Portfolio Manager Justin Tugman discusses how value stocks have benefited as inflation expectations and interest rates climb. Investors must now focus on which companies can continue to profit as the economic recovery broadens.

Key Takeaways

• As investors begin to anticipate the end of the COVID pandemic and a broader economic recovery, inflation expectations and interest rates have risen, to the benefit of some value stocks.
• While it remains to be seen how long the recent trends will last, many of the drivers that led investors to flock to growth stocks have reversed and are now in value stocks’ favor.
• Historically, value versus growth outperformance is multiyear in nature. We believe this could be the case again, particularly in small-cap stocks, especially if rates and inflation continue to march higher.

For some time, we have said that rising inflation would be a positive development for value stocks relative to growth stocks. With both current and future inflation expectations increasing, interest rates are also moving higher and the yield curve is steepening. So, it is not surprising that interest rate-sensitive financial industries such as banks are performing well year to date. Accordingly, value indices have generally outperformed growth indices over this time period, as they tend to have much higher exposure to stocks in the financials sector.

Significant progress in the fight against the COVID pandemic has led to expectations that gross domestic product (GDP) will surge in 2021, fueled in large part by massive monetary and fiscal stimulus and the post-pandemic reopening of the economy. This may bode well for cyclical stocks, which make up a much larger portion of value benchmarks relative to their growth counterparts. Commodity stocks, for instance, tend to benefit in an inflationary environment, and many of those companies have been strong performers thus far in 2021. Indeed, higher inflation expectations have resulted in strong stock prices in energy, chemical and steel companies due to their ability to pass through higher prices to customers.

“Stocks as Entertainment:” Eventually, Valuation Matters

For years, investors have piled into growth stocks given declining interest rates, the prospect of capitalizing on disruptive technologies and anemic economic growth prospects. Investors also sought growth stocks’ better earnings growth potential relative to value equities ‒ regardless of high valuations.

While it remains to be seen how long value leadership will last, many of the drivers that led investors to flock to growth stocks have reversed and are now in value stocks’ favor. We believe that investor complacency ‒ particularly regarding the valuation of growth relative to value ‒ is contributing to the recent moves. Many market participants have suspended any belief that valuations matter, especially when looking at stocks with no earnings and no prospect of generating earnings for the foreseeable future. Rather than a focus on valuation metrics and fundamentals, the story or social media activity around a stock often takes center stage and becomes the main driver of the stock’s price.

Small-cap value indices in particular have several of these “story” stocks with no earnings that have seen share price weakness recently; clean energy names are a prime example. This new phenomenon of “stocks as entertainment” has the potential to end in disaster for brokerage account values when momentum reverses and share prices decline. We have seen this behavior before during the tech wreck of 2000. While investor euphoria can last far longer than seems sane, eventually valuation does matter.

Can Small Caps and Value Continue to Outperform?

Small-cap stocks are by nature more economically sensitive than larger-cap companies, and this was especially evident as they declined during the COVID-related sell-off. Nearly nine months ago, however, we became increasingly positive on small-cap stocks and smaller stocks within the mid-cap space, given the enormous valuation gap that had developed between small and large caps. Since that time, we have seen small caps outperform, and that valuation gap has narrowed. Despite this, we believe the outlook is still brightest for small caps because of faster future earnings growth expectations and an improving economic picture in the U.S., where small caps generally have more exposure compared to large caps.

Given the gains over the last six months, however, caution is warranted. As we have seen with the recent market environment, price moves can be fast and furious. The recent sell-off in growth stocks has been painful for those exposed to that particular style, while value has logged attractive absolute and relative gains over the past six months. On a five-year basis, value is still significantly underperforming growth by over 4,100 basis points¹ as it attempts to close this enormous performance gap. However, historically, value versus growth outperformance is multiyear in nature. We believe this could be the case again, especially if rates and inflation continue to march higher.

 

¹Russell 2000^® Growth vs. Russell 2000^® Value, 3/8/2016 – 3/8/2021.