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Investors brace for ‘major shift’ as momentum and value collide

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The strength of the recent rally in cheap stocks could trigger a rare shift in equity market dynamics that some investors expect will fuel the gains of financial and energy companies.

For much of the past decade, so-called momentum stocks have been on fire, layering gains upon gains. Meanwhile, unloved “value” stocks have limped behind, frustrating a generation of fund managers who made their reputation eking out equity market bargains.

Since November’s coronavirus vaccine breakthroughs, however, value stocks have benefited from their high sensitivity to economic cycles. Now, they are climbing fast and consistently enough to start classifying as momentum stocks as well. It is an uncommon union of two normally conflicting market “factors” that could send billions of dollars that typically chase trends towards once-shunned value shares.

“There’s going to be a major shift in what will fall into the momentum basket,” said Andrew Slimmon, senior portfolio manager at Morgan Stanley Investment Management. “The value sector has outperformed the growth sector since last summer, and there is going to be a major rebalancing in these funds from tech and healthcare to financials, energy, materials and industrials.”

Although equities have historically been divided into distinct, static sectors — such as utilities or technology — investors are increasingly sorting the stock market by more dynamic financial characteristics known as factors.

Line chart of Relative returns year-to-date (%) showing Value stocks are finally enjoying a renaissance

Unlike sectors, factors can and often do overlap, and companies can drop in and out of different baskets. However, momentum and value are often seen as nemeses, with one usually doing badly if the other is on the upswing. After all, if a value stock climbs for long enough, it is no longer cheap enough to qualify as one.

Yet the superlative performance of many long-shunned areas that dominate the value stock universe has fed expectations that they will also be categorised as momentum stocks when weightings get periodically reshuffled. A value-momentum convergence is the “holy grail” of quantitative investing, according to Bernstein strategist Inigo Fraser-Jenkins — something so rare that it is intriguing many investors in the field.

Line chart of 1 signifies perfect correlation, while -1 is perfect negative correlation showing Momentum and value factors typically move in opposite directions

“It’s just beginning. Value stocks outperforming will become momentum stocks,” said Denis Panel, head of quantitative multi-asset solutions at BNP Paribas Asset Management. “I wouldn’t say they’re anti-correlated, but it will be interesting. It’s sort of yin and yang.”

Using index provider MSCI’s widely followed definitions, momentum has dramatically outpaced the broader US stock market over the past decade, while value has lagged behind. By one measure, value stocks have suffered their worst run in two centuries.

However, the growing prospect of a global post-pandemic economic boom has helped value thump both momentum and the broader stock market since November. BlackRock’s $14bn iShares MSCI USA Value Factor ETF has soared almost 40 per cent since the start of November 2020, widely beating the 23 per cent gain for its momentum counterpart.

Factors defined

VALUE Is the oldest and best-known factor, tracing its genesis to seminal work by Graham and Dodd in the 1930s. It refers to the tendency for relatively cheap securities to outperform relatively expensive ones, as many investors wrongly prefer the glamour of racier “growth” stocks.

MOMENTUM Reflects how assets with a positive trend tend to continue to do well, and those that are falling continue to slide. Most academics say the phenomenon is rooted in human psychology and how we initially underreact to news but overreact in the long run, or often sell winners too quickly and hang on to duds for too long.

QUALITY Is powered by the fact that lower risk, safer companies tend to do better than riskier, more indebted ones. The factor is often attributed to how investors systematically underpay for companies with boring, defensive business models.

VOLATILITY is based on the observation that stolid stocks with muted movement tend to outperform more volatile ones over time, contrary to the view that investors should be compensated for the additional risk of buying more turbulent shares.

SIZE One of the better-known factors. Captures the tendency of smaller stocks to do better than bigger ones in the longer run, possibly because they are less glamorous or more risky.

Yin Luo, vice chair and head of quantitative strategy at Wolfe Research, estimates that value and momentum have been correlated with each other only briefly three times over the past three decades, but will come together again by summertime. 

Currently, tech high-flyers such as Tesla, Microsoft and Apple dominate momentum strategies such as the one followed by BlackRock momentum ETF. Less glamorous technology names such as Intel, IBM and Cisco sit atop the asset manager’s value factor fund, with financial and energy companies also taking on a bigger weighting.

