It is an obvious point to state that 2020 has been a period of extreme financial market volatility.
The market gyrations have been precipitated by the response to a global pandemic of epic proportions—more than 180 countries have been impacted by the covid-19 virus at this time, writes Chandra Seethamraju, head of quantitative strategies at Franklin Templeton multi-asset solutions.
Probably in a recession
The speed with which the United States and other countries had to shut down their economies is unprecedented.
A look at the job loss numbers showcases the impact on the US economy: more than 30 million people filed for unemployment in a six-week period as of 25 April.
This is only part of the evidence of the fact that we are probably in a recession at this point.
Gross domestic product (GDP) estimates and company earnings forecasts are currently being revised downwards substantially, showcasing the substantial negative impact the virus has had on the economy.
We are likely looking ahead to a period of heightened volatility over the next few months and quarters.
The market environment is going to be driven by the level of success the United States and other countries have in controlling the medical situation, particularly in terms of the availability of testing and development of a vaccine, and the reopening of the economy.
Additionally, the economic impact will become more apparent as various financial indicators like GDP numbers get reported in the next few months, potentially adding to market volatility.
Factors that we track—value, quality, momentum and low volatility—work well over a full market cycle (as evidenced by industry and practitioner research), and relative performance can depend on which part of the cycle we are in.
Interestingly, factor behaviour in the current environment has been consistent with past downturns and crisis periods.
The quality factor has performed well consistently across geographies such as global, the United States, developed markets ex-US and emerging markets.
This has also been true for low volatility (with the exception of emerging markets).
Momentum has also performed reasonably well across geographies.
The value factor has the been the worst-performing factor during the current period (31 December 2019 – 31 March 2020).
These results are consistent with factor behaviour in prior crisis periods like the global financial crisis (GFC) (see Exhibit 1).
Exhibits 2 and 3 (below) chart the progression of factor returns during the current covid-19 crisis and the GFC.
While we only show US factor returns for the sake of brevity, our findings are broadly consistent for global markets, emerging markets and the EAFE (Europe, Australasia and Far East) market as well.
Flight to quality
Factors like value tend not to work in volatile markets as valuations of companies appear to be less important to investors as they are exiting declining markets.
Additionally, the covid-19 crisis has been so fast that equity markets got decimated extremely quickly.
The performance of the quality and low volatility factors is consistent with the notion of a ‘flight to quality’ and a search for less volatile stocks as a tool for downside protection.
Our observations in reference to historical bear markets, along with the current covid-19 crisis, are corroborated with widely used metrics of factor performance as well.
Fundamental measures of quality such as high profitability, low earnings variability and low leverage exhibit strong performance during crisis periods.
Today’s letter is…
There is considerable debate about whether the economic recovery from the covid-19 crisis will be V-shaped or U-shaped or follow some other pattern.
This downturn can be characterised as being a ‘voluntary’ recession, in the sense that it is not a natural cyclical recession that economies generally experience.
The question now becomes one of how long this downturn will last.
This is somewhat uncharted territory for the reason noted above, and it could take anywhere from six months to more than a year.
More important is the question of how does one position their portfolio for the rebound that will follow.
Our research indicates that value has historically been the best performing stand-alone factor as we move into an expansion/ recovery phase (see Exhibit 1 for the GFC’s recovery period).
Quality, in contrast, has tended to produce flat to marginally negative results during such periods.
Quality as a factor is inherently tilted toward stable, profitable businesses with less cyclicality, whereas value is inherently tilted toward cyclical companies with high financial and operating leverage.
Hence it follows that quality would typically perform well during crisis, while value would do well during the recovery phase.
Momentum and low volatility, meanwhile, historically have been the worst-performing factors during recovery.
The progression of factor returns in the United States during the recovery period following the GFC is shown in Exhibit 4.
Looking at other geographies, we found broadly consistent results, with value the best-performing factor in the recovery after the GFC.
This is also corroborated by our observation of the performance of commonly used value metrics such as price-to-earnings ratios.
Many beats one
However, more than any stand-alone factor, our research (Exhibit 5 – below) indicates that a diversified multi-factor approach has historically provided the best risk-adjusted returns cumulatively through a downturn and a recovery (a market cycle).
This is important because it is difficult to time a downturn or recovery, which may be especially true for this most recent downturn, as it has proven to be different from any other.
As can be seen in Exhibit 5, the multifactor approach has the highest total return and Sharpe ratio, significantly better Information ratio, lower tracking error and lowest maximum drawdown when compared to any of the single factor outcomes shown in the table.
A philosophy that diversifies across well-defined factors that have been combined in a meaningful manner is likely to be key to performance potential.
Even during a period of extreme volatility, we expect such an approach can provide some downside protection while positioning a portfolio for the longer term.
This article was written by Chandra Seethamraju, head of quantitative strategies at Franklin Templeton Multi-Asset Solutions; along with research analyst and portfolio manager Sundaram Chettiappan and senior research analyst Raghu Ram Kalluri.