Value-Growth Reversal Potential Rising

The prospects for a long-overdue reversal in U.S. value stocks relative to growth stocks are rising rapidly as the macroeconomic picture and extreme valuation divergence point to significant value stock outperformance. While declining real yields have benefitted growth stocks much more than value stocks in recent months, a reversal in the value-growth performance will not require a rise in real yields as is widely expected.

S&P 500, S&P 500 Growth Index, and S&P 500 Value Index

Source: Bloomberg

Lower Real Yields Have Benefitted Long Duration Stocks

The precipitous decline in U.S. inflation-linked bond yields has helped drive gains in U.S. growth stocks over recent months as the lower discount rate raises the appeal of future dividend payments relative to current ones. When future cash flows are discounted at a lower rate, companies that are expected to deliver these cash flows in the distant future become more attractive relative to those delivering cash flows now. Growth stocks effectively have much longer duration and, therefore, tend to respond more positively to lower real interest rates.

PIMCO founder Bill Gross noted last week that growth outperformance versus value has been driven primarily by the decline in real yields. He noted that, when real rates decline like they have over the past few years, the discounting of current dividends skyrockets the price, while, in the case of value stocks, this discounting effect is much less pronounced. He also noted that a rise in real yields is likely to trigger a reversal in value’s recent underperformance.

Value-Growth Reversal Not Beholden To Real Yield Outlook

We share the view that value will post a strong relative recovery but do not believe this relies on rising real interest rates, which look set to remain deeply negative. While declining real yields have played a role in recent growth outperformance, we expect this relationship to break down over the coming months.

Little Historical Correlation Between Value Vs Growth And Real Yields

Source: Bloomberg

The above chart shows the performance of U.S. value relative to growth stocks compared with the 10-year inflation-linked bond yield. Despite the tight correlation in place since the start of the year, there has not been much of a positive correlation during the previous 20 years. In fact, in 2000, at the height of the tech bubble peak, real yields were a full 500bps above current levels, strongly suggesting that real yields are not a major driver of the relationship.

Economic Fundamentals May Favour Value Stocks

From an economic perspective, in the absence of activist monetary policy, low real interest rates would reflect an abundance of real savings relative to the demand for investment. This abundance in savings should benefit growth companies as they rely on large amounts of time and investment to become highly profitable in the future. However, the current deeply negative real interest rates do not reflect high levels of savings needed to facilitate investment, but rather financial repression owing to loose fiscal and monetary policy. In reality, as explained in ‘The U.S. Has A Savings Problem The Fed Can’t Fix‘, real savings rates are very low which bodes poorly for growth, while the Fed’s aggressive easing raises the prospect of inflation.

Amid a backdrop of a high degree of economic uncertainty and rising inflation pressures, we think companies with high levels of profits and dividends currently, and an ability to do well during rising inflation, should outperform. With this in mind, deeply negative real interest rates could go hand in hand with outperformance in value relative to growth as inflation expectations recover to the benefit of financials and energy stocks.

Valuation Divergence Has Reached New Extremes

The extreme divergence in valuations between U.S. growth and U.S. value stocks suggests value sector outperformance is highly likely regardless of the macroeconomic outlook. Even on a trailing price-to-earnings basis, the S&P Growth index is now trading at 1.7x the level of the S&P Value index, its highest ratio since 2001. Meanwhile, the ratio of price-to-EBITDA of the two markets trades at 2.0x, while the value index has a dividend yield roughly 2.6x higher. Given the uncertainty facing the U.S. economy, we believe a bird in the hand is worth two in the bush.

P/E Ratio Of S&P Growth Index Vs S&P Value Index

Source: Bloomberg