One Step Ahead: 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 stock markets.
Markets follow and react to what dominates the news. The withdrawal from Afghanistan, which began in February 2020 and ended on August 30, 2021, attracted media attention around the world. It has also influenced the asset allocation decisions of retail and institutional investors.
We looked at the lessons of three major regime changes in 30 years: the collapse of the Soviet Union, the Kosovo war and the Arab Spring.
We found that during the transition of power over a period of six to 19 months:
• Defensive stocks, especially the quality sub-factor (high gross earnings relative to assets) tend to outperform;
• Risky stocks, especially small caps and high volatility, underperform;
• US and European investors favor risk aversion during periods of global political turbulence.
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 quality sub-factor as defined above) stood out for outperformance, and high volatility and small cap for underperformance. Figure 1 shows the average monthly returns over these periods, relative to the broader market.
During these periods, several quality sub-factors performed well. In the United States, the average monthly return on quality was 22 basis points. In Europe, it was 13 basis points. For volatility, the average monthly return in the US was -13 basis points and in Europe -2 basis points. High volatility stocks during the Kosovo war 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. In small caps, average monthly yields in the United States fell by 18 basis points and those in Europe by 20 basis points.
However, the most notable metric was the high gross earnings on the assets, which consistently generate above-market returns over long periods of time. The underperformance of high-volatility, small-cap stocks during these times is understandable: investors shy away from high-risk investments during times of uncertainty. UPS and SAP are examples of high-quality stocks, while low-volatility large-cap stock ranks include Nestlé and Microsoft. Airbus and Disney are examples of high volatility stocks.
Figure 2 shows how each of these sub-factors fared throughout each of the time periods we examined.
As far as emerging markets are concerned, they should not be expected to react in the same way as the American and European markets. The performance of emerging market factors differs from that of 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 change of regime or a transition of power does not lead to a significant outperformance of value or growth. However, the rising interest rate environment we find ourselves in is having an impact.
Rising interest rates have traditionally boosted value stocks, but our research found that value will only outperform over the long term if rates rise fast enough. In the US, this means that the 10-year rate increases by more than 5% in a month and in the UK, the minimum rate is around 20%. Rising interest rates will also contribute to a growing risk mentality, which will boost larger cap stocks. Likewise, small-cap stocks, which often carry more risk for investors, will likely underperform.
Performance of the Q3 factor
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.
The United States saw an outperformance of quality, large-cap and low-volatility stocks. This indicates a continued preference for defensive stocks. Dynamic stocks also outperformed during the quarter. Recently, these stocks have been linked to quality stocks more than value or growth, since quality stocks have had a more consistent positive performance (momentum) than value and growth which has continued to go and come.
Throughout the quarter, the value/growth swing continued. Value was market-like in July, lost in August and gained in September. Growth was market-like in July, picked up in August and was mixed in September. Quality performed mixed in September, but we expect improvement in the coming months.
In Europe, stability and quality metrics outperformed while earnings and leverage quality metrics either underperformed or tracked the market. Value was down and growth was up until September, when value outperformed and growth lagged the market by about 70 basis points (excluding forecast growth, which outperformed by 70 basis points in September). UK interest rates rose over the quarter, but especially in September when they rose from 0.6% to 1%. This increase is consistent with the stock’s outperformance in September. As in the United States, the outperformance of the value was not sufficient to turn the whole quarter in favor of the value.
At the time of writing, the political situation is still unstable and the humanitarian crisis in Afghanistan is deteriorating. 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 similar defensive investment choices, supporting quality and suppressing risky decisions. When it comes to value and growth, interest rates will decide.
Damian Handzy is Head of Research and Applied Analytics at Investment Metrics and James Monroe is Senior Consultant