A big shift in financial markets

After a sleepy end to the year, financial markets started off 2022 with a bang. The yield on the 10-year Treasury bond has risen by almost a quarter of a percent in just the first five trading days of the year. Real interest rates (nominal rates less inflation expectations) have risen by even more. These have been some of the most aggressive increases in interest rates over the last 20 years.

At the beginning of the week the rate move seemed to be based on optimism that the omicron wave would be fast and the economy would escape substantial damage. But then the Fed released minutes of their December meeting and suggested that they could remove stimulus at a faster pace than the market expected—specifically, by reducing their nearly USD 9 trillion of government and mortgage bond holdings at a quicker-than-expected pace. And then Friday’s payroll report suggested that the labor market is rapidly approaching full employment. As a result of these drivers, we believe the yield on the 10-year Treasury bond can continue to rise and hit 2% in the coming months.

Growth stocks benefited from falling rates and a shift in spending

The moves in the bond market were mirrored by similar moves in the stock market. Over the last few years, growth stocks (e.g. tech) have been some of the biggest beneficiaries of extraordinarily low interest rates. Over this period, there has been a very strong correlation between the relative performance of value and growth stocks and the level of real interest rates. Value stocks significantly underperformed as real rates fell to some of the lowest levels in history.

The value of any company is the net present value of all expected future cash flows. Growth companies generate the bulk of their cash flows well out into the future. Mathematically, this makes growth companies much more sensitive to changes in the “discount rate” that investors use to derive the net present value. In contrast, because value companies grow more slowly, they generate more of their cash flows in the early years of the forecast horizon. This makes them less sensitive to changes in the discount rate.

We can observe this by looking at the forward price-to-earnings (P/E) ratio for growth stocks. The P/E ratio for the Russell 1000 Growth index has increased from 22x right before the pandemic, to 31x now. The fastest-growing and most speculative companies have been the biggest beneficiary of this dynamic. In contrast, the P/E ratio for the Russell 1000 Value index has only risen from 13x to 16x.

Growth companies now trade at 15 P/E points higher than value companies, compared to the long-term average of 6. As the discount rate rises, valuations for growth companies should compress more rapidly relative to value stocks. And that is exactly what has happened in the first week of the year. Value stocks are up 0.5% while growth stocks have fallen by 4%. More speculative, very rapidly growing, non-profitable tech companies have fallen even more and are down 10%.

Growth companies, and especially tech, also benefited from some of the trends unleashed by the pandemic. Businesses have been scrambling to digitize their businesses, driving strong earnings growth for large segments of the tech complex. As the pandemic transitions into something more endemic, consumer behavior and the economy should normalize and spending could shift away from some of the winners in 2021.

Rotation into value is set to continue as market moves higher

As a result of the prospect for higher interest rates and a normalization in spending patterns, we believe the recent rotation into value stocks this year could have further to go. Importantly, overall economic growth remains solid and value companies, which are more tied to economic growth, should continue to produce relatively strong earnings growth. In fact, profit growth for value companies looks poised to outpace growth companies in 2022 (when stripping out the one-time benefit of bank loan loss releases in 2021). This is the crux of our preference for value over growth stocks. We have a neutral view on the S&P 500 Information Technology sector.

At a market level, the more hawkish Fed shouldn’t be a significant headwind for the market. Bear in mind that, historically, stocks have risen about 5% in the three months before the first Fed rate hike. In addition, the Fed has become incrementally more hawkish since June of last year and the S&P 500 is still up more than 10% over this time period. Furthermore, stocks rise by about 5% in the six months after the first rate hike. Fourth quarter earnings results will start to be released next week and we expect another good earnings season, which should be supportive for the market. Our year-end 2022 S&P 500 price target is 5,100.

If the first week of the year is any indication of what to expect over the coming months, investors will have to be nimble in 2022, and be aware of any outsize exposure they may have to growth stocks.

Co-authored with David Lefkowitz, Head of Equities Americas

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