What’s driving the Value/Growth dynamic?
INSIGHT ARTICLE |
In our June 2021 Investor Insights:Value stocks lead the market; can it last? we discussed the significant outperformance of Value stocks year to date. As data has continued to accumulate, another interesting dynamic playing out so far this year has surfaced between the relative performance of Value and Growth stocks and nominal 10-year Treasury yields. After starting below 1.0% and peaking at 1.74% in late-March, nominal yields have now retraced their steps to around the midpoint as investors weigh the potential for the Delta variant to upend progress towards social and economic normalization. As illustrated in the chart above, the outperformance of Value stocks relative to their Growth counterparts has been closely tied to interest rate movements — the correlation1 of 0.80 this year has been quite strong
compared to the 10-year average of 0.50. The underlying drivers of these interest rate changes may help investors better understand why interest rates are influencing the Value-Growth dynamic to such a large degree.
The sharp increase in nominal yields earlier this year pointed to expectations for increasing economic growth, as well as modestly rising average — or breakeven — inflation expectations. However, nominal Treasury yields rose at a much faster pace than breakeven inflation (i.e. real rates increased), indicating that the rise in yields emanated primarily from an increase in economic growth expectations, which benefited more cyclical, Value-oriented sectors such as financials and industrials.
Since peaking at 2.54% in mid-May, breakeven inflation has settled down into a range between 2.2% and 2.4% (gray line). Over the same timeframe, nominal yields (green line) have trended steadily lower. The widening gap between breakeven inflation and yields in recent months, caused by falling yields as opposed to rising breakevens, suggests investors are lowering economic growth expectations in light of the risks stemming from the Delta variant, which has put downward pressure on those cyclical, Value-oriented sectors. At the same time, investors gravitated back towards Growth stocks, which have shown more earnings resilience in lower-growth environments.
Looking ahead, we expect longer-term Treasury yields to resume their upward trend while inflation begins to moderate. This would likely result in a narrowing of the gap as investors re-adjust economic growth expectations higher as supply chain bottlenecks abate, labor market conditions continue to improve, and vaccination rates reach herd immunity. This scenario — should it play out — bodes well for Value stocks. However, as is the case with all risk assets, COVID-19 and variants of it remain a key risk to monitor.
1Correlation ranges from -1 to 1 and measures the strength of a relationship between two variables. A correlation of: 1 means the prices of two assets change by the same amount at the same time, 0 implies that the price movement of one asset has no effect of the price movement of the other, -1 means the prices of two assets change by the same amount (in opposite directions) at the same time.
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