Examining Factor Performance Against Weakness In The Chinese Yuan by Nick Kalivas, Invesco
Low volatility, quality outperformed when yuan under pressure
China has dominated market headlines early in the new year, with weakness in the Chinese yuan – also known as the renminbi – unnervering investors and leading to a sharp sell-off in US equities. The Chinese economy can often be difficult to gauge, and the country’s stock market is inherently unstable. Economic news is generally opaque and the Chinese government actively intervenes in the markets – making investing in China often feel like a roll of the dice. There doesn’t even have to be a direct link between the equity market and the economy. After all, stocks aren’t gross domestic product futures.
China hurt by capital outflows
One of the factors pressuring the yuan is the outflow of capital from China. The chart below displays estimated capital flows relative to the offshore yuan/US dollar rate (CNH/USD). The current rate is inverted to show how the yuan tends to weaken when capital is flowing out of China and strengthens when capital net inflows are positive.
Although the yuan has fallen sharply in the early days of 2016 – off 13.81% through Jan. 12 – the economy is giving mixed signals.1 Consider how the following indexes performed in December:
- The Caixin China General Manufacturing PMI – a broad indicator of economic health –showed weakness in the manufacturing (-0.4 to 48.2) and service (-1.0 to 50.2) sectors.1
- Baidu – China’s most-used search engine – reported that online interest in small- and medium-sized enterprises increased, as indicated by the Baidu Index, which rose from 1 to 100. 1
- The China Logistics Prosperity Index rose 0.8 to 55.0 – indicating that logistics activities have increased. 1
- The Westpac MNI China Consumer Sentiment Indicator rose 0.6% to 113.7. 1
Is debt the real problem?
I believe the bearish tone of the Chinese market is largely a reflection of both capital outflows and a significant debt bubble. It’s difficult to get a grip on the mountain of Chinese debt and its impact on the economy, but press stories have highlighted the potential economic stress resulting from high debt. The Wall Street Journal recently covered the surge in new government and corporate bond issuance in China and sinking profits at state-owned companies. An analyst interviewed as part of the story suggested that bad loans in the most distressed sectors of the economy could lead to $151.7 billion in bad loans and cause 1.7 million workers to lose their jobs.2
China’s debt load appears to be something that could stunt Chinese growth in the coming years. For some, the debt situation in China may even recall bad memories of the Japanese economic bubble bursting in the early 1990s, or the US mortgage and financial crisis of 2008.
Factor performance during yuan weakness
Given lingering risks from China, it might be worth examining factor performance during periods of yuan weakness. It is hard to isolate market events, but the yuan appeared to weaken at three distinct times over the past few years:
1) Jan. 17, 2014, to Jan. 8, 2016 – a relative low in the USD/CNH exchange rate and the start of a yuan weakening trend1
2) Oct. 14, 2015, to Jan. 8, 2016 – a period that saw a meaningful, but not dramatic, drop in the value of the yuan1
3) Aug. 12, 2015, to Jan. 8, 2016 – a period covering several devaluations in the yuan1
The tables below displays the following factor returns during these periods of yuan weakness:
- The low volatility factor, as represented by the S&P 500 Low Volatility Index;
- The quality factor, as represented by the S&P 500 High Quality Ranking Index;
- The value factor, as represented by the Dynamic Large Cap Value Intellidex Index and FTSE RAFI US 1000 Index;
- The momentum factor, as represented by the Dorsey Wright Technical Leaders Index, and;
- The small-cap momentum factor, as represented by the Dorsey Wright SmallCap Technical Leaders Index
The change in the USD/CNH exchange rate is also provided in the tables below. The second table highlights excess returns –factor returns in excess of those generated by the S&P 500 Index.
As you can see below, the best-performing factors during periods of weakness in the yuan were low volatility and quality. Across the three periods, there was excess return above the S&P 500 Index for each of these factors, which was strongest when the yuan was weakening.
By contrast, small-cap momentum was the worst-performing factor. It declined in each period and dramatically across the entire timeframe. The value and momentum factors delivered mixed results. Value lagged momentum early in the in the period of yuan weakness, but improved more recently. Value was pressured by cyclical weakness from a weaker Chinese economy and profit pressures from a weaker yuan. Momentum faced headwinds from a risk-on/risk-off market, which was focused more on broad macro themes than individual company fundamentals.
