Recent messages from the Federal Reserve coupled with the strong October U.S. jobs report have investors betting on the Fed to increase its policy rate in December and thinking about what a strengthening economy and rising rates mean for their portfolios. For equities, when rising rates are spurred by expectations for economic growth, it may be a catalyst to reverse an unusually long period of value stocks underperforming growth.
The value premium, or the greater risk-adjusted returns delivered by value over growth stocks, has been widely documented in both academic and practitioner research. However, recently we have experienced a growth premium. For the 10 years ended October in the U.S., growth stocks, as measured by the Russell 1000 Growth Index, have outperformed value stocks (Russell 1000 Value Index) by 235 basis points (bps) annualized. For the one-year period, growth outperformance is nearly 1000 bps! We believe the declining rate environment has contributed to this divergence in style performance.
What is the connection between style performance and rates? First, since the falling and persistently low rates were a reflection of fears about economic growth in the wake of the financial crisis, more cyclical and economically sensitive value stocks faced a headwind. Given those concerns, investors were attracted to companies whose growth is less dependent on the performance of the global economy – think Amazon, Google and Netflix. Second, lower policy rates mean lower discount rates, and since growth company valuations are driven by determining the present value of future cash flows, lower rates make future earnings more valuable today. Said differently, since growth stocks have a greater portion of their cash flow occurring sometime in the future, they are essentially long duration assets and have benefited from rates trending lower.
These years of outperformance have increased the valuation gap between growth and value. While growth stocks should almost always trade at a premium, at these levels, the discount for value stocks has increased significantly.
A final thought to consider is that today’s market is demonstrating very little breadth, as just a handful of large-cap technology companies are driving the S&P 500 Index higher. Narrow markets tend to be unsustainable and can often lead to a change in market leadership. A strengthening economy, rising rates, a valuation discount and a narrow market led by a few large growth companies could all be catalysts for a return of the value premium.