A low growth, low interest rate environment, combined with the longest recovery in history, has accelerated growth stocks’ valuations further and further away from value.
The effect of this divergence is now being seen away from simple valuations. Though the failure of Neil Woodford’s investment firm was due to several factors, some of which related to the unusual way he ran money, his value style certainly contributed to the poor performance that lead to the redemptions that, in turn, collapsed the house of cards. Tim Russell, lauded almost as highly as Woodford for his expertise in UK equity investing, saw his firm Sanditon Asset Management announce its closure last month due to lack of demand for its value-based strategies. Nevertheless, tThere are still plenty of value managers pitching their funds on the basis that value stocks are trading at an almost record discount to growth. However, investors seem immune to the ‘mean reversion’ argument and have increased their exposure to growth even further.
Alongside a growth bias, some investors have weighted their portfolios quite heavily towards US equities. The US stock market is itself biased towards growth companies, so the two trades fit naturally together. The US has outperformed in recent years and, for those that believe that there is more of this cycle to come (which includes ourselves), it may seem logical to assume that what has worked to date will continue to do so. However, there are several reasons to question that assumption.
Firstly, current US policy increases the chance of inflation rising, which could benefit value stocks. The Federal Reserve (Fed) Chair Jerome Powell has said that interest rates will not rise without “a really significant move up in inflation that’s persistent”. Inflation has reached the Fed’s target of 2% just twice in the last few years, only to fall back again almost immediately, so the Fed may want the rate to exceed the target for some time before they calm growth.
Secondly, President Trump wants a weaker US dollar to help close America’s trade deficit. Any such weakening of the currency helps overseas markets, especially Asia and Emerging Markets (EMs) where many countries borrow in US dollars. With stock markets in these regions trading at a meaningful discount to US equities, a pick-up in Asian or EM growth could see investors move money out of the US market.
Indeed, in September there was a sharp (if brief) rotation out of growth into value. Whilst the value rally petered out, investors that had high exposure to the US/growth trades experienced a sudden period of underperformance. It will be interesting to see if this reminder of the dangers of over-concentration affects investor behaviour, as such events can precipitate the end of such crowded trades.
For now, our core case remains that this low growth, low interest rate environment continues, in which case both trades could continue to perform well. However, we believe that the risks have increased and being diversified around a range of potential outcomes is wise. Whilst we may not benefit fully from further upside in the two trades, we are not overly exposed to the alternative scenario. Market changes can come very quickly, so whilst being greedy on such trades may play out, it comes with elevated risk.