Yes, we believe value stocks can resume their leadership relative to the broad market over the next six to 12 months, provided we are correct in our assessment that the economic impact of COVID-19 Delta variant will be limited in major developed markets and China. The success of these investments longer term is unclear and dependent on at least one of several factors: sustained high levels of economic growth, increased public and private sector investment translating to higher productivity across a broader range of companies, and prospects for higher taxes and regulatory pressure falling disproportionately on large, global tech-focused companies.
For further discussion on this topic, please see Celia Dallas, “VantagePoint: Can Value Outperformance Endure?,” Cambridge Associates LLC, July 2021
Value’s heavy overweights in financials and more cyclically oriented businesses relative to the broad market make the factor sensitive to economic growth momentum. The period of value outperformance that began last fall has been fueled by a strong economic recovery as major economies reopen following pandemic-related restrictions. To the extent that governments and the medical community can continue to advance vaccination progress and contain the spread of COVID-19 variants, economic strength can be expected to continue and spread beyond the United States and Europe. While much of the economic acceleration from reopening in the United States has played out, the economic expansion phase should continue as there is plenty of support for economic growth through excess savings, increased household wealth, and continued accommodative financial conditions and fiscal and monetary policy. Value stocks, particularly financials, tend to be positively correlated with rising interest rates and a steepening yield curve, and that has certainly been the case in this cycle.
Beyond the reopening boost as we recover from the pandemic, policymakers appear to be taking in the lessons of the last decade by seeking to avoid austerity and invest in infrastructure, education, and technology. Corporations operating in COVID-19–affected environments have also sharply increased investment in information processing equipment and software (total private fixed investment has increased and now exceeds 2019 levels), and the number of patent filings in the United States has increased over the last several years. As the economy transforms digitally, widespread access to broadband and affordable education will be essential to retrain workers to continue to support demand. If done well, such investments can boost long-term growth and expand productive capacity.
Value stocks have also struggled to outperform as large-cap growth companies have been the strongest earners globally and there has been increased persistence in profitability dominance among the most profitable firms since the global financial crisis, according to analysis by Wellington Management. However, the pendulum has swung too far on the ability of large global firms to control markets and engage in global tax arbitrage. Public opinion has turned the tide, and politicians and regulators are working to restore some balance, which should ultimately benefit value firms.
As such, value stocks provide useful diversification to portfolios with heavy tech and growth equity exposure, as tech stocks have been negatively correlated with rate moves this cycle. They also provide a nice hedge against the risks of rising taxes of foreign income and anti-trust action aimed squarely at large tech companies that have been a key driver of US growth stock earnings and margin strength. We maintain modest tilts into strategies more geared to economic growth like value, small caps, and global ex US equities. In addition, quality is a useful diversifier to portfolios as it tends to have a low correlation to the value factor. It should also prove defensive if COVID-19 variants create economic setbacks or should the economy move out of the expansion phase into a more mature economic phase faster than we anticipate. Finally, a premature tightening of interest rates relative to market expectations is a threat to all risk assets, especially those growth stocks that discount large earnings growth in the long term.
Value’s day in the sun will likely continue over the next six to 12 months and large investments in infrastructure, including broadband access and green technology, could serve to support value stocks for a more extended period. These investments could facilitate an increase in productivity through wider distribution of technological advances that could enable a non-inflationary increase in wages and fuel a virtuous cycle of increased consumer demand that leads to increased earnings, investment, and job growth. If such economic conditions occur, they would be highly supportive to value outperformance making an extended stay.