The COVID 19 vaccine announcement in November last year resulted in expectations of a rebound in economic growth, rising inflation expectations, and modestly higher long-term interest rates (10-year bond yields). In equity markets, we believe this environment has proved favourable for Value stocks and hostile for Growth stocks. Since the start of the year to mid-May, the MSCI World Value index has outperformed the MSCI World Growth index by 11.7 percent.
We believe the rotation into Value stocks can continue into the second half of 2021 as growing inflation concerns put more upward pressure on bond yields, resulting in a steeper yield curve. Historically, a steeper yield curve has been supportive of Value and hostile for Growth. Any sense that central banks will not be able to keep interest rates on hold for as long as they have publicly stated will likely accelerate these trends.
While the catalysts for the rotation into Value stocks is a changing macro landscape, the bull case for Value is given extra vigour due to it being cheaper than normal. At the end of last year, the cheapest price-to-earnings (P/E) quintile of the S&P 500 was trading at a 43 percent forward P/E discount to the market median, compared to a long-term average discount of 31 percent. While the strong Value rally seen this year has reduced this ‘valuation discount’, it remains cheap and currently trades on a 37percent forward P/E discount to the market median.
While there are Value opportunities, there are also traps. Investors should consider aspects such as a company’s track record of earnings delivery and the quality of its balance sheet when looking at Value opportunities. During the COVID-19 pandemic, some companies took on debt and now trade on earnings that look reasonable compared to equity value but are less attractive when both their equity and debt are combined (their enterprise value). We favour higher quality value stocks that are best positioned to thrive in a post-COVID-19 world.
We have maintained a positive stance on Value since last summer and expect it will continue to perform well as we head into the second half of the year, as a result of the current macro and valuation picture.
Looking further ahead, if we just use history as a guide then rotations into Value following a significant period of weakness can be protracted, i.e. persist for several years. But all cycles are different. Macro momentum will inevitably slow as we move toward 2022 and some of the trends that supported Growth stocks in the last 5-years, such as the rise of highly profitable technology companies, are structural and likely to reassert themselves. Longer term, this is likely to drive greater breath of market factor leadership. That said, Value remains cheap and the post-COVID-19 world of higher inflation and higher interest rates looks more positive for Value investors compared to that faced in the previous 5-years.