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After one of the most volatile years, what lessons can we take? What happened to equity markets, sectors, themes, and styles? What were the reasons for the rotation in favour of value, what more can we expect going forward, does the current rotation have further legs and will momentum turn for the best of value? Is there value in value?
Already in the summer of 2019 we wrote “[…]the value style needs either a sustained re-acceleration of global growth or, at the other extreme, a full-blown recession, forcing a premia re-pricing and quality momentum style underperformance[…]” and “While the value factor and style have rarely been so cheap, they do need fundamental support from the economy, lower policy uncertainty and rising bond yields to gain sustainable momentum. Since last November, the derating of quality momentum has started and the conditions for a sustained value rally have never been this positive in the last decade.
Exactly a year ago, markets touched their 2020 lows after experiencing one of the worst and most volatile quarters ever amid the COVID pandemic and global economies in strict lockdowns. Work-from-home, stay-at-home, play-at-home, eat-at-home, buy-at-home, entertain-at-home were the new mantras of the time. Swift action from governments and central banks spurred a unique recovery with no historical parallel and propelled a meteoric rise in growth stocks. While bond yields were smashed into occasionally-negative territory, investors deserted cheap (value) stocks, as many of them were more exposed to cyclical industries, financials, and services, which had been deeply impacted by lockdowns and crippling global growth. Concurrently, oil prices also plunged below zero, as demand crashed while supply was increased by OPEC. The MSCI ACWI Value index was under siege and touched its eight-year low on March 20, 2020! Relative to the growth index, a 21-year low was touched on Sept 30.
MSCI ACWI Value/Growth (price)
By the summer, value stocks had reached relative valuation levels only seen after crises like in 2002 (graph 1) or 2009. Despite unusual cheapness, a trigger was required to initiate the rotation out of the darling quality growth and stay-at-home baskets. This came in early November with the extraordinary news on vaccines, the prospect of a quick re-opening and later, the election of Biden with the perspective of massive fiscal stimulus. Bond yields started to rise (graph 2), yield curves steepened even further with expectations of higher inflation, improving economic activity (graph4) and falling policy uncertainties (graph3) as well as default credit risks. Cyclical sectors outperformed, while value, low quality, or high-volatility styles shined on the back of economic optimism.
Graph 1: Dispersion in Expected Return for Behavioral Value strategies
(dispersion is computed, sector by sector, as the expected return of 1st quartile – expected return of 4th quartile, then aggregated for the universe by sector weight)
Graph 2: Rising long term Bond Yields have been supportive of outperformance of value vs. quality (or growth)
Graph 3: falling policy uncertainties, market uncertainties (Vix), or financial conditions, will support compression of dispersion,
re-capture of valuation premium and delivery of excess performance (here for US).
Graph 4: improving PMI (YoY%) has been supporting relative outperformance of Value vs. quality (Europe & US)
What can we expect from here? The rotation has already been strong in anticipation of the global growth recovery, helped by massive fiscal stimulus packages and financed by ever-more dovish central banks and strong household savings. Although some deep, cyclical areas have already recovered from their lows (e.g. automobiles, technologies, mining, China exposure), pockets of opportunity still exist in re-opening themes, financials, energy, or some stocks exposed to consumer services but despite the spectacular reversal, the value factor rebound has lagged the move in cyclical stocks. Furthermore, positioning in value styles is still low. The momentum from recent earnings revisions turned in favour of value baskets and relative valuation (and the still-very-expensive growth and quality factors) still favours value.
Value strategies that are positively correlated with rising bond yield (the opposite of long-duration trades like technologies and growth style) are providing investors a natural bond risk diversifier and hedging vehicle. So far, the rise in bond yields has been rather modest by historical standards. Further normalisation can be expected, but value strategies have undershot the rise in yields. Confidence has been increasing with vaccine efficacy and a steady rollout will soon allow economies to re-open, unleashing huge pent-up spending and investment demand. Inflation expectations are rising quickly, as the price of commodities has been surging and supply-chain shortage pushes pressure downstream. In this environment, steepening yield curves will be supportive (graph5), as will the general reduction in policy uncertainties (graph6). Equity rotation will benefit from a tailwind from rate markets. High-multiple stocks will stay under fire as rates erode their value.
Graph 5: steepening yield curves (here German 10yrs- 2yrs) will support the outperformance of value
Graph 6: falling policy uncertainties will be supportive for outperformance of Value vs. Quality globally
Final (and more technical) support will be provided by the internal rotation within the “rival” momentum baskets. Many such strategies are built on a trailing 12month return moving window. Now, these baskets are starting to morph more into value, high beta/risk, or lower-quality stocks. This shift should accelerate the rotation from next month onward.
Graph 7: Value/growth rotation cycles
Source: JP Morgan
All in all, financial conditions will remain supportive of risk-on trades and value style’s relative outperformance. In any case, and as usual, after a period of strong sector rotation, the compression of the valuation premium will percolate throughout the various industries and give a second boost to the factor. In Europe, the pace of recovery has been hampered by a slower-than-expected vaccine roll-out, but the US is powering ahead with its vaccination program and massive fiscal stimulus. The USA will be the first beneficiary of the reflation trade, but will contaminate the rest of the world too! Value’s long-awaited dawn is finally here, make sure you don’t hit the snooze button.