This article was written by Invesco PowerShares Senior Equity Product Strategist Nick Kalivas.
The exact definition of the quality factor is debatable, as many investors measure quality in different ways. However, in constructing its S&P 500 High Quality Rankings Index, financial research company Standard and Poor’s (S&P) defines a quality company as one with a high level of stability and growth in earnings and dividends over a 10-year period. S&P’s quality ranking methodology, used since 1956, provides a strong basis for examining the quality factor.1
Since July 2014, the high-quality factor has benefited from:
- A pickup in equity market volatility.
- A strong US dollar.
- Widening of high yield spreads.
While there can be no guarantee of future results, investors may want to talk with their advisors about exploring the quality factor, given the current macroeconomic environment.
Volatility spurs investors toward quality
Historically, noticeable increases in equity market volatility have caused investors to seek quality stocks. When earnings growth — a driver of the direction of equity volatility — is falling or impaired, generally there is more risk to equity investment, and investors tend to move to seek the safety of quality stocks. The VIX, a widely used measure of market risk, has increased since the middle of July 2014, driven in part by the outlook for tighter US monetary policy and a sharp drop in energy prices.
The chart below displays the relationship between the S&P 500 High Quality Rankings Index and the S&P 500 Index (the blue line) compared to the VIX (the red line). Simply put, an increase in the blue line illustrates high-quality outperformance over the broad market, and an increase in the red line shows rising volatility. The chart illustrates that spikes in the VIX in 2011 and 2012 led to relative strength in the High Quality Rankings Index, and likewise the recent increase in volatility coincided with strength in the high-quality index.
VIX Spikes Have Historically Signaled Flight to High-Quality Stocks
Strong dollar strengthens quality stocks
In addition to the pickup in volatility, dollar strength has historically benefited high-quality stocks because of their track record of stability and growth in earnings and dividends. Between January 2014 and January 2015, the dollar rose 16.6%.2 The blue line in the chart below illustrates that high-quality stocks outperformed the broader market during this time. The strong dollar has caused some companies with international exposure to warn of weak profit growth and question earnings growth and stability, which puts a premium on the quality factor, in our view.
A Strong US Dollar Has Historically Benefited High-Quality Stocks
Since its inception in May 2010, the relative performance of the S&P 500 High Quality Ranking Index to the S&P 500 Index has shown a 0.43 correlation to the US Dollar Index (DXY). However, this correlation has jumped to 0.95 since Aug. 15, 2014.3 The dollar has been driven higher due in part to a favorable interest rate advantage. Given strong January US payroll growth and the European Central Bank’s implementation of quantitative easing, the outlook for a firm dollar is entrenched with recent signs of stronger European growth providing downside risk and the potential for a more two-way trade in the foreign exchange market.
High yield spreads drive quality
Widening high yield spreads have also played a role in driving quality. Since the Barcap U.S. Corporate High Yield to Worst ‒ 10-Year Treasury Spread Index hit a low of 222 basis points (bps) in the week ending June 20, 2014, it has widened to a recent peak of 493 bps in the week ending Dec. 12, 2014, and was still elevated 446 bps on Feb. 6, 2015.4
The relationship between high yield spreads and the quality factor, which can vary over time, is most clearly seen during periods of credit stress. To illustrate the relationship, the correlation between the Barcap index and the relative performance of the S&P 500 High Quality Index was 0.87 between June 20, 2014, and Feb 6, 2015.5 Strong January payroll growth and the 0.5% rise in average hourly earnings may put pressure on the Federal Reserve to normalize interest rates and could create some uncertainty and volatility in the high yield market as the market positions for rising short-term rates, in our view.
Macro environment puts quality factor in play
Investors tend to seek the quality factor during periods where earnings and dividends are vulnerable to weakness — as in the current environment with the recent increase in volatility, rise in the dollar and widening of credit spreads. Trends can and do change, but the quality factor could be in play for a while given today’s macro environment. Learn more about the quality factor and the PowerShares S&P 500 High Quality Portfolio (SPHQ).
1 Source: us.spindices.com/indices/strategy/sp-500-high-quality-rankings-index
2 Source: Bloomberg L.P., as of Jan. 30, 2015
3 Source: Bloomberg L.P. as of Feb 6, 2015, four-week average
4 Source: Bloomberg L.P., as of Feb. 6, 2015
5 Source: Bloomberg L.P., as of Feb. 6, 2015
Important Information
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