The news that Pfizer seems to have an efficient and workable vaccine for COVID-19 prompted a remarkable market rally. Yet much the most interesting aspect of this bounce-back was that many tech-based growth stocks significantly underperformed while more traditional value stocks, especially those with a strong cyclical bias shot up disproportionately in value.
Quant analysts have been banging the drum about value underperformance for years now, warning that when the reversal came, the ‘turn’ would be brutal. And so, it was, with some stocks advancing by more than 25% in just one day's trading. So, contra we value cynics, maybe value investing is not dead after all although the time compression of this bounce-back was so brutal that if you had have been stuck in that cave with a poor mobile signal you would have probably missed the value revival.
But COVID-19 aside, there is need for a more fundamental reckoning. My hunch is COVID-19 has not really changed anything for investment fundamentals and especially not factor analysis, yet COVID-19 has reminded us that central bankers have become the new frontline for macroeconomic policy.
Sure, there has been fiscal rebalancing, which was much needed, but who can honestly believe that come the next economic downturn, central bankers will not be raiding the armoury for new monetary weapons and tools – top of the list will be e-money and direct money transfers. My point in emphasising the role of central bankers is that they are here to stay, and their influence will not be diminishing any time soon.
Which brings us nicely to why this might have an impact on investment styles and factors. Put bluntly quant investors need to accept that the old textbooks written before QE (BQE) need rewriting in an age of experimental monetary (and fiscal) policy – post QE or PQE. This binary distinction between BQE and PQE is crucial to understanding how loose monetary policy has introduced strong drivers that in turn affect factor-based outcomes.
In simple terms, PQE policies have hugely skewed factor-based results. I would suggest there are two transmission mechanisms at work which shape this skew towards some factor premia. The first is ably outlined in a recent paper by US equity analysts at French investment bank Société Générale (SocGen). They have crunched the numbers on how the Federal Reserves has skewed key benchmark indices. The key driver here has been changed to the discount rate, based around an internal equity risk premium framework.
This drives through to changes in the US Treasury 10-year bond yields which, when added to other variables such as total Fed assets, leads to the following conclusion: “Since 2009, the cumulative impact of the different waves of GE on US Treasury 10-year bond yields were approximately 180 basis points. Without QE, US Treasuries would have been around 2.8%.”
How has that impacted equity markets in the US? The SocGen team reckon the most impacted index has been the Nasdaq and the least impacted are US small caps in the S&P 600. “As of October 2020, the Nasdaq price level was 57% explained by QE. In fact, without QE, the NASDAQ 100 should be closer to 5,000 than 11,000 while the S&P 500 should be closer to 1,800 rather than 3,300.”
A common sense narrative backs up this analysis. Large caps have disproportionately benefitted from low interest rates plus they boast low payout ratios and higher book to price numbers while growth stocks have spent large amounts of cash on buy backs. According to the SocGen analysts, “small and mid-caps, on a relative basis, given their higher payout and lower price to book value ratios, are less sensitive to bond yields”.
Again, in simple terms, QE benefits growth stocks and quality stocks, but all bundled up within a framework that favours mega large cap stocks overall. By contrast, small caps have less access to the bond markets, have weaker balance sheets and can spend less money on dividends and buybacks. Therefore, PQE the traditional small-cap premia starts to fade away.
Widening income inequalities
I would also hazard to add a second transmission – the distribution of wealth. For the record, I am no socialist and I have a fairly relaxed view about wealth and income inequalities (to a point) but even I would hazard the observation that PQE we have seen an increase in inequality as wealthier, equity investors (and they tend to be much wealthier, older and male) have disproportionately benefitted from QE. If one accepts this analysis – and it is hard to disagree with the hard numbers behind this conclusion – then we also need to peer into the behavioural mindset of these wealthy investors and their advisers.
I would hazard three crucial drivers of behaviour which in turn might impact different factor premia. The first is wealthier investors can, by and large, afford to take more risks.
Therefore, they are more willing to invest in less liquid stuff (private equity for instance) or higher rated stocks (tech and growth stocks) because they can afford the downside risk.
Wealthier investors are likely to have elongated life expectancies which means they can afford to take a longer time horizon for their investments, therefore increasing their appetite for risk. In addition, wealthier investors also tend, in my experience, to hold a large share of what I call primary, personal assets such as housing wealth. These assets have disproportionately benefitted from PQE which in turn allows these older, wealthier investors to take more risk with the (smaller) proportion of wealth invested in risky assets.
Another driver might also be a bias against dividend-oriented value stocks. Most market commentators have tended to assume that PQE policies have pushed investors towards a scramble for yield, which should benefit higher yielding stocks. But I would wager that the opposite has in fact played out. Wealthier investors have less need of a large, sustained income from their risk assets.
If they seek a pre-determined income outcome they are more likely to a) seek out alternative assets such as infrastructure with defined income terms or b) in effect drawdown income by liquidating capital gains and in turn avoiding a tax liability. Therefore, these investors are more likely to be interested in preserving and growing their wealth rather than prioritising income at all costs.
Add these drivers up and we can begin to discern a possible, putative transmission mechanism at work driven by PQE policies. Wealthier investors – older, male and middle class – will be more inclined to chase momentum flows because they can afford to take extra risk. They will also seek out quality stocks rather than classic dividend-focused value stocks.
Lastly, because they have a longer investment time horizon, and a greater willingness to take risk, they will also be more willing to embrace growth-based strategies. The subset of older investors who are more risk-oriented and income hungry might by contrast find themselves gravitating towards low vol strategies and quality.
This second transmission mechanism PQE based around inequality is more speculative but does offer some possible narratives which explain how factor premia outcomes might have been skewed by central bank monetary innovation. I would add one caveat though – none of the above would mean that any particular risk premia will vanish PQE. As the value bounce in recent weeks amply demonstrates, if investors can make more returns by betting on cyclical, post-COVID-19 bouncebacks, they will willingly embrace that risk.
David Stevenson is a columnist at the Financial Times
This article first appeared in the Q4 2020 edition of Beyond Beta, the world’s only smart beta publication. To receive a full copy,click here.