consequences not only in our everyday decisions, but also in how the capital markets behave.  

When equity investors consider the prospects of an individual company, a set of securities in an industry, or just the entire equity market of a country, the future economic environment is paramount in their thoughts. Therefore, would it not also matter for a factor portfolio, a set of securities that share a common characteristic? What is surprising is the widely-held belief that factor timing, or varying your portfolio’s factor exposure over time, is a fool’s errand!

Factor investing has become a valid choice for investors seeking to implement the shares slice of their portfolio. As investors implement factor strategies more often, it becomes more important for them to understand a factor’s cyclical tendencies.

Briefly, we can summarise the characteristics of a broad set of factor-based portfolios: namely, momentum, value, size, low volatility, and quality. The momentum factor represents a group of securities that performed best over the last year. The value factor represents the lowest priced securities relative to the respective company’s economic size. The size factor represents a group of the smallest companies. The quality factor represents companies with a strong and stable financial scorecard. Finally, the low volatility factor represents the securities that do not rise or fall on a par with the market.  

A portfolio of securities based on each of these characteristics has proven to perform better than the market over the modern financial era. 


Just like the broad equity market or the securities in a common industry, different factor portfolios perform differently in different economic environments.  Let us simply define the economic cycle as three basic stages: a recession, the following recovery, and a period of growth, which is better characterised as the economic calm that persists until the next recession.

Across the three economic stages, two major themes are at play. First, the higher economic exposure of a value and size factor portfolio separates them from the less economically leveraged factors of low volatility and quality. The pro-leveraged factor portfolios of value and size perform poorly during the negative growth of a recession and perform better during the faster growth of an economic recovery. The opposite applies for the anti-leveraged factor portfolios of low volatility and quality. 
The second theme is momentum, which performs better during the longer-lasting growth periods. In the shorter and more economically significant, but less sustained, recession and recovery stages, momentum produces poor performance outcomes. 

Equity securities are discounting mechanisms. Security prices are forecasting the future, rather than what is current or has been. Likewise, the performance of equity securities, and their composite factor portfolios, consider the economic environment three or six months into the future. But, economic data lags reality. We do not get gross domestic product (GDP) growth numbers until well after each quarter’s end. We could forecast the economy. This undertaking keeps a plethora of highly qualified and compensated economists busy. We could also argue that large advances in computing power and the ability to process big datasets herald the dawn of a new era in prediction, but regardless of this foresight, the further we look into the future, the murkier our view gets.  

If only we could synthesize the collective knowledge of all the efforts of these economists. Luckily, we need to look no further than the relative state of factor portfolios to forecasting or now-casting the economic environment. We find two measures matter: a factor’s discount and a factor’s momentum. Therefore, if we are keeping track of the economy, we need to look to a broad range of factor investment strategies to inform our opinions.

We know that during a recession, the value and size factor portfolios perform poorly. At the end of September, 2020, value portfolios around the world were priced at 50% discounts to average, and they had fallen about 30% in the preceding 12 months. Conversely, we see positive factor momentum of quality strategies, averaging 16% as of September 2020, and priced at a 25% premium to average. A recession would do that! We do not choose randomly the end of September, 2020. In the five months since that date, we have seen the trend reverse. The performance of value securities has surged, and quality companies have languished.  

In the US, within the last few weeks, a value portfolio has surpassed the performance of the overall stockmarket, a result that gives it positive momentum. Alternatively, quality is moving sideways. We see similar results in other parts of the developed world.


What can we intuit from the differential performance of factor portfolios since the third quarter of 2020? Investors believe the global economy is recovering. Investors came to this conclusion during September 2020, about five months ago, and have been cautiously reflecting a recovery in security prices. That said, the markets have a long way to go.

Globally, value securities are still priced 30% below average, whereas some quality factors are priced at a 40% premium to their average valuations.

Cheap valuations and the global economic recovery are building. We rarely get opportunities to invest in portfolios with such strong tailwinds. 

Michael Aked is director of research for Australia at Research Affiliates.

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