Monetary Policy Setting Stage for Stock Market Growth-to-Value Rotation?
Federal Reserve and other major central bank stimulus should benefit high-quality value stocks and foster inflation’s “green shoots” as the global economy emerges from recession.
After several head-fakes in recent years, the market is once again abuzz about a potential rotation from growth to value equities globally. Since mid-2011, the MSCI ACWI Growth Index has trounced the MSCI ACWI Value Index, with the performance deviation between the two hitting historic highs, while valuation differentials have also rarely been wider.
Perhaps the rubber band has become so tightly wound that it is value’s turn to spring past growth. But all the speculation about shifting style factor currents misses a few bigger structural points on sound portfolio allocation and wealth creation. As Thornburg Chief Investment Strategist and Portfolio Manager Brian McMahon points out: “Money is made over time in markets, not in trying to time them.” That suggests investors are best served in the long run by maintaining sensibly sized core allocations to both high-quality, dividend-paying value stocks and to select growth stocks with accelerating, long-term, structural earnings drivers.
Periodic rebalancing between growth and value makes good financial sense, but not necessarily on a calendar basis nor in wholesale fashion. Just as wise portfolio managers trim positions deemed to be fully valued and prudently re-purpose the proceeds in others with greater upside potential, investors should consider doing the same within their broader portfolio allocations.
It wouldn’t be a bad time to harvest some gains from growth stocks and move them into value, for several reasons. The most obvious is a margin of safety favoring stocks trading at depressed valuations, rather than at a premium. After a decade-long run that has put the ACWI Growth Index’s annualized return at 13%, towering over the ACWI Value Index’s 6.8% advance, there’s plenty of room for the global benchmark’s value wing to ascend and the high-flying growth component to take a breather, as historical mean reversion would suggest. The ACWI Value Index’s price differential relative to its ACWI Growth counterpart has rarely, if ever, been greater.
Where’s the Margin of Safety?
And the price per unit of earnings of the ACWI Growth Index is now double the P/E of the ACWI Value Index, up from a 36% premium five years ago.
Paying Up for Growth
Value/Growth Mean Reversion as the Economic Cycle Turns
To be sure, mean reversion isn’t necessarily an historical imperative, given secular changes that growth companies pursue with evolving technologies, changing consumer tastes and even at times government regulation and incentives (think renewable energy or a trendy electric vehicle.) “These are often good and reasonable stories,” says Thornburg President and CEO Jason Brady. “But every bubble and crazy valuation always starts with a great story. The 2000 Tech Bubble wasn’t wrong. It was good story extended to ridiculousness.”
Mean reversion between growth and value equity leadership often reflects the economic cycle. Historically, value stocks have tended to outperform growth stocks in the recovery phase, only to lag growth after the economy has again hit its stride. Typically, during an economic shock, investors flee risk assets for safe havens—high-quality sovereign debt, largely but not only, U.S. Treasuries. The dollar strengthens and the price of gold rises. Central bankers then slash key interest rates and ramp their asset purchases, driving down returns on “risk-free” assets, which nowadays yield next to nothing or less than zero.
That prods investors out on the risk spectrum amid still depressed economic growth and inflation expectations. But markets are forward looking, so risk assets recover faster than employment and the wider economy. That accounts for all the headlines about a “disconnect” between high equity prices and a still ailing economy, which central bankers prioritize by continuing to juice risk asset prices. And that, in turn, is why risk asset prices become inflated relative to broader economic fundamentals. As the economy stabilizes, the monetary medics proceed to “prick” the growing financial bubbles with a new tightening cycle. Before long financial conditions tighten, market volatility ensues, the economy slows or sometimes falls into recession. The stage for value’s periodic reemergence over growth is again set.
This historical pattern may well explain why, after the last three recessions, the U.S. equity value benchmark outperformed its growth counterpart in the first half of the 1990s, the mid-aughts and for a few years following the Great Recession, when the ACWI Value Index also beat the ACWI Growth Index over the same relatively brief period.
The Elasticity of GDP Relative to the Price of Money
Over the last decade, conventional consumer price measurements rarely rose to the target level across the developed world, allowing major central banks to keep the stimulus spigots mostly open. Since the pandemic hit, they have flooded markets with aggressive debt monetization. The U.S. Federal Reserve, for example, has inflated its balance sheet by roughly $3 trillion to just more than $7 trillion, a 70% increase in just seven months.
Inflation’s Green Shoots?
Value stocks are conventionally understood to populate cyclical sectors such as industrials, financials, materials and energy, which tend to break out early in reflationary environments. All the monetary and fiscal stimulus should support economic recovery and shore up personal incomes until a vaccine and effective therapeutics are developed and broadly distributed. At that point, pent-up consumer demand should spike, shrinking the large output gap from the virus-induced demand shock.
