Inflation, rising rates, and the return of the value cycle
With the Fed monetary policy tightening in full swing and the ending of its monthly bond-buying program in March, rising interest rates will characterize markets for the foreseeable future. Investors are now searching for assets that can withstand both high inflation and rising interest rates. Does this signal the return of the value cycle?
Support for growth stocks dissipates
Markets over the past several years have been supportive of growth stocks. A broadly disinflationary environment with the Consumer Price Index averaging 2.37% over the decade 2010 to 2020 was coupled with low interest rates around the world—even negative rates in Europe—and growth almost exclusively concentrated in the technology sector. Added to this, COVID-19-related consumer and small business stimulus set the scene for rapid post-lockdown recovery, which has manifested in various forms, including decades-high inflation and an overheated housing market.
Compounding already high inflation is a recent spike in oil and gas prices, which is pushing food and materials higher too. Supply chain backlogs look set to further exacerbate high prices. Altogether an unsustainable picture emerges, which has started to unwind, and which we believe will continue on that trajectory as the U.S. Federal Reserve (Fed) continues monetary tightening.
Many investors are asking, “What will happen to equities in a rising rate, accelerating inflation environment?” Looking back in history, 10-year bond yields have been on a downward trajectory for over 40 years. During the periods 1954 to 1981 and 2002 to 2007, when 10-year yields were moving up, value steadily outperformed growth.
Value has outperformed growth in rising yield environments
U.S. 10-year yields and value vs. growth relative returns, 1926–2022
Source: Fundstrat, Bloomberg, FAMA until 1975, Boston Partners, January 2022. For illustrative purposes only, not representative of any fund. Growth and value universes are defined by the FAMA database prior to 1975 and Russell indexes thereafter. Growth is represented by the Russell 1000 Growth Index, which tracks the performance of publicly traded large-cap companies in the United States with higher price-to-book ratios and higher forecasted growth values. Value is represented by the Russell 1000 Value Index, which tracks the performance of publicly traded large-cap companies in the United States with lower price-to-book ratios and lower forecasted growth values. Price index for value versus growth is based on daily net return (value less growth) since 1926. It is not possible to invest directly in an index. Past performance does not guarantee future results.
The outperformance of value in a rising yield environment coincided with periods of price-to-earnings (P/E) multiples compression, an effect of both rising rates and higher inflation. Historical indicators show that inflation above 4% can lead to a compression in P/E multiples, often besetting growth stocks most.
The market as a discounting mechanism—compression in P/E multiples
Historically, when inflation accelerates above 4% and interest rates rise, investors demand a higher rate of return to offset both higher inflation and higher interest rates. In our analysis, we’ve also noticed a negative relationship with 10-year bond yields and P/E multiples: As yields have gone up, P/E multiples typically drop. Given the presence of both these factors in today’s markets, we believe it’s reasonable to expect P/E multiples to contract. We’ve already seen some of this, and we believe it will persist.
Compression in P/E multiples at differing levels of inflation
S&P 500 Index average P/E ratio trailing 12 months, CPI YoY tranche, 1950–2021
Source: Strategas, as of 3/31/22. For illustrative purposes only, not reflective of any fund. The S&P 500 Index tracks the performance of 500 of the largest publicly traded companies in the United States. The Consumer Price Index (CPI) tracks the average change of prices over time by urban consumers for a market basket of goods and services. It is not possible to invest directly in an index. Price-to-earnings (P/E) is a valuation measure comparing the ratio of a stock’s price with its earnings per share. YoY refers to year over year. Past performance does not guarantee future results.
Longer duration assets are more sensitive to rising rates
Growth stocks are known as longer duration assets, as a significant portion of company cash flows are further into the future. Similar to the bond market, in which 30-year bonds will lose substantially more value than 1-year notes if interest rates rise 1%, growth stocks typically lose more value relative to shorter duration value stocks in a rising interest-rate environment.
Traditional value sectors such as financials, energy, and industrials have been leaders in periods of rising inflation. Banks’ net interest margins benefit from rising interest rates, while strong commodity prices help boost cash flows in the energy sector. Leading industrial companies can often raise prices to offset increased costs. By comparison, high multiple, long duration growth sectors such as technology and communication services have typically lagged as valuations tend to compress more severely for these traditionally high P/E groups.
Overextended growth stocks look less compelling than value stocks
Historical average median P/E ratio, growth vs. value (%)
Source: The Leuthold Group, 3/31/22. For illustrative purposes only, not reflective of any fund. Median valuations are the largest 3,000 companies. Market caps and universes are defined by Leuthold as: large cap, greater than $39.1 billion; mid cap, $5.8 billion to $39.1 billion; and small cap, $1.4 billion to $5.8 billion. Historical average median P/E period is from January 1982 to March 2022. Price-to-earnings (P/E) is a valuation measure comparing the ratio of a stock’s price with its earnings per share. Past performance does not guarantee future results.
As growth companies reach the upper end of historically high averages, there’s a risk of rerating spreading from outlier high-growth stocks to capitalizations across the growth spectrum. Large-, small-, and mid-cap growth stocks are trading at multiples far above historical averages. Value stocks, meanwhile, are at more reasonable levels and, as such, we believe they’re ideally poised to reward investors in 2022 and beyond.
The views expressed are those of the author(s) and are subject to change. No forecasts are guaranteed. This commentary is provided for informational purposes only and is not an endorsement of any security, mutual fund, sector, or index.
Investing involves risks, including the potential loss of principal. A portfolio concentrated in one sector or that holds a limited number of securities may fluctuate more than a diversified portfolio. Past performance does not guarantee future results.