- Global Investment and Multi-Asset Strategist
Asia ex-Japan, Institutional
Change
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In recent years, growth stocks have had the upper hand over value stocks — a trend bolstered by the ascendence of megacap US tech stocks. Asset owners often ask us about this period of outperformance and their own growth and value exposures, and we’ve found that some rely on old rules of thumb that don’t stand up to scrutiny.
In this article, we take on two of these “rules”:
- First, the belief that value’s ability to outperform is dependent on the economic cycle
- Second, the idea that value is still dominated by a handful of mature and cyclical sectors (e.g., financials and energy)
Why reconsider these rules now? As we explain below, our research suggests that three macro drivers matter most when it comes to value outperformance: inflation, real interest rates, and real GDP. Based on our outlook for these drivers, we see a positive case for value stocks over the next three to five years and believe asset owners would do well to seek more balance in their value and growth allocations after a long stretch of growth leadership.
For value, it’s not all about the cycle
For many asset owners, the working assumption is that value outperforms in the post-recession recovery and expansion phases of the economic cycle. We find the evidence of this relationship to be inconclusive at best. We looked at the performance of US value and growth stocks in the six and 12 months following each of the nine recessions since 1960 (Figure 1). In the six-month post-recession periods, value outperformed growth five out of nine times. In the 12-month post-recession periods, value outperformed growth six out of nine times. All in all, it’s not a clear-cut pattern.
Figure 1
All of that said, we did find historical evidence of a value/growth cycle as illustrated in Figure 2. Looking at smoothed 10-year value/growth cycles over the same time period as Figure 1, we identified a pattern where five years of value outperformance (ascending line) were followed by five years of growth outperformance (descending line). The exception was the cycle in the 1970s and 1980s, when high inflation defined the economic environment. Value outperformance lasted almost 10 years in that period, after which growth took the lead.
Figure 2
If recessions are not the primary driver of value/growth cycles, what is? To answer that, we looked at a broad pool of style factors to identify those with the highest and most stable explanatory power (R-squared) for value/growth performance. We also interviewed a range of Wellington value and growth portfolio managers about their investment process, to help confirm our quantitative findings.
Our analysis revealed that three factors have tended to drive value outperformance: higher inflation, higher real interest rates, and higher economic growth (real GDP). Importantly, the impact of these drivers can vary greatly from one regime to another. Consider some of the stronger periods for value. During the 1970s, for example, high inflation played a significant role in value’s outperformance. The first half of the 1990s was a period of strong economic growth coming out of the US savings and loan crisis. The post dot-com bubble years (2000 – 2005) were another positive period for value, powered by elevated real rates and relatively solid growth.
Turning to the weaker periods, value barely broke into positive territory during the first half of the 1960s thanks to mediocre growth, record low inflation, and real interest rates close to zero. Value struggled from a similar mix of factors during the post-GFC period of 2010 – 2020. Since the COVID pandemic, value has been held back primarily by recession fears and AI enthusiasm.
Sector diversification: Value has come a long way
Another common assumption is that value stocks are generally limited to mature, cyclical sectors, such as financials, energy, materials, and industrials — all of which are often characterized by low P/E ratios, stable cash flows, low growth rates, and high dividend yields. Conversely, growth stocks are typically linked to sectors that are considered innovative or disruptive and have higher P/E ratios, such as technology, health care, and consumer discretionary.
We found that over time the sector composition of the value and growth stock universes has changed markedly. As shown in the top chart in Figure 3, value has become less concentrated and more diversified than growth, as the latter has been reshaped by the growth of megacap stocks in the IT, communications, and consumer discretionary sectors. (It should be noted that there have been times when some of these same stocks have been designated as “value,” due to their low P/B ratios, and that index rules that govern value/growth designations vary.) Currently, value’s largest weights are in health care (16%) and financials (20%), followed by industrials (15%), IT (13%), and consumer staples (9%). Energy is only at 7%. This is a very different mix than 10 years ago, when energy and financials made up 13% and 25% of the value index, respectively. The large weight of IT in the value index may be especially surprising to some; it is driven by industries such as hardware, semiconductors, IT services, and communications equipment, rather than software companies, which are more likely to be found in the growth index. As shown in the bottom chart in Figure 3, growth is highly concentrated in IT (almost 40%, up from 25% a decade ago), followed by health care and consumer discretionary at about 15% each.
Sector changes like those we’ve described tend to occur over long periods of time, so we expect value to continue providing more sector diversification than growth for the foreseeable future.
Figure 3
Our positive outlook for value
We see some of the key drivers of value premia that we identified earlier lining up in favor of value over the next three to five years.
Inflation
Even if central banks have managed to rein in inflation for the near term, we expect several structural factors to play a role in keeping inflation elevated relative to recent history — a theme emphasized by our Global Macro team. Tight labor markets are likely to persist, driven by shrinking working-age populations and uncertainty about immigration, among other factors. Amid rising geopolitical tensions, deglobalization and supply chain disruptions (e.g., encouraging businesses to shift from offshoring to “friendshoring” with allies) will add to inflationary pressures. Finally, the spending required by the green energy transition could create supply/demand imbalances across a swath of commodities, such as copper, nickel, and cobalt, driving prices higher (particularly given recent underinvestment in commodity production).
Real rates
In an environment of higher inflation, it is reasonable to assume that real rates will also need to be higher as a result of tighter monetary policy. Higher interest rates have a direct impact on financials (which, as shown in Figure 3, remain a large weight within the value index), and especially banks, which experience a boost to net interest margins. In 2023, higher rates wrought havoc with the capital levels of some regional banks due to losses on their long-duration securities portfolios compared to their short-duration liabilities, and those smaller banks may be under pressure in the near term. But financials offer a wide playing field beyond banks, including insurance companies, asset managers, and payment services, where we think there may be attractive value opportunities. Higher real rates may be supported by improving economic growth as well — a combination that is typically beneficial for value (we may already be seeing signs of this in improving equity market breadth as discussed below).
Risks to our view
The main risk we see to our positive outlook for value is generative AI. If the optimism about AI is matched by the reality of an enormous addressable market that could drive exponential earnings growth over coming years, regardless of the economic cycle, then growth stocks could continue to enjoy a multiyear period of outperformance.
That said, we are seeing signs that markets are differentiating between the megacap tech stocks more and that as recession fears have receded, the equity rally is broadening to include value-oriented sectors, small caps, and equity markets outside the US. Longer term, we also see potential headwinds for megacap tech stocks. Policymakers are being called on to create standards and regulations to ensure the safe use of these powerful new tools, potentially reducing AI’s impact on growth and productivity. In a similar vein, regulatory scrutiny could limit the growth of companies in this space, at least via acquisitions. We also think the amount of capital spending required to meet large TAM (total addressable market) estimates may exceed revenue growth expectations given that we remain in the early stages of AI adoption by industries outside of technology.
Conclusion
Our research suggests that the performance of value stocks is not necessarily aligned with the economic cycle. In different periods, inflation, real rates, and GDP can contribute to the value/growth cycle. In addition, the sector composition of the value stock universe is more diversified than in the past, with technology, health care, and other traditionally growth-oriented sectors now better represented. Over the next few years, we believe structurally higher inflation and real rates will both be supportive of value. At the same time, since there are pitfalls in relying on any historic model to predict the next cycle, we think asset owners should seek more balance in their portfolios after growth’s long rally.
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Equity Market Outlook
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Andrew Heiskell
Nicolas Wylenzek