Turmoil In Markets Sets Up A Flight To Quality

By Michael Msika, Bloomberg Markets Liver reporter and strategist

Markets were already being rattled by soaring bond yields and slowing economic growth, now geopolitics and an escalating conflict in the Middle East are adding to investor worries.

In this uncertain context, the quality factor as an investment style could be the best bet to protect portfolios. A good thing, then, that this pocket of the market has become much cheaper.

Quality has not been a winning strategy this year, languishing among the laggards, while buybacks and value have set the pace. But the trading tactic is back in vogue as soaring bond yields rattle markets, and it could prove a rewarding bet in a world of higher-for-longer interest rates and worries about the economic outlook. More recently, quality has been among the best performing long/short factors since the last Fed meeting.

“A macro backdrop of slowing growth and recession risk is a favorable environment for quality stocks,” say Bernstein strategists led by Sarah McCarthy, adding that valuations on shares covered by this strategy in Europe have eased versus the broader market. “The relative multiple has fallen from 1.6 times to 1.3 times. This de-rating offers a good entry point.”

It’s also an attractive wager in periods of weakness in the economy. “Historically, quality stocks have outperformed the market by 11% on average during both slowdown and recession periods,” the Bernstein strategists say. Among outperform-rated stocks that have strongly de-rated this year they cite Adyen, Hexagon, Novozymes, Roche, Diageo, Pernod Ricard and LVMH.

A Goldman Sachs basket of stocks screened for quality attributes such as stable growth, strong balance sheets and good profitability has underperformed the broader market this year, rising just 1.4%, while the Stoxx 600 is up 4.5%.

“The momentum of the quality style is set to continue,” says Oddo strategist Thomas Zlowodzki. “In a bear market, adding quality style stocks provides an alternative form of portfolio protection to traditional defensive stocks with little sensitivity to the economic cycle.”

Still, the strategist is wary about the elevated valuations of some quality and defensive shares, which could be vulnerable to rising bond yields. He recommends focusing on reasonably priced stocks like Deutsche Boerse, Scout24, Viscofan, Enagas or Merck.

A quality bias could help protect performance for pure equity investors, especially at a time when broader asset allocations are leaning toward cash, and when equities have become less attractive relative to bonds.

Meanwhile, while credit spreads remain relatively well behaved for now, higher-for-longer interest rates and a potential recession could alter that picture and stir up volatility in equities. “A quality tilt makes sense given growing credit risk,” say Barclays strategists. They note that current price swings in stocks look rather subdued relative to the bond market.

“We continue to favor high profitability, good earnings visibility and low leverage, in other words ‘quality,’” says Luca Paolini, chief strategist at Pictet Asset Management. Otherwise, global equity markets are relatively unattractive given unfavorable economic conditions, he says, maintaining a neutral rating for stocks.