Fueled by the stimulus gusher, accelerating inflation could accompany the economic rebound. In addition to surging demand, inflationary pressures will likely come from costly supply chain realignments, especially in strategic sectors such as health care and telecommunications, not to mention growing protectionism and deglobalization more generally. The dollar also tends to weaken when inflation picks up, a trend that’s already reflected in rising commodities prices, from energy to base and precious metals, to agricultural products. The U.S. Dollar Index has dropped 9% from its March peak.
Inflation is also being flagged in U.S. dollar five-year five-year (5y5y) forward inflation swap rates, which reflect expectations for inflation five years from now. The measure has climbed 60% to 1.94% from its March low of 1.22%. Even the 5y5y euro inflation swap rate has jumped 66% to 1.19% from 0.72% over the same period.
Maybe the market’s starting to sniff out the opportunity, because once inflation gets a little too hot for monetary authorities’ comfort, rising rates become supportive of value and less so for growth. The ACWI Value Index gained 4% over the first couple weeks of August versus the ACWI Growth Index’s 2.5% total return, although the global growth equity benchmark caught up with its value counterpart over the following week. The movements were largely mirrored in the U.S. blue-chip value and growth segments.
Different Breeds of Value
Unlike growth companies, earnings of which are usually expected to grow on average faster than the broader market’s aggregate rate, value can generally mean different things to different people. Many see value plays as highly leveraged, economically sensitive stocks trading at cheap valuations, which may simply reflect weaker business fundamentals. These types of stocks, which can see big jumps in returns when the economic cycle turns, have been out of favor for a decade.
Yet high-quality value stocks, which tend to have solid balance sheets, a record of strong resource allocation and more resilient free cash flow generation, have also been out of favor. Perhaps that’s due to their economic sensitivity: top-notch global banks in a low-rate world, or energy supermajors struggling against lackluster global growth and ample energy supply. Or because of their capex-intensive businesses: take telecoms, which many investors spurn–even those delivering a decent return on investment, i.e., above their cost of capital–even when revenues are booming.
A Good Hedge in Inefficient Markets
The market is often far from rational in recognizing the merits and return prospects of high-quality value, which boasts both the ability and willingness to pay dividends, when regulators allow. They pay their investors along the way, unlike most growth stocks, which have a terminal value. The through-cycle payment of dividends is historically helpful for total return. But it’s especially nice for income-focused investors, who can consider quality value a good bond hedge, particularly at a time when dividend yields are generally far greater than bond yields from the same corporate issuer. The aberration isn’t that surprising, given market inefficiency.
While leading telecoms proved defensive during the worst of the global selloff in March, for example, by the end of May their share prices were already lagging broad-market benchmarks. Why? “Work from home” and the accelerating adoption of secular digital themes means that telecom pipelines were benefiting: the MSCI ACWI Telecom Services Industry Group sales and earnings increased sequentially in the second quarter from the first on rises in subscriber messaging, time spent on calls, mobile hot spot usage, gaming and streaming.
Erratic energy price swings provide another example of market mania. Front-month West Texas Intermediate prices went from $61 a barrel at the beginning of 2020 to negative $37.63/bbl on April 20. WTI has since crawled back to around $42/bbl but is still down around 30% year to date. Such wild price movements don’t really reflect underlying fundamentals, which don’t turn on dime like that. Rather, the volatility reflects the day-to-day shifts in market perceptions for supply, demand and inventories, all of which drive heavy futures trading in the space. Despite the pandemic’s blow to economic growth, the globe still consumed an estimated 93 million barrels of oil products in July.
Unlike leveraged, higher-marginal cost upstream exploration and production companies, most of the supermajors possess high-quality assets and produce billions of dollars in free cash flow. Yet both upstream the U.S. E&Ps and vertically integrated supermajors with global marketing and refining operations were swept lower in tandem during the spring selloff.
Because the market’s frequently not rational, it takes time for it to differentiate between high- and lower-quality value stocks. The latter tend to go down a lot more than quality value in downdrafts, and while they may bounce back strongly in recoveries, they don’t compound as well over time. Part of the reason for quality value compounding at higher rates is they tend to come out of economic shocks facing weaker competitors, enabling them to gain market share.
When the dust settles, the market does tend to recognize and reward high-quality cyclical value stocks. Given their historic valuation lows, unprecedented monetary and fiscal policy stimulus and prospects for an economic turn in the cycle, quality equity income strategies should be a meaningfully sized, core portfolio allocation.