(from our weekly report of May 29th)

Momentum continues to carry the market. Of the main pure factors listed by Bloomberg for
the US, it is the best performing on a YTD and a one-year basis (top-left chart). At the other end
of the scale, the value factor has struggled. The rise in yields has been the major macro event
of the year. Higher yields will ultimately be problematic for equities, although the path won’t
be direct. That is, we think the US stock-bond ratio will trend down after its peak in January,
although it won’t move in a straight line.

Looking a bit deeper, it is instructive to see how equity factors have behaved in relation to yields.
We can see in the top-right chart that the 1-year correlation between value and momentum
is insignificant, almost zero. However, when we look at the correlation with the yield curve
(bottom-left chart), we see that value has a very high positive correlation to the yield curve, and
momentum a high negative correlation of almost the same magnitude. If this continues to even
partially hold, it is clear we will need to see the yield curve steepen before we see the value vs
momentum trade start to perform. As we wrote last week, the low level of fixed-income volatility,
Fed balance-sheet reduction and crowded positioning make it difficult for us to see much more
curve flattening. We add to this list the negative-carry cost of putting on curve flatteners, which
has been rising again (bottom-right chart).  (Click on image to enlarge.)

Charts showing YTD Return, Equity Factors, and the US Yield Curve