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.

Related articles

Important information

This document has been prepared only for those persons to whom Invesco has provided it for informational purposes only. This document is not an offering of a financial product and is not intended for and should not be distributed to retail clients who are resident in jurisdiction where its distribution is not authorized or is unlawful. Circulation, disclosure, or dissemination of all or any part of this document to any person without the consent of Invesco is prohibited.

This document may contain statements that are not purely historical in nature but are "forward-looking statements", which are based on certain assumptions of future events.

Forward-looking statements are based on information available on the date hereof, and Invesco does not assume any duty to update any forward-looking statement. Actual events may differ from those assumed. There can be no assurance that forward-looking statements, including any projected returns, will materialize or that actual market conditions and/or performance results will not be materially different or worse than those presented.

The information in this document has been prepared without taking into account any investor’s investment objectives, financial situation or particular needs. Before acting on the information the investor should consider its appropriateness having regard to their investment objectives, financial situation and needs.

You should note that this information:
•    may contain references to amounts which are not in local currencies;
•    may contain financial information which is not prepared in accordance with the laws or practices of your country of residence;
•    may not address risks associated with investment in foreign currency denominated investments; and
•    does not address local tax issues.

All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. Investment involves risk. Please review all financial material carefully before investing. The opinions expressed are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

The distribution and offering of this document in certain jurisdictions may be restricted by law. Persons into whose possession this marketing material may come are required to inform themselves about and to comply with any relevant restrictions. This does not constitute an offer or solicitation by anyone in any jurisdiction in which such an offer is not authorised or to any person to whom it is unlawful to make such an offer or solicitation.