Andrew’s Angle

Navigating Contraction

Andrew Ang |Jul 15, 2020

The capacity of factor strategies appears large 

Since the onset of the COVID-19 crisis, our economy has experienced the biggest real shock since the Great Depression. It has been more than ten years since the US economy entered a recession. Now that we’ve moved from expansion to contraction, how should our portfolios be positioned, and can factors help us navigate these difficult times?

Since the onset of the COVID-19 crisis, our economy has experienced the biggest real shock since the Great Depression. It has been more than ten years since the US economy entered a recession. Now that we’ve moved from expansion to contraction, how should our portfolios be positioned, and can factors help us navigate these difficult times?

The economy has turned

In May, our economic regime indicator shifted from slowdown (where it had been since April 2018) into contraction. This signal relies on the BlackRock Investment Institute’s Growth GPS, which combines traditional economic data with new sources of information like internet searches and text mining of corporate earnings.

Our growth outlook fell sharply as the rapid spread of coronavirus drove declines in consumer and manufacturing data and increases in initial jobless claims.

BlackRock's Growth GPS for US and G7

BlackRock's Growth GPS for US and G7

Source: BlackRock Investment Institute. As of 30 June 2020. The BlackRock Growth GPS shows where the 12-month forward consensus GDP forecast may stand in three months’ time.

Using history as our guide

The current downturn is unique – we are living through a historically defining event due to the COVID-19. But, we can make observations about the performance of factors in past, through contractions and recoveries to inform our views.

The classic V-shaped recovery was 2001: the dot-com bubble burst swiftly, but with little structural damage done to economic fundamentals. The 2001 bubble was also unique because the bubble itself reflected a very large run-up in growth at the expense of value. The correction of that run-up resulted in a strong pop in value right out of the gates, and then again as the economic recovery accelerated out of contraction.

The global financial crisis of 2008, on the other hand, was marked by widespread structural challenges that spread through the real economy. It took time for markets to find bottom and for the economy to climb out of the recession. In that slow grind, quality and minimum volatility factors outperformed. Finally, in March 2009 as the rebound took hold, value staged a strong rally.

In both the 2001 and 2008 market declines, defensive factors did well entering the contraction, while pro-cyclical factors, especially value, did well coming out from the economic trough.

The comeback of value?

Value firms are often associated with large amount of fixed assets, or business models that have large economies of scale. Being very efficient at doing one thing, however, makes them inflexible. This can cause value stocks to underperform during the late stage of a business cycle—and we’d been in an extended late-stage economy entering 2020.

The performance of value was so dreadful from 2017 to the beginning of 2020 that it’s too early to call it a rebound. However, we think some of the headwinds for value have been removed and we have seen periodic rallies in value since the market bottom on March 23, 2020. Value’s performance has been inversely related—a mirror image—to the performance of momentum.

Performance of Value and Momentum indexes post-selloff

Performance of Value and Momentum indexes post-selloff

Source: BlackRock, Morningstar, MSCI as of 6/15/2020. Chart shows cumulative return of the MSCI USA Enhanced Value Index (“Value”) and MSCI USA Momentum Index (“Momentum”) in excess of the MSCI USA Index from 3/24/2020 through 6/15/2020. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

Since the market bottom on March 23, 2002, days with strong outperformance of value have been associated with improving investor sentiment toward the pace of economic recovery. The rally in value in mid-May came on the heels of positive announcements around vaccine development. Value also outperformed in early June as jobs data surprised to the upside. Our expectation is that the economy will continue to recover, which is one reason we increased exposure to value in our factor rotation models in May.

Other tilting indicators

When we consider which factors are attractive tactically, we look at several indicators to tilt around a well-diversified portfolio of style factors. Considering several predictive indicators is important because calling macro turning points is difficult. Our current environment is recent proof of that. Four of our signals are:

  1. Economic regime – Does the factor tend to do well in the current economic regime?
  2. Valuation – Is the factor rich or cheap compared to its own history and to other factors?
  3. Relative strength – Does the factor have a supportive price trend?
  4. Dispersion – How robust is the opportunity set for the factor?

Based on these characteristics in June 2020, we favor quality, minimum volatility, and value over momentum. The current economic contraction largely drives our preference for quality and minimum volatility. Value is attractive because it looks cheap relative to historical valuations. In addition, there is extreme dispersion in the valuations of cheap stocks vs. expensive stocks, meaning there is greater potential for differentiated outcomes between the two groups. In contrast, our underweight to momentum is driven not only by our contraction view on the economic cycle, but also that is relatively expensive.Looking ahead, we will continue to be impacted by the COVID-19 crisis. Our commutes, social experiences, and consumption habits have changed and will evolve further. Just as we tilt our daily lives in response to the environment around us, we will also continue to shift our portfolios.

Andrew Ang
Andrew Ang
Head of Factor Investing Strategies
Andrew Ang, PhD, Managing Director, coordinates BlackRock’s efforts in factor investing. He leads BlackRock’s Factor-Based Strategies Group which manages macro and style ...
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