There has been a sharp change in market dynamics in 2022. The growth trade which has prevailed for more than a decade – and especially since the onset of the COVID-19 pandemic – has shown signs that it is beginning to reverse. Previously unloved value stocks have come back in favour.
But while commentators are characterising this change an ‘equity market rotation’, we believe what is happening goes beyond a temporary cyclical preference – this is only the beginning.
To analyse the reasons we think this, it is important to put in context the long build-up and frantic final months of the growth boom.
HOW DID WE GET HERE?
The great ‘bull market in everything’ had its origins in the Global Financial Crisis (GFC) of 2008-09. In response to this crisis, central banks around the world delivered conducive monetary policy, including historically low interest rates and quantitative easing on a large scale.
Under these monetary policy settings between 2010 and 2020, growth companies led the equity markets, steadily and persistently outperforming value companies over the decade. The arrival of the pandemic in 2020, only served to turbo-charge this dynamic, as Chart 1 shows.
In our view, there were three factors at play over 2020 and early 2021.
The first was simply a thematic preference for technology stocks, as we all stayed at home connected to our smartphones, computer software, online shopping, and streaming services.
The second was the general misconception that unlike a normal recession, the pandemic with its lockdown-induced downturns were not necessarily deflationary.
In a normal recession, demand for goods and services generally falls, however, supply of such goods and services remains largely unchanged. This is, by definition, deflationary for prices.
But unlike a more traditional or normal recession, Government’s responses to the pandemic were to lockdown whole economies. This resulted in a reduction in the aggregate supply curve of the economy, which in combination with the reduction in demand creates an outcome which is uncertain for general prices. The result could be deflationary, as in ‘normal recessions’, but conversely could also be inflationary (Chart 2).
And finally (and what we consider the most significant factor) Governments released the lockdown handbrake from the economy through an expansive fiscal and monetary response– most notably, the bigger emphasis on fiscal stimulus. The previously tightly controlled modern monetary experiment was expanded to the general economy, adding capital (and stimulus cheques) simultaneously to ‘Main Street’ and ‘Wall Street’.
We think markets reached ‘peak hysteria’ in the first quarter of 2021. The history books will show new record price multiples on technology stocks, a boom in loss-making initial public offerings (IPOs), extraordinary price rises in crypto currencies such as Dogecoin, and the GameStop phenomenon.
At the time, as a valuation investor, it felt like the final throes of the long-running momentum growth boom. And, this is what in fact happened.
ENTER INFLATION
The return of inflation has sparked a change in market preferences. Or more specifically, the likelihood of Central Banks rising interest rates in response to higher inflation.
When rates are rising (or expected to rise), investors need to discount cashflows at a higher rate. That is generally negative for growth companies which are expecting to make the bulk of their profits in the future and relatively better for value companies where more of the earnings are expected in the nearer term. It is particularly bad for speculative companies with cash flows deferred a long way into the future, or companies trading on very high or in some instances infinite multiples.
In the second half of 2021 and early into 2022, inflation has continued to surprise markets on the high side. The US Federal Reserve (the Fed) has had to revise its rate outlook upward.
The results in equity markets, have played out as we would expect. The most speculative assets have sold off the most and traditional value stocks have outperformed. Interestingly, the mega-cap growth names have so far proven resilient.
Key questions for investors are: How persistent will inflation be? How much will rates rise? And how quickly?
OUR LONG-TERM INFLATION VIEW
We expect that in the foreseeable future, inflation in the developed world will be structurally higher than that experienced in the past decade.
While some forces driving the inflation spike, including supply chain disruptions, a surge in demand for goods, and higher energy prices may be transitory, we believe that the long cycle of disinflation/low inflation is over.
Several structural factors are influencing the shift to higher inflation, including:
Higher demand partially induced by fiscal and monetary stimulus;
Aging demographics that will contribute to pressures in the labor market; and
Rising costs of doing business, including the cost associated with climate change.
We acknowledge that technology and its remarkable contribution to productivity gains is an offsetting factor, as it has been for the past three decades. However, overall we believe, these new and considerable structural factors point to sustained higher inflation than we have experienced in the recent past.
PORTFOLIO IMPLICATIONS
Higher inflation clearly has implications for global equity portfolio allocations.
Even modestly higher inflation that leads to higher assumed interest rates can have a major impact on asset prices when many valuation models appear to have permanently lowered discount rates. As mentioned, this is acute for high-multiple speculative stocks which have a long duration earnings profile, and we have already seen the narrowing of market leadership in the growth space down to a small number of mega-cap IT stocks.
Given the dramatic performance dispersion between these mega-cap IT stocks and the rest of the market, we think investors need to be mindful of concentration issues should this trade unwind. While the fall in speculative assets may be more dramatic, any fall in the mega-cap names at the top of the S&P 500 index may end up being of far more consequence.
The top five names currently in the S&P 500 index make up more than 20% of the index total (Table 1). These names also populate many active and ‘smart beta’ strategies. Many investors will likely be holding these same stocks across a number of portfolios in a ‘diversified’ blend of funds. In short, many portfolios and even including the most diversified of equity market portfolios, the index, has become very narrow and a play on one mega-cap IT bet.
We believe the market is yet to fully price in higher discount rates into the mega-cap IT stocks. Even a stock like Microsoft (which we have previously owned) could potentially suffer a material fall in its share price if the discount rate applied to its cashflows is revised in line with a shift upwards in the risk-free rate assumption from 1% to as little as 3%.
Under the most conservative of assumptions needed to justify its current share price, which as of the end of March 2022, traded on around 30x cashflow, when increasing the risk-free rate assumption from 1% to 3% would result in a value change of at least 30%.
While arguably, we have yet to see a large or sustained enough shift in inflation and interest rate expectations to hit these stocks, investors need to be attuned to the risk due to the large role they play in portfolios.
LOOKING AHEAD
While relative returns have been strong for valuation-focused investors over the past six months, market pricing has become distorted over a very long period. We believe the adjustment has only just begun.
As ever, we are hunting for companies that have predictable earnings streams, are financially productive and generate a solid return on assets, but we do it with a value focus.
Given the dearth of value opportunities, we believe this is a time when investors need to be concentrated and selective and need to be with managers who are prepared to make active investment decisions.
Warryn Robertson is a portfolio manager and analyst at Lazard.
