Thought of the day

Growth stocks have outperformed their value counterparts so far this year, benefiting more from hopes of an early end to rate rises. The MSCI All Country World Growth index is up over 10% year-to-date, compared with the Value index’s 3.9% gain. This is the reverse to last year’s dynamic—value beat growth by around 20 percentage points in 2022.

But this year's outperformance of growth over value has slowed in recent weeks, from 4.7 percentage points in January to 1.8 percentage points in February. Historically, value stocks have tended to outperform in periods of elevated inflation, while growth sectors are disproportionately harmed by higher interest rates.

In our view, recent economic developments lend themselves to a renewed period of relative strength for value over the near term.

Price pressures remain, despite an easing of headline inflation. Based on data going back to the 1970s, value stocks have outpaced growth when inflation is over 3%. The latest US consumer price index release for January has reinforced our view that inflation is only likely to fall below this level later this year.

While the headline rate of annual inflation declined to 6.4% year-over-year, the slowest pace since late 2021, various other price gauges pointed in the wrong direction. On a month-over-month basis, the January print accelerated to 0.5% from 0.1% in December. There was no decline in monthly core inflation in January, which held steady at 0.4%. In addition, the three-month annualized rate rose to 4.6% in January from 4.3% in December, while the six-month annualized rate also ticked higher to 5.3% from 5.1%.

Fed officials have stressed that further rate hikes are essential, a greater potential drag for growth sectors. Growth sectors, like tech, tend to suffer more from higher rates, since this reduces the current value of more distant profits. So, the recent hawkish tone of comments from top Fed officials could also tilt the balance between growth and value sectors.

This week St. Louis Fed President James Bullard said he wouldn’t rule out a 50-basis-point hike at the Fed’s March policy meeting, after slowing the pace of rate rises to 25 basis points in February. He added that “it will be a long battle against inflation.” The Cleveland Fed’s Loretta Mester also said this week that she “saw a compelling economic case for a 50-basis-point increase” at the recent meeting, and added that “we can move faster, and we can do bigger at any particular meeting.”

The recent inflation data—along with the fall in the unemployment rate to a 53-year low in January—has also prompted markets to imply a higher peak in interest rates. Fed funds futures are now implying a peak of 5.29% in July, up from 4.8% at the start of February.

Tech, the largest growth sector, faces additional headwinds beyond rate worries. The recent rebound in tech has made valuations in the sector even more demanding, in our view. The MSCI World IT sector trades on a 12-month forward price-to-earnings multiple of 22 times, 20% above the sector’s 10-year average, as of 13 February. By contrast, value sectors are generally more moderately priced. In addition, we expect global tech sector earnings growth to slow further due to a weaker enterprise outlook and lukewarm consumer demand.

So, we prefer value to growth. We incorporate a combination of defensive (like consumer staples), value, and income opportunities that should outperform in a high inflation, slowing growth environment, alongside select cyclicals that should perform well as and when markets start to anticipate the inflections.