- Interest rates are playing a deciding factor in the relative performance battle between growth and value stocks.
- Valuations of growth stocks have spiked, while the relative valuations of value stocks are near historic lows.
- Elevated growth stock valuations are dependent on low interest rates lasting forever, while value stocks are much less sensitive to forecasting an uncertain future.
Market Reactions to Monetary Policy Have Sent Rates Falling
Despite the early second quarter rebound in favor of value, the relative performance battle between value and growth stocks in the market continues to rage on. Fear-driven selling of cyclical and value stocks was on full display in June as the market overreacted to a perceived shift in monetary policy to a more hawkish stance. The Federal Reserve acknowledged that inflation was temporarily running hot and that if inflation proved to be anything but transitory the Fed would act to cool it. While no actual activity was taken, the change in tone had a powerful effect as interest rates tumbled across the yield curve, with real interest rates sinking to levels not seen since the European debt crisis (Exhibit 1).
Exhibit 1: Real Interest Rates
Growth-Value Shifts Are Faster and More Intense
In simple terms, most value stocks are highly correlated and major beneficiaries of higher interest rates, while growth stocks enjoy the opposite relationship. Currently, this performance battle is exhibiting extreme levels on two fronts:
First, the negative correlation between growth and value is at historic and almost binary levels, which explains the speed and intensity in recent shifts between the two style camps (Exhibit 2).
Exhibit 2: The Correlation of Value and Growth Has Never Been Lower
Second, the valuations of growth-tilted stocks that benefit from lower rates have spiked to bubbly levels versus history, while the rate-sensitive value camp is near the trough levels that marked the lowest relative valuation level for value in history (Exhibits 3 and 4).
Exhibit 3: Relative Valuations of Stocks Positively Correlated with Treasurys (Lower Yields)
Exhibit 4: Relative Valuations of Stocks Negatively Correlated with Treasurys (Higher Yields)
Value Stocks Are Less Sensitive to Forecasting Uncertainty
With real interest rates falling to crisis-level lows and growth stock valuations spiking to historic highs, these extreme levels are highly dependent on the current forecast for low interest rates forever playing out. This arguably makes growth stocks more dependent on the macro outlook than cyclical value stocks.
However, one of the benefits of investing in stocks with lowered embedded investor expectations is that you are essentially asking very little of the future. This is currently the case for the value stocks we own. The benefit of having modest expectations in a stock’s price is that it makes a valuation-disciplined portfolio much less sensitive to forecasting an uncertain future. In addition, you can make very solid returns if the prevailing forecast turns out to be wrong, which is most often the case. After this recent reset in prices, many value stocks just need an average economic recovery to continue and the Delta COVID-19 variant cases to crest. We expect both outcomes to occur as the current turbulence for value clears.
If rates do indeed stay low and the COVID-19 recovery will have been just a short-term affair as the market is increasingly reflecting, this would be welcome by most investors, as it would allow them to stay positioned for the comfortable norms of buying long-duration growth stocks and bonds at very elevated levels versus history. However, investors must recognize this is an aggressive bet on what is familiar and leaves very little room for error if we are indeed in a new market cycle. We think investors may be underreacting to the risk that things have indeed changed, and we expect the comfortable patterns of the past growth cycle to continue to give way to something different.