The road ahead for US equities is going to be bumpy. While the market volatility continues to pose a threat to US equities, the JPMorgan US Quality Factor ETF has proven to be exceptionally resilient during such turbulent times.
- iFAST Research Team | Published on 07 Jun 2022
• Having an exposure to quality can help navigate ongoing market turbulence, as US equities are increasingly challenged by a mix of growth, earnings, and policy headwinds in the late phase of the economic cycle.
• The flight-to-quality has started in the US and we expect it to continue. High-quality companies have stronger fundamentals, are less volatile, and tend to hold up well during periods of economic and market uncertainty.
• For exposure to US Quality, we recommend the JPMorgan US Quality Factor ETF (NYSE:JQUA). It has not only demonstrated resiliency in times of market weakness but is also less volatile relative to the broader US equity market.
Factor investing is a strategy of selecting assets based on characteristics linked to greater returns. It is designed to enhance diversification, generate above-market returns and manage risks. There are primarily six common equity factors: Value, Low Size, Low Volatility, High Yield, Quality, and Momentum (Table 1).
The quality factor is a widely used investing style, especially during periods of market volatility. It is defined as buying companies with strong and durable long-term earnings prospects and competitive advantages. Quality can also be classified as “defensive”, given that it is typically more resilient during times of market turmoil, especially in the late phase of the economic cycle.
That said, the quality factor has shown strong performance over the long-term as well, and its outperformance is not limited to volatile periods. The US market is one such example. As shown in Chart 1, US Quality has exhibited stronger long-term performance against the broader US equity market, having returned 94% (in USD terms) over the past five years (since 2017) as compared to the MSCI USA which has returned a total of 71% over the same tenure (as of 31 May).
As US equities enter the late phase of the economic cycle, we believe having an exposure to quality can help investors navigate the current market turbulence. In this article, we outline the reasons why, and highlight our recommended product for an exposure to US Quality.
Table 1: Well-Known Systematic Factors from Academic Research
Systematic Factors | What It is | Commonly Captured by |
Value | Captures excess returns to stocks that have low prices relative to their fundamental value | Price to book, price to earnings, book value, sales, earnings, cash earnings, net profit, dividends, cash flow |
Low Size (Small Cap) | Captures excess returns of smaller firms (by market capitalization) relative to their larger counterparts | Market capitalization (full or free float) |
Momentum | Reflects excess returns to stocks with stronger past performance | Relative returns (3-mth, 6-mth, 12-mth), historical alpha |
Low Volatility | Captures excess returns to stocks with lower than average volatility, beta, and/or idiosyncratic risk | Standard deviation (1-yr, 2-yrs, 3-yrs), downside deviation, standard deviation of idiosyncratic returns, Beta |
Dividend Yield | Captures excess returns to stocks that have higher-than-average dividend yields | Dividend yield |
Quality | Captures excess returns to stocks that are characterized by low debt, stable earnings growth, and other “quality” metrics | ROE, earnings stability, dividend growth stability, strength of balance sheet, financial leverage, accounting policies, strength of management, accruals, cash flows |
Source: MSCI Research Insight: Foundations of Factor Investing, iFAST Compilations |
Chart 1: Long-term performance of US Quality and the broad US equity market
Bumpy road ahead for US equities
Moving ahead, we expect US equities to be increasingly challenged by a mix of growth, earnings and policy headwinds. First, an aggressive Federal Reserve leads to a heightened probability of a policy misstep. The inflationary pressures generated from the Russia-Ukraine war and China’s regional lockdown has forced the Fed to adopt a more aggressive stance. This raises the risk of US economic growth falling off a cliff if policy rates rises too much above restrictive territories (above terminal rates of 2.5% – 3%) to curb inflation.
Second, the US economic growth has already started to moderate and will likely soften further. As seen in Chart 2, the ISM Manufacturing and Services Index, which is considered a key indicator of the economic state of the US economy, has been declining. Mounting inflationary pressure and tighter financial conditions are weighing on US macro growth. Macro data such as US PMI and consumer confidence indicators are signaling softening growth while labour market data such as wages and jobs growth are also beginning to slow. We expect US growth momentum to slow further, with the further tightening in financial conditions and a gradual softening in consumer demand.
Third, US corporates are increasingly facing profit headwinds and earnings outlook is getting challenging. During the recent US earnings season, many companies have cited greater pressure on margins due to higher material and labour costs. Softening consumer demand is also a rising concern for companies as there has been a significant jump in the mention of ‘weak/ lower/moderating demand’ in the latest earnings season. More recently, tech companies have begun to hit the brakes on hiring, implying an expectation of a slowing economic outlook. From the bottom-up, there are multiple signals of a potential deterioration in the US corporate earnings outlook. Despite these signals, EPS estimates remain optimistic in our view, setting up some room for risks of earnings downgrades.
Chart 2: ISM Manufacturing and Services Index has declined, but remained in expansionary territory
The flight to quality has started
Recognising the above risks and challenges, investors have started to seek out high-quality companies in the US for their resiliency in times of an economic slowdown. As seen from Chart 3, earnings for high-quality US companies (gauged by the MSCI US Quality index) tend to moderate at a lesser magnitude (relative to the MSCI USA index) during periods of slowing economic growth – denoted by falling ISM Manufacturing and Services Index data.
Furthermore, earnings growth for these high-quality companies, on a year-on-year basis, tends to remain positive for longer, even during periods of economic malaise. In terms of earnings revision, high-quality US companies tend to face less drastic negative EPS revisions during times of economic weakness.
