- Since spring 2016, rising inflation expectations have favored a shift toward value stocks.
- While the value rotation trade is strong now, we believe this is still only a trade—not a complete change in climate.
- Global GDP dynamics should help value stocks in 2017, but the longer-term trend favors defensive growth
A change in style trends
Equity markets were shaken more thoroughly in 2016 than any of James Bond’s martinis. At first glance, index returns for major markets stayed in normal ranges, but just under the surface was one of the most forceful sector rotations since the 1980s. This resulted in previously unloved sectors like mining, energy and—in the US—banks outperforming by a wide margin, while former investor darlings like consumer staples found themselves left behind. So how can investors get a grip on trend reversals like the one we experienced with growth and value stocks in 2016? Setting aside for a moment certain bottom-up (ie, company-specific) drivers and valuation factors, we have identified three key top-down (ie, macroeconomic) drivers that can move stocks along the spectrum from defensive growth to cyclical value.
This recovery lacks the resilience and self-sustaining qualities it needs to achieve 'escape velocity'
The level and direction of gross domestic product growth plays a major role in sector rotation. Periods of low or decelerating economic activity help companies exhibiting superior growth rates precisely because growth is scarce in such an environment. This has been the case since 2011, when low absolute and less dynamic GDP growth began pushing investors toward growth stocks. We believe global growth dynamics will turn around and move slightly upward in the near future—partly driven by easing fiscal strains in Japan, the UK and the US—which should help value stocks slightly. However, this situation should not last past 2018 or 2019, because the ongoing recovery still lacks the resilience and self-sustaining qualities it needs to achieve “escape velocity”.
Projections of increasing prices generally support recovery rallies in cyclical value names, while persistent disinflation typically helps defensive growth stocks. This explains why rising inflation expectations—which are often seen in conjunction with rising commodity prices and some pick-up in economic growth—tend to drive up earnings estimates in traditional cyclical value sectors like mining, energy and banks. Since the spring of 2016, many developments have contributed to rising inflation expectations, and we believe some of these will be sustained in 2017: Overly depressed market expectations have begun to correct themselves, commodity prices have recovered and we have seen some initial adjustment to overcapacity in China. Moreover, output gaps have begun gradually closing around the globe—particularly in the US labor market. This should lead to increasing wage inflation, especially if the Trump administration starts to fiscally stimulate the US economy, which has a labor market that is already close to full employment.
The tight US labor market could lead to wage inflation, especially under fiscal stimulus from Trump
The direction of bond yields
Bond yields reflect both growth and inflation expectations, but they also tell us about investor positioning and monetary-policy expectations. Lower bond yields are better for the defensive growth end of the spectrum, and we have seen this situation manifest itself in recent years. During this time, bond markets priced in a secular stagnation scenario, which allowed for the discounting of distant future cash flows at ever-lower discount rates, driving up earnings multiples for growth stocks considerably. With risk/return perspectives deteriorating in sovereign fixed-income securities, this shift also made defensive equities a serious investment alternative for multi-asset allocation funds. Today, however, the leading global bond market (the US) is slowly waking up to a tough rate-hike path, unusual late-cycle fiscal stimulus, stronger inflation and too-ambitious valuations—which mean US bond yields are expected to move higher during 2017. This should favor value names—particularly banks, especially when higher bond yields come with steeper yield curves.
A closer look at valuations
Beyond these macro drivers, valuation of course plays a role in sector rotation,
The valuation gap between pricey growth and cheap value has already closed quickly
and there is still some room to move in today’s market. For example, banks are still at above-average discounts relative to markets, and consumer staples look pricey despite a recent correction. However, the huge valuation gap between pricey growth and cheap value has already closed quickly, especially with value areas like materials and energy appreciating markedly.
Tilting toward value
We believe bond yields will be the strongest of our three top-down drivers in the next year;
We believe bond yields will be the strongest of our three top-down drivers in 2017
GDP growth expectations are only slightly upward-turning, and inflation already moved dynamically during 2016. As the accompanying graphic shows, the outlook for inflation expectations and bond yields favors cyclical value names in the coming months; however, the GDP growth picture is improving only moderately, which is an argument in favor of defensive growth stocks.
As a result, while the value rotation trade is too strong to ignore and should continue for some time, we believe that in the end, this is still only a trade—not a complete change in climate. The big picture for GDP growth has not been altered, and there are still constraints to supply such as low productivity, deteriorating demographics and reform fatigue in many parts of the Western world. Once the markets realize this, rising inflation expectations and bond yields should slow— which would once again argue for an above-average valuation premium for defensive growth stocks.
In between, equity markets will probably continue to be shaken between the two styles—and investors may find themselves in need of a drink from their favorite bar keeper.
Macroeconomic Indicators Slightly
Rising inflation expectations and bond yields support
Favor Value Investing
a shift to value, but still-low GDP levels favor defensive growth.
Source: AllianzgGI Economics & Strategy