Given how deeply many value shares have underperformed the market in recent years, analysts say the value-momentum convergence could last for longer than the brief periods it has in the past. 

“We are potentially on the cusp of a new macro regime,” Quant Insight, a research company that tracks the shifting correlations between various market factors, said in a recent report.

“Given the huge amount of capital following [factor] strategies, such a rebalancing has the potential to add significant further impetus to the rotation trade,” Quant Insight said, referring to the move away from stocks that prospered during the pandemic to ones more sensitive to economic fluctuations.

Some value stocks are starting to screen as momentum stocks; Chart shows the number of stocks that screen as the top quintile of value (defined as price-to-book) and momentum (defined as 12-month price momentum) in respective MSCI indices, rebalanced quarterly

More fuel for the value stock renaissance would also be a welcome fillip for the dwindling tribe of traditional value-oriented hedge funds — many of which have been hurt badly by the style’s dismal past decade — and those tactically positioned for the rebound.

Sydney-based Platinum Asset Management, Lee Ainslie’s Maverick Capital and London-based Lansdowne Partners are among funds already benefiting from the market rotation from once-hot “growth stocks” to value stocks. Some believe that the duration and depth of value stocks’ wretched run means there is left plenty of room for the recent rally to continue. 

“We’re at one of the most extreme positionings in markets in terms of value versus growth,” said Platinum co-founder Andrew Clifford, who believes such stocks could do well over the coming years. The recent rally, “while impressive, is quite small in the context of previous underperformance”.



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Markets

European stocks stabilise ahead of US inflation data

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European equities stabilised on Wednesday after a US central banker soothed concerns about inflation and an eventual tightening of monetary policy that had driven global stock markets lower in the previous session.

The Stoxx 600 index gained 0.4 per cent and the UK’s FTSE 100 rose 0.6 per cent. Asian bourses mostly dropped, with Japan’s Nikkei 225 and South Korea’s Kospi 200 each losing more than 1.5 per cent for the second consecutive session.

The yield on the 10-year US Treasury bond, which has dropped in price this year as traders anticipated higher inflation that erodes the returns from the fixed interest securities, added 0.01 percentage points to 1.613 per cent.

Global markets had ended Tuesday in the red as concerns mounted that US inflation data released later on Wednesday could pressure the Federal Reserve to start reducing its $120bn of monthly bond purchases that have boosted asset prices throughout the Covid-19 pandemic.

Analysts expect headline consumer prices in the US to have risen 3.6 per cent in April over the same month last year, which would be the biggest increase since 2011. Core CPI is expected to advance 2.3 per cent. Data on Tuesday also showed Chinese factory gate prices rose at their strongest level in three years last month.

Late on Tuesday, however, Fed governor Lael Brainard stepped in to urge a “patient” approach that looks through price rises as economies emerge from lockdown restrictions.

The world’s most powerful central bank has regularly repeated that it will wait for several months or more of persistent inflation before withdrawing its monetary support programmes, which have been followed by most other major global rate setters since last March. Investors are increasingly speculating about when the Fed will step on the brake pedal.

“Markets are intensely focused on inflation because if it really does accelerate into this time near year, that will force central banks into removing accommodation,” said David Stubbs, global head of market strategy at JPMorgan Private Bank.

Stubbs added that investors should look more closely at the month-by-month inflation figure instead of the comparison with April last year, which was “distorted” by pandemic effects such as the price of international oil benchmark Brent crude falling briefly below zero. Brent on Wednesday gained 0.5 per cent to $69.06 a barrel.

“If you get two or three back-to-back inflation reports that are very high and above expectations” that would show “we are later into the economic recovery cycle,” said Emiel van den Heiligenberg, head of asset allocation at Legal & General Investment Management.

He added that the pandemic had sped up deflationary forces that would moderate cost pressures over time, such as the growth of online shopping that economists believe constrains retailers’ abilities to raise prices. Widespread working from home would also encourage more parents and carers into full-time work, he said, “increasing the labour supply” and keeping a lid on wage growth.

In currency markets on Wednesday, sterling was flat against the dollar, purchasing $1.141. The euro was also steady at $1.214. The dollar index, which measures the greenback against a group of trading partners’ currencies, dipped 0.1 per cent to stay around its lowest since late February.



