Big investors have over the past two months bought up shares in companies with strong growth prospects over cheaper value stocks in an abrupt reversal driven by shifting views on interest rates, inflation and the threat of a US recession.
US value strategies, which look for inexpensively priced companies based on measures such as profits, cash flows or book value, have lagged since mid-June when the blue-chip S&P 500 index began to rebound from its low point this year, a recovery fuelled by fresh bets by investors on technology stocks and other growth sensitive sectors.
This revival of interest in growth stocks and underperformance for value represents a return to a trend that was dominant from the early days of the coronavirus crisis in 2020 until December 2021. Surging inflation and central banks’ plans to remove pandemic-era stimulus took the shine off of growth stocks in the first half of 2022, but now recession jitters have caused the pendulum to swing back.
“Investors were obsessed about inflation risks in the first half of the year and they are now haunted by worries about recession. That explains the violence of the flip in sentiment to growth stocks from value,” said Michael Hartnett, chief investment strategist at Bank of America.
The S&P 500 value index gained 12.6 per cent including dividends from June 16 to the close of play on Thursday while the S&P 500 growth index delivered a total return of 22 per cent, reflecting portfolio shifts by some of the world’s largest investors.
For the first time since August 2020, more fund managers now expect growth stocks to outperform value over the next 12 months, according to the latest survey from BofA, which canvassed the views of 250 investment managers with combined assets of $752bn.
Around 88 per cent of the investors polled by the bank expect US inflation to decline over the next 12 months and their fears that the Fed will impose further draconian increases in interest rates have also started to subside.
That led to a rotation from defensive sectors including utilities, healthcare and consumer staples into tech, banks, energy and consumer discretionary stocks in July, said Hartnett.
Tech industry titans Apple, Amazon and Tesla have benefited from the rebound in growth stocks while value plays including Pfizer and Dow have struggled to keep pace.
The flip in sentiment is also evident in US exchange-traded fund flows. Data from State Street show that US-listed value ETFs registered net outflows of $39mn in July, the first withdrawals after 11 months of positive inflows. Meanwhile, US-listed growth-focused ETFs, which were out of favour in the first four months of this year, attracted net inflows of $4.9bn in July.
Toby Gibb, global head of investment directing for equities and fixed income at Fidelity International, said that as concerns have shifted from the risk of stagflation to recession, investors have shown more willingness to pay up for companies that can deliver strong revenue growth.
“But this is still a compelling environment for value strategies based on idiosyncratic or contrarian ideas, particularly if a company’s fundamentals are strong. Buying cheap stocks just because they are trading on an inexpensive valuation is not likely to succeed as a strategy. Investors need to be more discerning when looking for companies that can be considered as value,” said Gibb.
The gap in valuations between cheap and expensive stocks globally — known as the value spread — has returned to the extreme levels seen at the peak of the price bubble in US tech stocks in March 2000, according to AQR, the quantitative investment manager.
Richard Halle, portfolio manager at M&G Investments, said the odds of success have swung more strongly in favour of value strategies because the valuation dispersion between cheap and expensive stocks is so extreme.
In addition, the severe impact of the current energy price shock has created greater uncertainty about the outlook for corporate earnings.
“High valuations attached to growth stocks imply a strong degree of certainty about future profits. However, the outlook for the economy has deteriorated and there will be losers as some companies will find it hard to match their rising input costs with the prices they charge to customers,” said Halle, who suggests investing in companies with lower price to earnings ratios rather than more expensive growth stocks.
But the continuing deterioration in economic activity data means that it is too early to jump back into value stocks, according to Mislav Matejka, an equity strategist at JPMorgan.
“Stronger economic data is generally favourable for value sectors including financials. We don’t see the macro data turning stronger before the fourth quarter,” said Matejka.
Mounting fears that the US economy will move into a recession have increased demand for safe government bonds. As a result, yields on US 10-year Treasury bond have dropped to 3 per cent from a high of almost 3.5 per cent on June 14, the day before the Federal Reserve raised its benchmark policy rate by 0.75 percentage points.
Roger Aliaga-Díaz, chief economist for the Americas at Vanguard, the world’s second largest asset manager, said value strategies usually have more exposure to economically sensitive cyclical stocks so they tend to fall out of favour when investors are anticipating a recession.
However, he also cautioned that investors should not expect any easing in monetary policy in the near future given the severity of current inflationary pressures and the need for the Fed and other central banks to re-establish price stability.
Recession warning signs from the US bond market are being ignored, according to Michael Wilson, chief investment officer at Morgan Stanley.
“Investors have interpreted the fall in bond yields as positive for growth stocks. They are also assuming that earnings from growth stocks will be more resilient in a recession. But that is mistaken,” said Wilson.
