A new year is right around the corner and with that will come ample speculation about which factors will serve clients well. While there's sure to be more growth vs. value debate, advisors can simplify things and eschew factor timing by considering quality.
Yes, quality is like any of the other major investment factors in that there are times when it excels and periods when it lags. However, quality's laggard days usually aren't severe. If anything, those stretches open the door to rare valuation opportunities in a style that often commands premium multiples. Additionally, periods of quality under-performance are often subdued and contained.
That's something for advisors to consider ahead of 2022 – a year that could be minefield for investors. While bonds are primed to vex again, the sledding may not be much easier with equities, highlighting the virtues of quality allocations.
“Will U.S. stock indices begin to reflect more of that weakness in 2022? It’s possible, especially as the world’s major central banks begin to drain the liquidity that has supported financial markets since the start of the COVID-19 pandemic in March 2020. But major uncertainties remain, including the pace of inflation, how central banks will react to it, and the direction of the virus,” according to the Schwab Center for Financial Research.
Quality Could Shine in 2022
Frame of mind and perspective are integral in conveying quality to clients. If nothing else, it's likely the investment style they're least familiar, but also arguably the one with the most benefits.
“Of course, no factor strategy is perfect and outperforms every day and in all market environments. Quality stands out among all factors because its periods of underperformance are relatively easy to identify and because this underperformance tends to remain pretty contained. Most factors can post double-digit underperformance in a short period of time, which has been less the case historically for quality,” writes Pierre Debru, head of quantitative research and multi-asset solutions at WisdomTree Europe.
As has been previously noted in this space, factor timing is a real pain in the you-know-what. That said, there are times when some factors work better than others. Assuming some of the market prognostications for 2022 prove accurate, next has all the makings of a winning climate for quality.
“Following a recession and a market drawdown, fiscal and monetary policy end up pretty loose, and liquidity flows to all corners of the economy,” adds Debru. “This pushes the prices of all companies up, in particular those of the companies that suffered the most in the crisis. This phenomenon usually leads to a low-quality rally at the beginning of the expansion cycle. However, at some point, central banks turn hawkish, liquidity dries up, volatility starts to reappear and investors start to get pickier when it comes to their investment.”
Translation: As the cycle evolves and growth slows, investors often turn away from some of the junkier, riskier names that led the post-recession rally and embrace quality stocks.
History Could Repeat
Remembering the old market maxim “history doesn't always repeat, but it often rhymes”, quality is worth considering in 2022 because...
“The latest two years fit that pattern to a T. Quality performed very strongly at the end of the previous cycle, i.e., in 2019 and in the early part of the COVID-19 crisis in early 2020,” concludes Debru. “Since the election of President Biden and the rollout of the vaccine, the low-quality rally has kicked into gear, and high-quality stocks have taken a bit of a back seat to the rest of the market. However, as we approach the first anniversary of the Biden presidency, and with the Fed starting to taper and hinting at a more hawkish stand, it appears that the early recovery phase may be ending, especially in the U.S.”
The point: 2022 could be tricky. Advisors can assuage skittish clients with quality.
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