We also expect high-quality companies to be more resilient amidst the current backdrop of elevated inflation. These companies tend to maintain stable revenue growth trends throughout the economic cycle, and robust balance sheet strengths relative to industry peers. As a result, they are better-placed to withstand the impact of higher input costs without experiencing a drastic fall in earnings. Moreover, many of these companies possess the pricing power to pass higher input costs to the consumer without a substantial loss in demand (due to factors like demand inelasticity, brand power, and industry dominance), which better protects their margins.
Chart 3: Earnings growth of high quality US companies hold up well during periods of economic weakness
Ride on the flight to quality
Looking ahead, we expect the flight to quality to continue and the JPMorgan US Quality Factor ETF is our preferred ETF. It is based on the JPMorgan US Quality Factor Index which is made up of US securities chosen from the Russell 1000 Index. The index employs a rules-based risk allocation and factor selection process. It screens and selects constituents based on three fundamental metrics – profitability, quality of earnings, and solvency – which are combined into a factor score to determine which securities will be included and their corresponding weights.
In terms of sector exposure, the ETF has a large allocation to high-quality companies in the IT sector (27% of the index), followed by the Consumer Discretionary sector (15%). Healthcare (14%), Industrials (13%), and Financials sectors (11%) make up the next three largest sectoral allocations. Exposure to the remaining sectors is around 5% or below (Table 3).
Table 2: Top 10 Holdings of SPHQ
Sr. No. | Holding Name | Net Assets (%) |
1 | META PLATFORMS INC | 2.10% |
2 | APPLE INC COMMON STOCK | 2.00% |
3 | VISA INC COMMON STOCK | 1.90% |
4 | BERKSHIRE HATHAWAY INC | 1.90% |
5 | JOHNSON & COMMON | 1.90% |
6 | PROCTER & GAMBLE CO/THE | 1.90% |
7 | MICROSOFT CORP COMMON | 1.90% |
8 | ALPHABET INC COMMON | 1.80% |
9 | MASTERCARD INC COMMON | 1.70% |
10 | HOME DEPOT INC/THE | 1.60% |
Source: JPMorgan U.S. Quality Factor ETF FactSheet, iFAST Compilations | ||
Data as of 30 April 2022 |
Table 3: Industry Breakdown & Number of Holdings of JPMorgan U.S. Quality Factor ETF vs the Russell 1000 (Index)
Sector Name | JPMorgan U.S. Quality Factor ETF | Russell 1000 Index (Benchmark) |
Technology | 27.0% | 25.0% |
Consumer Discretionary | 15.1% | 11.2% |
Health Care | 13.5% | 13.9% |
Industrials | 12.9% | 8.6% |
Financials | 10.9% | 13.3% |
Consumer Staples | 5.7% | 7.0% |
Energy | 4.1% | 4.1% |
Real Estate | 3.5% | 3.6% |
Utilities | 3.0% | 2.4% |
Telecommunications | 2.6% | 8.3% |
Basic Materials | 1.7% | 2.2% |
Number of Holdings | 262 | 1012 |
Source: JPMorgan U.S. Quality Factor ETF FactSheet, iFAST Compilations | ||
Data as of 30 April 2022 |
Resilient in times of economic weakness and uncertainty
As seen in Chart 4 , the JPMorgan US Quality Factor Index (the index was used instead of the ETF due to the availability of data) has held up better than the Russell 1000 index during periods of market weakness (defined as US business cycle peak-to-trough by the US National Bureau of Economic Research). The JPMorgan US Quality Factor Index outperformed during the 2001 and 2008 US recession where it returned -3% and -29% (in USD terms) respectively. This surpasses the Russell 1000 index’s return of -9% and -37% in 2001 and 2008 respectively.
The JPMorgan US Quality Factor Index has also managed to outperform its peers and the Russell 1000 index year-to-date (Chart 5). Despite the heightened volatility and market carnage, the ETF was only down by -4% (in USD terms) in the year-to-date (as of 31 May). We believe the ETF’s resilient performance during periods of market weakness can be attributed to its defensive characteristics, which arise from its selection of high-quality companies.
The index is also less volatile as compared to the broad US equity market. As seen from chart 6, its annualised volatility over the past year (0.16) was lower than that of the Russell 1000. This is an attribute that is fairly consistent over time as the index shows consistently lower annualised volatilities across various time horizons, from a one to 10-year period.
The ETF’s defensive nature can also be observed by comparing the JPMorgan US Quality Factor Index’s maximum drawdowns relative to the broad US equity market. As highlighted in Chart 7, over the past one, three, and five years, the index has recorded a smaller maximum drawdown. This is also consistent during recessionary periods as seen in 2001, 2007, and 2020, where the JPMorgan US Quality Factor Index saw maximum drawdowns between -22% to -46%. On the other hand, the Russell 1000 index witnessed maximum drawdowns between -26% to -53%.
Chart 4: Price Performance of the JP Morgan US Quality Factor Index vs the Russell 1000 during prior economic slowdowns (Indexed to 100)
Chart 5: Price Performance of the JPMorgan US Quality Factor Index vs the Russell 1000 during the current stock market decline (Indexed to 100)
Chart 6: Annual Volatility of the JPMorgan US Quality Factor Index vs the Russell 1000 Index
Chart 7: Max Drawdown of the JPMorgan US Quality Factor Index vs the Russell 1000 Index
Concluding thoughts
The road ahead for US equities will be a bumpy one and fault lines are emerging. As the US economic cycle matures, macro growth and corporate profit have started to soften. Combined with the ongoing monetary tightening and a drawdown in market liquidity, US equities will likely face greater uncertainties and volatility.
In a tumultuous market, we believe a focus on the Quality attribute can help investors shelter from the storm as high-quality businesses have proven to be remarkably resilient during such periods. We recommend the JPMorgan US Quality Factor ETF (NYSE:JQUA) for exposure to US Quality.