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Potash/grains: prices out of sync with fundamentals

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The rising tide of commodity prices is lifting the ricketiest of boats. High prices for fertiliser mean that heavily indebted potash producer K+S was able to report an unusually strong first quarter on Tuesday. Some €60m has been added to the German group’s full year ebitda expectations to reach €600m. Its share price has gone back above pre-pandemic levels.

Demand for agricultural commodities has pushed prices for corn and soyabeans from decade lows to near decade highs in less than a year. Chinese grain consumption is at a record as the country rebuilds its pork herd. Meanwhile, the slowest Brazilian soyabean harvest in a decade, according to S&P Global, has led to supply disruptions. Fertiliser prices have risen sharply as a result.

But commodity traders have positioned themselves for the rally to continue for some time to come. Record speculative positions in agricultural commodities appear out of sync even with a bullish supply and demand outlook. US commodity traders have not held so much corn since at least 1994. There are $48bn worth of net speculative long positions in agricultural commodities, according to Saxo Bank.

Agricultural suppliers may continue to benefit in the short term but fundamentals for fertiliser producers suggest high product prices cannot last long. The debt overhang at K+S, almost eight times forward ebitda, has swelled in recent years after hefty capacity additions in 2017. Meanwhile, utilisation rates for potash producers are expected to fall towards 75 per cent over the next five years as new supply arrives, partly from Russia. 

Yet K+S’s debt swollen enterprise value is still nine times the most bullish analyst’s ebitda estimate, and 12 times consensus, this year. Both are a substantial premium to its North American rivals Mosaic and Nutrien, and OCI of the Netherlands, even after their own share prices have rallied.

Any further price rises in agricultural commodities will depend on the success of harvests being planted in the US and Europe. Beyond restocking there is little that supports sustained demand.

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Amazon sets records in $18.5bn bond issue

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Amazon set a record in the corporate bond market on Monday, getting closer to the level of interest paid by the US government than any US company has previously managed in a fundraising. 

The ecommerce group raised $18.5bn of debt across bonds of eight different maturities, ranging from two to 40 years, according to people familiar with the deal. On its $1bn two-year bond, it paid just 0.1 percentage points more than the yield on equivalent US Treasury debt, a record according to data from Refinitiv.

The additional yield above Treasuries paid by companies, or spread, is an indication of investors’ perception of the risk of lending to a company versus the supposedly risk-free rate on US government debt.

Amazon, one of the pandemic’s runaway winners, last week posted its second consecutive quarter of $100bn-plus revenue and said its net income tripled in the first quarter from the same period a year ago, to $8.1bn.

The company had $33.8bn in cash and cash equivalents on hand at the end of March, according to a recent filing, a high for the period.

“They don’t need the cash but money is cheap,” said Monica Erickson, head of the investment-grade corporate team at DoubleLine Capital in Los Angeles.

Spreads have fallen dramatically since the Federal Reserve stepped in to shore up the corporate bond market in the face of a severe sell-off caused by the pandemic, and now average levels below those from before coronavirus struck.

That means it is a very attractive time for companies to borrow cash from investors, even if they do not have an urgent need to.

Amazon also set a record for the lowest spread on a 20-year corporate bond, 0.7 percentage points, breaking through Alphabet’s borrowing cost record from last year, according to Refinitiv data. It also matched the 0.2 percentage point spread first paid by Apple for a three-year bond in 2013 and fell just shy of the 0.47 percentage points paid by Procter & Gamble for a 10-year bond last year.

Investor orders for Amazon’s fundraising fell just short of $50bn, according to the people, in a sign of the rampant demand from investors for US corporate debt, even as rising interest rates have eroded the value of higher-quality fixed-rate bonds.

Highly rated US corporate bonds still offer interest rates above much of the rest of the world.

Amazon’s two-year bond also carried a sustainability label that has become increasingly attractive to investors. The company said the money would be used to fund projects in five areas, including renewable energy, clean transport and sustainable housing. 

It listed a number of other potential uses for the rest of the debt including buying back stock, acquisitions and capital expenditure. 

In a recent investor call, Brian Olsavsky, chief financial officer, said the company would be “investing heavily” in the “middle mile” of delivery, which includes air cargo and road haulage, on top of expanding its “last mile” network of vans and home delivery drivers.



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