Is the reflation trade that favoured value stocks, cyclicals and small caps already over? We do not believe so. The factors that recently turned against this trade should again revert given the broadly supportive macroeconomic environment, particularly the expectations of further growth and higher inflation, and high valuations of growth stocks.
This is an extract from our Equity Outlook – A temporary reversal
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What are the risks? Too much stimulus in the US may cause inflation expectations to become unanchored, forcing the US Federal Reserve to raise policy rates sharply. However, the markets currently do not reflect such a scenario. The Fed has continued to stress it is comfortable with the anticipated increase in inflation and that it is in no hurry to raise rates. This helps explain the recent reversal in nominal US bond yields.
Medium-term inflation expectations have eased slightly, perhaps reflecting the impact of rising taxes on growth after the debt-fuelled stimulus. The details of the Biden administration’s broadly defined ‘infrastructure’ packages will be crucial. The size of the spending and the degree to which it is paid for by higher corporate and personal taxes or further debt issuance will determine the extent to which bond yields, i.e. market rates, will rise.
The persistent potential of value stocks
Rising bond yields benefit value stocks such as financials. Other factors support value such as higher crude oil prices. Crude prices have returned to pre-pandemic levels. As the US and Europe loosen the pandemic-related restrictions further and reopen borders, we expect the rebound in demand to drive oil prices higher.
The shift to value stocks reflects the rotation in demand away from lockdown beneficiaries, such as technology companies, to ‘reopening winners’ such as transportation. This shift can also been seen in analysts’ earnings estimates: They are rising faster for value stocks than for growth.
The greater earnings momentum for value is accompanied by far lower earnings multiples. Looked at another way, the premium that growth stocks command over value stocks is still high despite the rotation we have had since last November.
Between strong earnings momentum, attractive valuations, rising energy prices and interest rates, we believe there is still room for value to outperform growth.
Small-cap stocks – Only taking a break?
The expected increase in taxes is one of the factors driving the reversal in small-cap stocks (see Exhibit 1). Another reason may be that small caps benefit less than large caps from the increase in infrastructure, welfare and Green New Deal spending as large companies can capture this incremental demand better.
US small caps have previously suffered under the same large-cap tech ‘curse’ as value stocks, meaning that the good returns for large-cap technology stocks dominated the index gains. To the degree that large-cap tech now lags the broader market, as part of the rotation to value, small caps could resume their outperformance.
The potential gains may be limited, however, given that small caps are now trading at the long-run average premium over large caps. From here on out, we believe it will take superior earnings growth for small caps to outpace large caps.
Alternatives to value and cyclical allocations
Instead of focusing on value or cyclical stocks, investors could choose to overweight countries or regions as a proxy. Indices that have matched the outperformance of cyclical or value stocks include the UK – due to its greater exposure to commodity sectors and underexposure to technology – and the eurozone. To capture cyclical outperformance, one might look to Canada and emerging markets.
What about a move from US equities into European equities to capture the next leg of the reopening trade? European equities are more cyclical than US equities, but the market may have priced in the recovery already. We are currently overweight US equities, but the prospect of higher interest rates and taxes in the US, when relative valuations remain in Europe’s favour, could yet tip the balance.
Or emerging market equities? We expect EM ex-China to outperform developed markets over time given the cyclical nature of emerging markets, the benefit from reduced trade tensions between the US and China and a weakening US dollar.
Rising US interest rates could delay the outperformance since higher US yields make EM investments relatively less attractive. The slower pace of vaccinations in emerging markets will likely postpone the benefits to growth from a re-opening of the borders. Finally, growth in China, which is a key determinant of EM prospects, will be challenged by Beijing’s efforts to deleverage the economy.
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