“The past is a foreign country; they do things differently there.” ― L.P. Hartley, The Go-Between
Conventional wisdom suggests that value-style investments (‘Value’) outperform their growth-style (‘Growth’) counterparts during periods of higher inflation. But in a period of growing inflation and unprecedented conditions, we believe it is useful to test this assumption. This article outlines how Value investments have performed in 2021 and what might be in store for Value investors if inflation leads to higher interest rates.
A decade of divergence
Over the past decade we have witnessed an unprecedented level of divergence between Growth and Value stocks, as shown in the chart below. Around 40% of the MSCI All Cap Weighted Index (ACWI) can be classified as Growth via Price-to-Book quartiles (P/B), while Value remains significantly under-represented in the same index.
Figure 1: Divergence between Value and Growth stocks in developed markets (MSCI ACWI ex AU)
Source: Realindex, Factset, MSCI. as at 30 Sep 2021.
The simple explanation for this is that cap-weighted indices reflect the market value (or capitalisation) of the companies in the index. When big companies become super-sized, they take up more space in the index.
A paper we published earlier this year shows how this phenomenon has played out on a large scale in emerging markets, with the Top 5 tech stocks (e.g. Ten Cent and Alibaba) accounting for 40% of the MSCI Emerging Markets Index weight. (This is one of several reasons why Realindex doesn’t use a cap-weighted approach.)
Growth feeds growth
When Growth is in favour among investors, then the value of these companies grows rapidly. The graph below shows how, in recent times, the average P/B ratio of the top quintile has pulled sharply away from the rest of the market.
In other words, the hot stocks have become even hotter - and more expensive. Historically, this growing gap has been driven by growth stocks becoming ‘pricier’ as opposed to value stocks becoming ‘cheaper’.
In the last 12 months, we have witnessed the start of a pullback (or reversion) of this trend, with Value outperforming Growth at the start of 2021 - this is where the blue line dips down in the chart below. However, this trend hasn’t been sustained in recent quarters, and we can see the blue line go up again as the market’s enthusiasm for growth stocks has returned.
Figure 2: Multiple expansion in Book Yield quintiles
Source: Realindex, Factset, as at 30 Sept 2021
But will this last? This is where the spectre of inflation comes in. Many commentators are now speculating that inflation will boost the fortunes of Value-style stocks, and the reasons why are explained below.
Inflation: here for good?
Inflation trade remains a central theme in global markets. Global bond yields spiked during Q1 2021 as inflationary expectations formed and confidence grew around the emergence of growth in global economies. However, it has since fallen away, as markets have worried about central banks raising interest rates in response to rising prices.
A big question is whether or not inflation is here to stay. If it’s just transitory, then policy settings are likely to remain broadly the same. However, if it looks like sticking around, we believe central banks will be forced to respond. For example, the current spike in the Consumer Price Index in the US could lead the Federal Reserve to stop the cheap-credit party and tighten rates sooner rather later.
How could inflation affect Value style investments?
It’s effectively about duration. If duration is long, then cash flows are further into the future – which is the case for Growth stocks. But it’s much harder to predict inflation and interest rates 10 years from now, than in the next year or two. As such, sensitivity to movements in interest rates is higher for these longer duration investments, compared to short duration (Value) stocks, where we have a better line of sight to their future earnings.
Think about a popular growth stock like AfterPay, where an optimistic growth forecast is already priced in, and compare this to a value stock such as a Big Four bank, where we are looking at a more stable revenue trajectory.
This is why it’s believed that increased interest rates, due to inflation increases, will adversely affect long-duration Growth names.
However, this misses an important point – cash flows will also increase due to inflation, so the impact is both positive and negative, and is not clear cut. A central issue will be the ability for the firm to pass through its increased costs into sales.
What does history tell us?
In a recent research paper, we tested the relationship between Value stocks and inflation over time by analysing historical data.
We found that:
- Value performs very well during medium inflation periods like the late 1950s, the mid-1970s, the late 2000s and the mid-2010s.
- Value’s strongest rallies do appear to coincide with high inflation periods
- However, the large Value sell-off after the tech wreck (2001) coincided with a high inflation period.
Much of the strong outperformance of Value over Growth dates to the high inflation periods in the mid and late 1970s, when monetary policy was quite different.
Overall, we found that the relationship is probably much more complex that just “high inflation means that value does well”.
A key reason is that the world has changed: we can’t rely on history. Central bank inflation policy has changed since the 1980s, meaning that sustained periods of high inflation are now unlikely, even though spikes in inflation are still likely, as we are currently seeing.
We also found that while inflation and Value are positively related, it depends on which period you choose. Selected historical periods of high or rising inflation in the past do indeed correspond with good Value performance, but there have been periods where this is not true; in fact the reverse might sometimes hold.
Ultimately, there is more to the story than just inflation. A number of other factors influence the value premium – for example, growth in corporate profits and forecast (rather than realised) inflation.
Conclusion: it's different this time
It has become a cliché to say we are living in unprecedented times, but it bears repeating in this context. We have never experienced such low interest rates over a sustained period, combined with government largesse, pandemic-driven price hikes and rising energy prices. It’s hard to predict the scale and impact of inflation in this scenario.
It’s also difficult to predict the future based on the past. What we can do is stay true to our investment style and process. For Realindex, that means a transparent but rigorous exposure to the value factor, which is a stable and consistent part of a diversified factor portfolio.
- A growth stock is any share in a company that is anticipated to grow at a rate significantly above the average growth for the market. A value stock is a security trading at a lower price than what the company's performance may otherwise indicate.
- The annual inflation rate in the US surged to 6.2% in October 2021, the highest since November of 1990 and above forecasts of 5.8% - Source: US Bureau of Labor Statistics
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