U.S. Equity Style Performance Update
The moderate pace of rate normalization helps value stocks to stage a small comeback
Style rotation became a fashionable topic following the burst of the tech bubble in early 2000. The trigger for the increased interest in the topic was the dramatic change in style performance during the build-up of the “new economy” era and the period following its collapse. Style cycles have been recorded well before the end of the 1990s, but market participants only started paying close attention, due to the very pronounced performance of growth stocks during the bubble, and the subsequent dramatic reversal in their performance.
There are numerous academic studies that have attempted to find a plausible explanation for the existence of the style spread (relative performance of value versus growth stocks), but the evidence remains inconclusive. Some attribute its existence to risk reward reasons (higher risk premia), while others to behavioral reasons. In order to keep things simple, we will assume that the style spread is impacted by three broad factors: business cycle, valuation, and equity market specific factors. Relative valuation factors are the most easy to grasp, as an overstretched valuation in one or the other style, will create expectations of mean reversion (the style spread is mean reverting). The overvaluation of growth stocks in the late 90’s is a good example. If the style spread reflects increasing or decreasing risk premia, the current and projected stage of the business cycle is crucial for its underlying performance, as macroeconomic risk impacts risk-reward relations and has an effect on sentiment factors.
As a general rule, value stocks tend to outperform during economic expansions, especially in the early stages, as they are short duration plays and can grow their earnings along with growth in economic activity, while growth stocks are long duration plays and their earnings growth capability is independent of the economic cycle. An environment of abundant liquidity and earnings growth is optimal for value stocks, as investors are not willing to pay a premium for growth that is not scarce. By contrast, during periods of economic slowdown and/or contraction, when earnings growth is more difficult to achieve, i.e. when earnings visibility is limited and earnings volatility increases, investors are willing to pay a premium for stocks that have more stable and consistent earnings growth capabilities.
It is, thus, not accidental that U.S. growth stocks have outperformed during 2015. Graph 1 presents the cumulative performance of the S&P 500 value and growth index since 2015. Style rotation in practice is shown in Graph 2 that plots the cumulative relative performance of the underlying style indices against the core S&P 500 index. All indices are expressed in total return.
The end of QE tapering in the middle of 2014, the anticipation of higher U.S. interest rates, as well as fears related to the impact of weak foreign demand, due to the slowdown in emerging markets and China, in particular, that is reflected in manufacturing PMIs and the rout in commodity markets, induced investors to seek the safety of stocks with superior earnings quality, consistency, and growth. The first U.S. rate increase after almost xxx years at the end of 2015, solidified expectations for a reversal of the ultra accommodative monetary policy environment.
The scenario of below trend global growth, weak commodity market performance and, further normalization in U.S. rates was carried over to the beginning of 2016. When it was clear, however, that especially the pace of U.S. rate normalization would be a lot slower than initially anticipated, the volatility in commodity markets declined and showed signs of stabilization, and U.S. macroeconomic figures started coming out better than expected, value stocks staged a partial come back and retain a small margin of outperformance (Graph 3-4).
Indeed, some conditions for value stock performance stabilization were definitely there; a rebound in commodity markets, a very gradual and slow pace of rate normalization by the Federal Reserve, as well as a continuous and sizeable monetary accommodation by other major central banks. On a cumulative basis, the value index outperformance year to date is approximately 2.60%.
Projected U.S. monetary policy, as well as the underlying strength of economic activity, is key for style performance till the end of the year. A rate hike and/or more aggressive forward guidance by the Federal Open Market Committee will most likely benefit growth stocks, as the market will readjust expectations and factor in a softer economic environment. By contrast, an environment of continued monetary laxness and accelerating growth will favour value stocks.