Over the last decade, value stocks have trailed their growth counterparts as the post-financial crash environment has been generally conducive for growth areas.
Value’s underperformance has been blamed on falling bond yields, low inflation and the scarcity of economic growth.
However, since the news of the Pfizer/BioNTech vaccine in November, value stocks have staged a comeback alongside rising bond yields and a positive economic outlook.
Sean Markowicz, research and analytics strategist at Schroders, said: “Naturally, these market moves have reinforced the narrative that higher interest rates and growth expectations are driving the rotation from growth to value.
Value stocks have beaten their growth rivals since the vaccine announcement last year
Source: Schroders
“Although this may be true, history shows that the link between value returns and such economic variables is unstable and namely changes in interest rates do not consistently translate into outperformance or underperformance.”
He added that given the relatively wide disparity between value and growth stocks, it is likely that value could outperform for the foreseeable future.
Below Markowicz looks at some of the common arguments why value starts to outperform growth and how the real picture might be more complicated.
The duration argument
It’s a widely held assumption that falling bond yields favour growth stocks because their expected cash flows extend over a longer time period.
This means they have a longer duration and are more sensitive to changes in the discount rate that are used to measure expected cash flows.
“Although value versus growth returns have been positively correlated with changes in real bond yields in recent years, the relationship has not been consistent over time,” said Markowicz.
Over the past three years, the correlation between the performance of the MSCI USA Value vs Growth index and yield changes on 10-year US Treasury Inflation-Protected Securities (TIPS) has been 0.55.
Value vs growth returns have not exhibited a consistent relationship with real yield changes
Source: Schroders
Yet, as the chart shows, over the past five decades, the average correlation has been 0.07 and has oscillated between positive and negative.
Therefore, the last three years have been extraordinary and in no other rolling three-year period since the 1990s has the correlation been this high.
“This implies that value does not automatically beat growth when real yields rise and vice versa,” the strategist added.
The speed of the move matters more
Markowicz explained that another contributing factor may be the speed of rate movements.
“Performance seems unrelated to gradual increases, while sharp and sudden changes are associated with having a large impact,” he said.
Value typically outperforms in periods of sharp and sudden real yield increases
Source: Schroders
For example, value has on average outperformed when real yields have risen by more than two standard deviations, but relative returns have on average been flat when real yields have risen by one or fewer standard deviations.
“Meanwhile, real yield decreases have generally been better for growth returns than for value, regardless of the size of the move,” he added.
Indeed, he made the point that value stocks have tended to underperform growth stocks in periods where inflation expectations have increased by one standard deviation or more.
Markowicz explained: “This may be because, assuming nominal yields remain unchanged, increases in inflation expectations push real yields lower, resulting in even higher valuations for long duration growth stocks.”
Value stocks are not necessarily cyclical
Markowicz also suggested that value’s relationship to cyclical exposure relative to growth is not constant over time.
He explained that cyclical sectors generally outperform when economic growth strengthens and yields rise, while defensive sectors outperform when economic growth slows and yields fall.
Value stocks often rotate from being overweight cyclicals sectors to underweight
Source: Schroders
Although value was overweight cyclicals from 2009-2017, it was actually underweight cyclicals and overweight defensives from 2017-2020.
“The net result of such rotations is that value stocks have, on average, had a very similar cyclical profile to growth stocks,” said the strategist. “Investors should not assume anything permanent about value’s cyclicality and hence correlation with bond yields.”
What next?
While the November rotation to value may have been caused by rising bond yields and growth expectations, this should not be considered the rule.
“The turnover and changes in composition of the value and growth indices over time means that their overall relationship with interest rates varies,” Markowicz added.
“The speed of changes in the macroeconomic environment as well as the relative cyclical exposure of value and growth stocks may be important drivers of returns.
“Arguably, the price investors pay is a more reliable indicator for future returns and, given the relatively wide premium at which growth stocks currently trade, the odds are increasingly stacked against them over the coming decade.”