These results are not entirely surprising, given that the low volatility and quality factors are generally expected to provide a smoother ride during periods of market stress, while potentially offering partial participation in rising markets. The fallout from the Chinese yuan crisis has allowed investors to examine the performance of investment factors in a new light. When analyzed against periods of weakness in the Chinese yuan, low volatility and quality emerge the clear winners. Investors interested in gaining access to the low volatility and quality factors may wish to consider the S&P 500 Low Volatility Portfolio (SPLV), the S&P 500 High Quality Portfolio (SPHQ), or both.
1 Source: Bloomberg L.P., Jan. 12, 2016
2 Source: The Wall Street Journal, Jan. 8, 2016
Important information
A factor is an objective style determinate used within an index to achieve mutually exclusive security selection.
Volatility measures the amount of fluctuation in the price of a security or portfolio.
Low volatility factor: Utilizes volatility rankings while seeking to minimize the effects of market fluctuations. Volatility is a statistical measurement of the magnitude of up and down asset price fluctuations over time. There is no guarantee that low-volatility stocks will provide low volatility.
Value factor: Aggregates stocks that are trading at less than their intrinsic values – usually identified by lower-than-average price-to-book or price-to-earnings ratios, and/or high dividend yields.
Momentum factor: Ranks securities relative to peers, utilizing relative strength methodology to identify the strongest and weakest investment trends. The momentum style of investing is subject to the risk that the securities may be more volatile than the market as a whole, or that the returns on securities that have previously exhibited price momentum are less than returns on other styles of investing.
Small-cap momentum factor: Ranks small-cap securities relative to peers, utilizing relative strength methodology to identify the strongest and weakest investment trends. The small-cap momentum style of investing is subject to the risk that the securities may be more volatile than the market as a whole, or that the returns on securities that have previously exhibited price momentum are less than returns on other styles of investing.
Quality/high quality factor: a ranking that reflects the long-term growth and stability of a company’s earnings and dividends. Focuses on companies that have a Standard & Poor’s quality ranking of A- or above that have historically exhibited higher Sharpe ratios and lower volatility.
The FTSE RAFI US 1000 Index is designed to track the performance of the largest US equities selected based on four fundamental measures of firm size: book value, cash flow, sales and dividends.
The S&P 500® Low Volatility Index consists of the 100 stocks from the S&P 500® Index with the lowest realized volatility over the past 12 months.
The S&P 500® High Quality Rankings Index is designed to provide exposure to the constituents of the S&P 500 Index that are identified as stocks reflecting long-term growth and stability of a company’s earnings and dividends.
The Baidu Index is used for keywords research and monitoring search trends in China.
The China Logistics Prosperity Index is produced by the China Federation of Logistics & Purchasing and gauges demand for logistic services in China.
The Westpac MNI China Consumer Sentiment Indicator tracks large consumer consumption patterns in China, with more than 100,000 data points — including housing, durable goods and savings and investment.
The Dynamic Large Cap Value IntellidexSM Index is designed to provide capital appreciation while maintaining consistent stylistically accurate exposure. The Style Intellidexes apply a rigorous 10 factor style isolation process to objectively segregate companies into their appropriate investment style and size universe.
The Dorsey Wright SmallCap Technical Leaders™ Index includes securities pursuant to a Dorsey, Wright & Associates, LLC proprietary selection methodology that is designed to identify companies that demonstrate powerful relative strength characteristics. Approximately 200 companies are selected for inclusion from a small-cap universe of approximately 2,000 of the smallest US companies selected from a broader set of 3,000 companies.
The Dorsey Wright Technical LeadersTM Index includes approximately 100 US companies from a broad mid- and large-capitalization universe. The Index is constructed pursuant to Dorsey, Wright & Associates, LLC’s proprietary methodology, which takes into account, among other factors, the performance of each of the approximately 1,000 largest companies in the eligible universe as compared to a benchmark index, and the relative performance of industry sectors and sub-sectors.
There are risks involved with investing in ETFs, including possible loss of money. Shares are not actively managed and are subject to risks similar to those of stocks, including those regarding short selling and margin maintenance requirements. Ordinary brokerage commissions apply. The Fund’s return may not match the return of the Underlying Index. The Fund is subject to certain other risks. Please see the current prospectus for more information regarding the risk associated with an investment in the Fund.
Investments focused in a particular industry or sector, such as the industrials sector are subject to greater risk, and are more greatly impacted by market volatility, than more diversified investments.
SPLV: There is no assurance that the Fund will provide low volatility.
