Outlook 2017: Factor investing in the coming year

Although it may sound like a well-worn cliché, we are at a critical juncture as 2017 approaches. Two important tests of voter sentiment – the U.S. general elections and the U.K.’s referendum (Brexit) to leave the European Union (EU) – have occurred in less than six months’ time, and the ramifications could prove profound. Although the U.S. is now in the seventh year of an economic expansion, the current recovery is among the slowest on record and has been subject to bouts of market volatility that have buffeted the financial markets and tested investors’ resolve.

President-elect Donald Trump’s surprise ascendency to the U.S. presidency figures to influence factor performance in 2017 – at least in the near term. Immediately following the election, the global equity markets reacted favorably on expectations of lower corporate tax rates, less regulation and possible stimulus spending. This same outlook has pushed both short-term yields and the U.S. dollar sharply higher, roiling the bond markets and putting pressure on emerging-market shares. Whether or not investors’ expectations will be realized, however, is far from certain.

What are factors?

Despite its new-found popularity, factor investing traces its roots to the 1960s, and is supported by a substantial body of academic research. At their most fundamental level, factors can be thought of as quantifiable characteristics that can help explain the risk and returns of a given asset. Commonly deployed factors like quality, low volatility, value, size and momentum have been shown to be rewarded over long periods of time. Factors are the building blocks of factor-based portfolios and can be combined with other factors (i.e., a multi-factor strategy) or with actively managed funds.

Ongoing economic expansion in slow-growth environment

The current slow-growth economic environment in the U.S. has generally benefited low volatility and dividend-paying stocks, while creating headwinds to value shares. To what extent these conditions continue in 2017 will hinge in part on economic policies pursued by the new administration in the U.S. and by policymakers elsewhere. While lawmakers don’t sell products or generate sales, the policies they purse can make it easier or more difficult for companies to grow earnings. Public policy can also influence consumer confidence and investors’ appetite for risk.

If U.S. economic growth accelerates from its current pace, we believe the value and small-cap size factors could benefit. Both value and small-cap shares have the potential to perform well during periods of accelerating economic growth. Higher interest rates are not likely to dampen this performance potential, as both value and small-cap stocks can still do well in a rising rate environment.¹

If stocks rally, it would not be surprising to see low-volatility shares underperform. Because low-volatility strategies attempt to attenuate the market’s highs and lows, the low-volatility factor may provide downside mitigation, but is expected to underperform in most bull markets.

Obstacles to U.S. economic growth remain

This is not to say that investors can’t benefit from low-volatility factor exposure over the coming year. Despite signs of a cyclical upswing – including reduced inventory overhang, increased capital spending and a bottoming in the profit cycle – the markets are still fraught with risk, and sustained economic growth is far from certain.

Automakers have been generating strong sales, but this momentum could be cut short in the event of increased consumer credit defaults. Some senior auto executives believe the U.S. auto market has peaked after an extended period of growth fueled by dealer incentives.² Additionally, we are seeing clear signs of wage inflation in the U.S.³ Hourly earnings and, by association, wage costs, are growing at their fastest pace since the economic expansion began. This could pressure profit margins and increase market volatility – particularly if worker productivity remains stagnant. Going back to the 1990s, average hourly earnings growth has tended to lead market volatility by about one year. Increased wage costs could make a case for strategies with risk mitigation objectives.

Late in 2016, expectations for future U.S. economic growth led to a near-term spike in Treasury yields and a rotation into cyclical sectors. In our view, a continuation of this trend in 2017 could aid the value and small-cap size factors, but hurt dividend-paying stocks as bonds begin to look more attractive.

International growth prospects vary

Europe is still making its way in a post-Brexit environment. Despite fears to the contrary, European markets have adjusted well to Britain’s vote in June to break from the European Union. However, with elections coming up in 2017 in France and Germany, the decision has created disintegration risks elsewhere in the EU. Meantime, many parts of the continent remain in a negative interest rate environment. Sustained economic growth would go a long way toward balancing out quantitative easing imbalances, but pockets of economic weakness remain and the European banking sector is still on shaky ground.

Emerging market prospects are mixed. While the end of the impeachment saga in Brazil and economic reforms in India provide reason for optimism, India’s decision to pull high-denomination bills from circulation threatens to overshadow this progress. In China, a devalued yuan may signal that government officials are concerned about future economic growth and continued capital outflows.

In aggregate, a confluence of risks could lead to choppy trading patterns in the coming year, which we believe could make a case for low volatility factor investing. This “risk on-risk off” backdrop would likely not bode well for the momentum factor, as momentum stocks have historically performed well in a sustained growth environment with clear and stable market leadership. Should global economic growth prove more consistent, however, we would expect to see periods of outperformance from the momentum factor.

The benefits of blending factors

Of course, factors can also be blended to accommodate different market scenarios and provide potential diversification benefits. For example, pairing value with low volatility could make sense for expectations of economic growth with periodic market disruptions.

The potential implications for diversification are even greater for factors with very low excess return correlation. Combining momentum and low volatility, for example, provides exposure to two factors that historically have tended to behave very differently from each other. Or, given the uncertainty of the coming year, blending defensive factors like low volatility and quality may help mitigate risk, while still providing potential diversification benefits.