The past decade has been dominated by growth stocks, in particular the US tech behemoths. The multi-year gains have been fuelled by technology unlocking capacity and superior earnings growth – as well as a favourable macro backdrop with low inflation, low interest rates and abundant liquidity. Strong sentiment further propelled segments of the market to extreme valuations.
The pandemic accelerated this trend by ‘pulling forward’ future growth and concentrated the gains in a handful of stocks. However, we may have reached a structural inflection point.
Rampant inflation, a hawkish Fed and a brutal spike in bond yields have largely driven the losses in global equities in the first half of 2022. After being in deep negative territory, the real 10-year US treasury yield turned positive at the end of April, and the rate shock has had a meaningful effect on US equity valuations. This has been particularly painful for long duration assets, such as growth and technology companies. On the other hand, value stocks have been providing investors with some shelter from the storm sweeping global markets.
A shifting landscape
Many investors have been conditioned by the post-GFC market environment to believe growth should ordinarily outperform value, but this has not always been the case. Style cycles have lasted years, but as we have seen, regime changes can be abrupt. The renaissance of value started over a year ago, but its continued rise in 2022 has reinforced this as a more durable shift in market conditions.
There are strong signs the environment is shifting. Materially higher levels of capital expenditure may be required to address capacity requirements in many industries to meet decarbonisation goals and address threats posed to supply chains as companies focus more locally. Additionally, governments may be more willing to engage in higher levels of fiscal spending to withstand future economic shocks and fulfil social agendas.
The combination of both higher capital expenditure and fiscal spending is likely to be beneficial to many value-oriented companies, as well as put ongoing upward pressure on both inflation and interest rates.
More sustainable rotation
While value can perform both defensively and cyclically, it has traditionally led the way out of market troughs and into economic recoveries. Despite increasing concerns about a global recession and adverse geopolitical developments – as well as the fact defensive sectors like consumer staples, healthcare and utilities have outperformed more cyclical areas like industrials and financials over the first half of the year – the MSCI World Value has outperformed MSCI World Growth by more than 15%.
There has been some benefit from the structural supply issues emerging in the energy and mining complexes, which has driven those sectors sharply higher, as well as the pronounced derating of the growth-heavy tech sector. However, this only accounts for an element of the dispersion.
More persistent inflation and rising rates change the investment landscape and support a more sustainable rotation into value-oriented investments. While previous rotations have been fleeting, a rising-rate environment is pivotal for value, given the correlation that exists between higher discount rates and the relative attractiveness of shorter duration stocks. In addition, typically higher inflation is associated with better prospects for energy and mining companies and is positive for firms with an existing asset base that should inflate.
Avoiding the extremes
Despite value meaningfully outperforming growth year-to-date, the P/E ratio premium for growth relative to value is currently at 61% – still well above the median of 36% over the last four decades. This places it in the 87th percentile of observations since 1984.
Further, valuation spreads in most countries are still above average historical levels, presenting good opportunities for a value-focused investors. However, it is important to understand secular risks and avoid value traps, so a focus on fundamentals will be critical.
As we face a paradigm shift in the global economy, now is not the time to invest in the extremes of value or growth. While many secular themes will endure – such as the cloud and cybersecurity – regime change also paves the way for quality cyclicals to benefit as headwinds of the past decade fade and new opportunities emerge, like the green transition. Diversification will key though, as the market continues to gyrate with a multitude of cross currents. It is no longer a question of value versus growth, and instead one of value and growth.