Factor investing in times of unconventional central bank policies

Analyzing which factors might be favored if monetary policy becomes more restrictive

Oct 3, 2018 | Julian Keuerleber

Ten years after the collapse of the investment bank Lehman Brothers, firm action from central banks around the world was often seen as a policy response that prevented worse from happening. In contrast to the Great Depression in the 1930s, monetary policy this time was strictly expansionary, and was further supported by low or even negative interest rates and large-scale purchases of assets by central banks – an approach also known as Quantitative Easing. These unconventional measures were the catalyst for a sharp equity-market recovery which started in 2009.

It is often said that these measures increasingly influenced asset prices, and as such, fundamentals have become less important. How did the main building blocks of Invesco Quantitative Strategies’ (IQS) multi-factor model - Momentum, including Earnings and Price Momentum, Quality, and Value - work in Europe in this environment? But the more interesting questions may be: Which factors might be favored if monetary policy becomes more restrictive and interest rates finally increase?

Since the Great Financial Crisis (GFC), Momentum was the strongest factor in Europe, while Quality and Value measures were only moderately positive (see Chart 1). We measure the signal quality of the equity factors using Information Coefficients which are, put simply, a measure of the relationship between a stock’s factor exposure and its realized return. In applying that measure systematically on approximately 1,000 stocks in the European investment universe, we can extract the performance of the factors over time.

Our Momentum measures were the best factors with a short period underperformance in the second and third quarter of 2009. Quality posted solid returns in the months following the Lehman bankruptcy but showed mixed performance ever since. Value, on the other hand, was in the red during the height of the GFC but recovered thereafter. However, over the past couple of years since 2010 there was hardly some contribution from Value.

Chart 1: Factor Performance in Europe

Our analysis shows that positive changes in rates have favored Value measures, while Momentum and Quality metrics might underperform (on a sector-neutral basis). We compared the average correlation of monthly changes in 10-Year Bund Yields with monthly equity factor returns using data going back to 2005 for Europe on rolling 36-month basis. The correlation between changes in rates and factor performance is negative for both Momentum metrics, indicating that these factors might underperform in periods of rising rates (see Chart 2). The same is true for Quality. Value is the only factor that exhibits a positive correlation, pointing to a potential outperformance if interest rates may rise.

Chart 2: Relationship between factor performance and changes in 10-Year Bund Yields

The IQS investment process is designed with the aim to look through the cycle, implementing broad factor diversification to proprietary Momentum, Quality and Value measures without a focus on stability of the factor weights over time. Our analysis has shown that our investment process worked over a decade of unconventional monetary policy and factor investors should not be afraid of rising interest rates. The IQS multi-factor approach is designed to have the potential for reliable and consistent outperformance in many different market environments.

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