Value rotation has further to run

The swing from growth stocks into value has been one of the major market themes in recent months.

Investors might have expected this trend to gain additional impetus from the more hawkish Federal Reserve meeting on 16 June, as growth stocks are typically affected more by higher rates. In fact, since the meeting, which showed officials forecasting a median of two rate hikes in 2023 versus zero at the March meeting, the Russell 1000 Growth index is up 2.7% versus a decline of 0.6% for value. While US value stocks are still up 16% this year versus 11% for growth, their recent weakness has caused some investors to ask whether this marks the end of value outperformance for now.

But we think that value stocks should regain the lead for several main reasons:

1. The outlook for a modest rise in long-term yields by the year-end favors value relative to growth.

• Part of the reason growth stocks have outperformed since the Fed meeting, in our view, is that the more hawkish tone didn’t push up long-term yields. As of 28 June, the 10-year US Treasury yield is little changed at 1.51%, down from a high of 1.74% on 31 March. However, we continue to believe that the 10-year Treasury yield will move up to 2% by the year-end as the global economy normalizes further, an infrastructure bill ultimately gets through Congress, and the Fed moves toward tapering its bond buying.
• So, in short, our outlook for long-term interest rates has not changed. Higher long-term interest rates should boost profits for financials, the largest sector in the value index, and weigh on valuations for growth companies.

2. Value stocks perform well in periods of strong economic growth, such as at present.

• The US economy is continuing to rebound after last year’s roughly 3.5% contraction, and we forecast economic growth of 6.8% this year. Our confidence in the growth outlook rests on the fact that US consumers are in good shape with a large pool of excess savings that can be deployed into spending, lean business inventories that are driving a pickup in capital spending, and a Fed that will likely keep monetary policy fairly accommodative for quite some time.
• Value companies tend to be more tied to economic activity and should therefore reap outsize benefits. As a result, we expect earnings for value companies to outpace growth companies this year. This earnings strength is likely to moderate next year, but profit growth for value should still rival growth companies—an unusual outcome considering that growth companies, by definition, should produce superior profit growth.

3. The high valuations of growth stocks relative to value make them vulnerable.

• The argument that growth valuations are looking more reasonable seems unwarranted, in our view. The forward price-to-earnings ratio of growth relative to value is at a post-dotcom bubble high, at close to a 1.8x premium. In comparison, the long-term average since 1980—excluding the late 1990s tech bubble—is 1.4x. Simply stated, relative valuations for growth companies are elevated and look vulnerable, especially if interest rates rise.

So, we maintain our most preferred view on US value stocks and would take advantage of recent weakness to add to positions. We continue to favor sectors such as energy and financials, and we see catch-up potential for select stocks exposed to economic reopening across the US, Asia , and Europe. Read more here on positioning for reopening and recovery.

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