Ahead of the curve: Drivers of policy change | Characteristics


The evacuation of US and coalition troops and civilians from Afghanistan and the Taliban takeover in August prompted us to examine other episodes of regime change and the reaction of the stock markets.

The markets follow and react to what dominates the news. The withdrawal from Afghanistan, which began in February 2020 and ended on August 30, 2021, has gained global media attention. She has also influenced asset allocation decisions for retail and institutional investors.

We looked at the lessons of three major regime changes over 30 years: the collapse of the Soviet Union, the war in Kosovo and the Arab Spring.

We found that during the transition of power over a period of six to 19 months:

• Defensive stocks, in particular the quality sub-factor (high gross profits relative to assets) tend to outperform;
• Risky stocks, especially small caps and high volatility, underperform;
• US and European investors take a risk-free approach during times of global political turmoil.

The periods included the six months from August 1991 to January 1992 during the collapse of the Soviet Union; the 14 months from May 1998 to June 1999 during the Kosovo war, and the 19 months from January 2011 to July 2012 during the Arab Spring.

In the US and Europe, high gross earnings on assets (the sub-factor of quality as defined above) stood out with outperformance, and high volatility and small cap with underperformance. Figure 1 shows the average monthly returns during these periods, relative to the overall market.

During these periods, several quality sub-factors performed well. In the United States, the average monthly yield to quality was 22bp. In Europe it was 13 basis points. For volatility, the average monthly return in the US was -13bp and -2bp in Europe. During the Kosovo War, high volatility stocks first lost ground and then rallied. If the Kosovo war is ignored, high volatility European stocks lost around 25 basis points per month during the collapse of the USSR and the Arab Spring. For small caps, average monthly returns in the US fell by 18bp and Europe by 20bp.

However, the most notable measure was the high gross profits on assets, which consistently generate above-market returns over long periods of time. The underperformance of high-volatility and small-cap stocks during these times is understandable: Investors move away from higher-risk investments during times of uncertainty. UPS and SAP are examples of high-quality stocks, while the ranks of low-volatility large-cap stocks include Nestle and Microsoft. Airbus and Disney are examples of stocks with high volatility.

Figure 2 shows how each of these sub-factors behaved during each of the time periods we looked at.

When it comes to emerging markets, we should not expect them to react in the same way as the American and European markets. The performance of factors in emerging markets differs from their US and European counterparts almost 90% of the time.

What about value and growth?
We can expect quality stocks to outperform over the long term, but when it comes to value and growth, the story is more mixed. A regime change or power shift does not result in a noticeable outperformance relative to value or growth. However, the rising interest rate environment we find ourselves in is having an impact.

Rising interest rates have traditionally given value stocks a boost, but our research has found that value will only outperform in the long run if rates rise fast enough. In the United States this means the 10-year rate increases by more than 5% in a month and in the United Kingdom the minimum rate is around 20%. Rising interest rates will also contribute to a growing risk aversion mentality, which will boost larger cap stocks. Likewise, small cap stocks, which often carry more risk for investors, are likely to underperform.

Performance factor Q3
In terms of timing, over the periods considered, it took several months for these impacts to materialize. This means that it is still too early to say how the withdrawal from Afghanistan will unfold. We tracked factor performance during the third quarter of 2021, which coincided with the withdrawal process and the first weeks of Taliban control.

In the US, high-quality, large-cap, low-volatility stocks outperformed. This indicates a continued preference for defensive stocks. Momentum stocks also outperformed during the quarter. Recently, these stocks have been linked more to quality stocks than to value or growth, as quality stocks have had a more consistent positive performance (momentum) than value and growth which has continued to go and come.

Impact of regime change on US markets

Throughout the quarter, the value / growth shift continued. The value was comparable to the market in July, lost in August and gained in September. Growth was comparable to that of the market in July, advanced in August and was mixed in September. Quality posted mixed performance in September, but we expect improvement in the coming months.

In Europe, stability-quality measures outperformed while earnings quality and leverage measures underperformed or followed the market. The value was down and growth was up until September when the value outperformed and the growth lagged the market by about 70 basis points (except for the expected growth, which outperformed by 70 basis points in September). UK interest rates rose for the quarter, but especially in September when they fell from 0.6% to 1%. This increase is consistent with the outperformance of the stock in September. As in the United States, the outperformance of stock was not enough to turn the entire quarter in favor of stock.

As of this writing, the political situation is still volatile and the humanitarian crisis in Afghanistan is worsening. In response to such geopolitical conditions, investors in Europe and the United States tend to become more risk averse. Other headwinds are also at play, such as the specter of rising interest rates. Longer term, it would not be surprising to see such defensive investment choices, supporting quality and suppressing risk decisions. When it comes to value and growth, interest rates will decide.

Damian Handzy is Head of Research and Applied Analysis at Investment Metrics and James Monroe is Senior Consultant


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