No. While the exciting developments in artificial intelligence (AI) have been a bright spot for equity markets this year, we do not think value will continue to lag growth. In fact, we expect it will outperform over the next several years.
Growth indexes have already retraced nearly all of last year’s underperformance relative to value. The shift began earlier this year as investors started anticipating an economic slowdown that would force the Federal Reserve to pause its hiking cycle. Banking sector stress elevated recession concerns, prompting bets that the Fed would cut its policy rate by year end. These developments benefited rate-sensitive growth stocks, which thrive when the cost of capital decreases. Furthermore, the release of ChatGPT’s latest iteration and the ensuing hype surrounding AI sparked an impressive rally among a subset of large growth names. Growth’s strong first half of 2023 has triggered concerns that value’s 2022 turnaround was merely a head fake rather than the start of a sustainable rotation. But there are several reasons to believe value investors will be rewarded for patience.
First, valuations are attractive. The recent growth rally has depressed relative valuations back to extraordinarily cheap levels. The MSCI World Value Index trades at a forward price-earnings multiple of 11.7x, versus 24.4x for its growth counterpart. This is in just the 3rd percentile on a relative basis versus the last 20 years of data and looks like the discount seen in 2021. Similarly, when looking at price as a multiple of normalized trailing earnings ratios, value also trades at a discount in the bottom decile versus history. Moreover, at this point, growth stocks look more likely to disappoint, given the narrow breadth of the growth rally this year and the lofty earnings expectations priced into those few mega-cap companies. Amazon, Meta, and NVIDIA are all expected to report year-over-year earnings per share growth of more than 100% in fourth quarter 2023, according to FactSet.
Second, if AI is about to experience an internet-like revolution, the IT sector will not be the only one to benefit, and companies with the highest productivity gaps stand to benefit the most. Tech companies with AI platforms have seen major re-ratings recently as lofty earnings expectations got priced into the first-order beneficiaries of the technology. But if the proliferation of AI technology plays out as hoped, it will boost profitability across many sectors, particularly in banking and healthcare, where key business functions are ripe for AI disruption. A recent McKinsey study estimated that banks alone could generate value equivalent to an additional $200 billion to $340 billion annually as generative AI accelerates digitization efforts, enhances customer service capabilities, and customizes retail banking offers.
Third, investors should not dismiss the possibility that AI has been overhyped relative to what it can realistically do for corporate profitability. If we are nearing or have already reached the so-called “Peak of Inflated Expectations,” a phrase coined in the popular Gartner® Hype Cycle methodology, then a forthcoming “Trough of Disillusionment” would surely take some wind out of the AI rally’s sails. Large-cap growth indexes are now more concentrated in fewer AI-linked names and private investment (PI) in the space has surged. According to Pitchbook data, completed venture capital deals in generative AI already exceed $13 billion in 2023, versus $4.5 billion in 2022. More broadly speaking, PI-heavy portfolios may have large exposures to sectors like IT and healthcare. Investors should consider public value strategies, which tend to overweight energy and financials, to bring better balance to aggregate sector exposures.
Finally, the growth/value performance dynamic will continue to be linked to the economic cycle. The US economy has remained defiant even in the face of higher interest rates and pockets of stress in the banking sector this year. If a mild recession does surface, or if a recession is averted entirely, rates could stay higher for longer. Such an environment could be supportive for value, as has been the case in prior cycles. Moreover, value has historically done well when economic activity improves, so we would expect it to outperform when the economic clouds eventually clear.
For these reasons, we recommend a tactical overweight to developed value equities. Growth’s recent surge amid AI excitement is palpable, but with a longer-term lens, we believe value stocks are well positioned to outperform going forward.
Sean Duffin, Senior Investment Director, Capital Markets Research