Fed rate rise could drive investors back to value

Charles Younes

Charles Younes

Eugene Fama and Kenneth French (both professors at the University of Chicago Booth School of Business) observed that two classes of stocks have tended to do better than the market as a whole: small caps, and stocks with a low price-to-book ratio – value stocks – especially when compared to growth stocks.

Recent history has proven them wrong, however, as we have now seen the largest underperformance of value against growth since the tech bubble.

There are a few reasons for this phenomenon. In this low-growth environment, investors have been willing to pay a premium for companies that have displayed higher levels of growth.

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The recent period has also seen changes to investors’ risk appetites. As a result, investors have been more receptive to paying a premium to access perceived safer areas of the market.

This translated into increased demand for bond proxies (consumer staples, healthcare, utilities and telecoms) as well as non-cyclical growth stocks.

Additionally, record low interest rates have encouraged investors to favour income-generating firms, which tend to be found in larger growth companies with stable earnings and cashflow visibility.

For all these reasons, growth companies now trade at elevated levels – irrespective of their fundamentals.

A recent study by M&G claimed the correlation between momentum and quality is currently at 90 per cent, so “investors buying good companies are actually buying into momentum”.

This trade is crowded, as highlighted by the outperformance of active UK equity managers in the second half of 2015, followed by their underperformance in the first quarter of 2016 when value surged in February and the momentum trend broke.

History suggests that shifts in monetary cycles can have a profound effect on this relationship between growth and value. An outperformance of value has been a feature of past tightening cycles.

According to the same study by M&G, value beat growth significantly in both the six-month and one-year periods following Fed tightenings in January 1987, February 1994 and June 2004.

Empirical studies on data since 2009 have confirmed this relationship between value/growth and interest rates. The return spread between value and growth since then has exhibited a significant positive sensitivity to changes in 10-year US Treasury yields.

A Morgan Stanley study has attempted to explain this relationship further. Given that growth companies tend to invest heavily in the near or medium term to maintain earnings growth, they likely deliver free cashflows and/or dividend payments further into the future than value companies.

Therefore, duration (or sensitivity to changes in interest rates) for growth stocks is likely to be longer than value stocks, which means they are more likely to benefit from a decline in interest rates.

This was confirmed by Morgan Stanley’s calculations: about 17 per cent of global stocks have a statistically significant sensitivity to changes in 10-year yields, either positive (8 per cent) or negative (9 per cent).

Stocks with a positive sensitivity tend to concentrate in the top-value deciles, while stocks with a negative sensitivity tend to have a more defensive, higher quality profile.