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Since April, yields have dropped and yield curves have flattened in developed market economies: The US 10-year yield fell from a high of 1.74% to below 1.20% recently. The main drivers of the falling yields were concerns about global economic growth peaking and the fear of the new Delta variant, while the transitory inflation narrative is still being viewed as the base case by central banks. As a consequence, there is a fear that the shortest recession in history might be followed by the shortest expansion in history. This would limit the FED’s time frame to tighten policy, implying a shallower rate path and a lower terminal rate. Consequently, the US curve flattened aggressively, driven by the belly of the curve. Due to these circumstances, value has lost its pole position versus growth over the last months.
Taking some inspiration from the quote ‘history doesn’t repeat, but it often rhymes’, let us look back at the year 2004. The first half of 2004 reminds us of the situation in which we currently find ourselves. After a strong rally led by cyclicals and a strong rebound of the economy, there was a period of sideways movement in markets and a deceleration of economic growth. After this period, cyclical and value stocks experienced another leg of strong performance helped by strong economic growth. We believe that this is the most likely scenario going forward.
We will start with the macro picture and then zoom into the valuation aspect. In general, the largest drivers of value are a strong economic backdrop and rising yields. Although the Covid delta variant has added to growth worries, the impact of this variant on the economy might not move the needle towards the downside if hospitalisations and deaths stay relatively low. Growth has most likely peaked, but at levels seldom seen before. One could argue that growth might stay elevated over the medium term, which is a supportive background for value stocks. In order to trigger the value outperformance, we need yields to rise, particularly the 10Y US treasury yield. Interest rates are like gravity to asset prices, where higher rates benefit value versus growth, as some of those highly valued stocks will be pulled back to earth. One of the catalysts for this repricing would be continued strong job numbers in the US, which would move 10Y US treasury yield toward higher levels. The FED focus strongly on employment for their tapering decision and, in the longer run, their decision to increase the Fed funds rate. We believe there is a good probability for higher yields due to this combination of stronger growth, a stronger labour market, and higher inflation.
In terms of valuation, the gap between value versus growth has been shrinking until April because of a very strong performance of the value style. After the recent outperformance of growth, this valuation gap has widened again to more extreme levels, as seen during the end of last year. The importance of the 10Y US yield for the value style is again shown by the fact that value underperformed, even though value stocks posted stronger earnings beats this quarter than their growth stock counterparts. We believe this wide valuation gap offers investors who missed the first leg of the value rally a new opportunity to jump on the value train.