For roughly the past decade, growth Stocks have outperformed their value counterparts by a wide margin. Investors have not discriminated in their preference for growth stocks over value when it comes to market capitalizations. As shown in the chart, small caps have also seen superior performance of the growth sector over value, the same way large caps have.
But the value side of the market may be about to seize the leadership baton. In the year ahead, the combination of economic strength, firming prices, and a less dovish Fed is likely produce higher interest rates across the curve. Theory implies and history shows that during periods of rising interest rates, value stocks tend to outperform growth.
It is a basic concept in finance that the present value of an asset is its expected future stream of cash flows discounted back to present value. The discount rate applied to those future cash flows is influenced by the so-called riskless rate such as the yield on US treasury coupon bonds. Other things being equal, when interest rates are falling or very low, present values should rise; and when rates rise, the opposite should be true. Such trend changes in rates would influence all asset prices; but logically the stocks of companies whose future cash streams are expected to be much higher due to high growth rates would be boosted more in lower interest-rate environment than slower growing value shares. Higher growth rate shares, in turn, would be hurt more in a rising interest rate environment.
That simple idea finds support not just in theory, but in the historical record, as well. During prior business cycles, the initiation of higher rates was followed by a reversal of an earlier trend of growth outperforming value: perhaps not right away, but eventually for sure.
Trends over the last two years, however, would seem to put the lie to that reasoning. After all, the Fed did initiate the current tightening cycle in December 2015. And, as it happens, value did appear to pass a turning point, outperforming growth until around the start of this year.
But then the Fed blinked within weeks of its initial tightening move. A sudden downturn in stock prices in early 2016, corresponding with the plunge in oil prices to $28, was interpreted by the Fed as a tightening of financial conditions which led them to postpone additional hikes that had been planned for 2016.
Also, it is not just central bank-administered rates that matter in the discount rate of the valuation equation; longer-term rates matter as well.
Indeed, throughout this whole episode, longer-term treasuries, bolstered by the Fed’s multiple QEs, have remained at abnormally low yields, helping to prop up the valuations of growth stocks. But the changing outlook for interest rates in 2018 could cause a dramatic change in equity market leadership. In last month’s Market Viewpoint titled Beyond the BOND BUBBLE, MRP outlined four disruptive changes that could soon push interest rates back towards more normal levels.
First, the quadrupling of the size of the fed’s balance sheet has arguably been a prop under the fixed-income markets, and its long-awaited shrinkage is just getting underway. Secondly, the makeup of the FOMC is changing dramatically over the course of just a few months, and the new lineup could turn out to be less dovish than in recent years. Third, the Fed has forecast three additional rate hikes for 2018 followed by two more in 2019, although the futures market is skeptical. And fourth, with the passage of the administration’s tax cuts, economic growth is accelerating in the US, coinciding with a growth pick up already underway in the rest of the world. A very different yield curve is likely to emerge with a three handle on the short end and a four handle on the longer end.
International markets are also showing increasingly bullish signs for value, particularly in emerging markets. The price-to-book value ratio of the MSCI Emerging Markets Information Technology Index is approaching a level that’s twice that of the broad MSCI Emerging Markets Index. With economies like India, China, and the ASEAN nations, IT makes up more than a quarter of the full index. There could be danger here: if these growth companies cannot continue to deliver the growth that investors expect, they could be at risk of a resulting correction.
As market interest rates rise across the curve, the discount rate in the present value equation should rise accordingly. When that occurs, companies’ discounted future earnings will be revalued downward – an effect that negatively impacts growth stocks more than value. The FAANGs have thrived in the low-rate environments of the last decade. Now, with a real push toward Fed tightening, justified by accelerating GDP growth and a massive tax reform bill freshly passed by congress, a rotation out of growth stocks and into value could occur in an environment of less robust performance for the overall market averages. Over concentration in high growth stocks has been very rewarding over the past decade, but going forward, it could be very costly.