What Happened to the Value Stock Rebound?

Is the value trade already over?

For much of the past decade, investors flocked to the high-flying stocks of companies promising faster-than-average profit growth, while their value-priced counterparts—the shares of which tend to trade at relatively lower price-to-earnings multiples—often languished. Growth stocks soared higher for much of 2020 as central banks responded to COVID-19 by cutting interest rates and investors favored shares of technology companies poised to benefit from accelerating trends in digital transformation.

However, as the U.S. exited its pandemic lockdowns and faster-than-expected economic growth brought rising long-term interest rates, value stocks began to shine. Along with cyclical stocks, which are closely linked to economic growth, value stocks outpaced growth stocks from October 2020 through March.

Yet, since then, U.S. growth stocks have rebounded, while value stocks have lagged behind. Since the start of the second quarter, the growth-style components of the Russell 3000 index of U.S. stocks have seen a 13.1% total return, nearly three times the 4.8% gain for value components.

While some investors have interpreted this as a return to dominance for growth stocks, we view the recent relative price moves as a pause, rather than a reversal, in an ongoing comeback for value stocks. Indeed, economic strength and rising inflation will likely favor both value and cyclical stocks, vaulting them back into the lead.

Investors are divided about the drivers of the recent shift. Some point to diminishing expectations for economic growth, while others say that inconsistent Federal Reserve policy-messaging around when it may start to raise key interest rates is a factor. A more likely culprit, however, may be the rising sensitivity to changes in interest rates among a host of assets, including many equities. As long-term rates have come down in recent months, growth stocks and large-cap technology names have been among the main beneficiaries of investors willing to wait well into the future for the potential profits that such companies are expected to deliver.

However, if long-term rates move back up, growth stocks could come under pressure because the value placed on their future earnings and dividend streams would be more heavily discounted in equity pricing models. And, while technical factors may keep rates low in the near term, we think they’re headed back up.

Our call for higher rates and a steeper interest-rate curve over the next 12 to 18 months is based on an optimistic outlook for capital spending, a strong housing market, which has multiplier effects for economic growth, and inflation from higher wages and rents. We believe growth in this business cycle will be faster and broader, fueled in part by fiscal stimulus, improving demographics as millennials approach higher-spending years, and a resumption of credit growth.

Recall that, as rates move up amid expectations for accelerating growth and inflation, many investors tend to become more quality- and value-conscious, while simultaneously growing more averse to rate-sensitive holdings. We recommend adding exposure to the large-cap financials sector. Along with providing a value-oriented hedge against rising rates, many components of the sector are enjoying suddenly brighter dividend and share-buyback prospects after being freed from capital restrictions put in place last year by regulators, amid concerns over potential losses related to the pandemic.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from July 6, 2021, “Why So ‘Rate’ Sensitive?” Ask your Financial Advisor for a copy or find an advisor. Listen to the audiocast based on this report.