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Rising Rates: Why Value Stocks Have Outperformed

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Value Stocks

Value Stocks

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The Benefits of Value Stocks in Rising Rate Environments

As investors flock to safety, value stocks have outperformed growth stocks year-to-date amid economic turbulence and rising interest rates.

Owing to their strong fundamentals and cash flows, value stocks may be returning into favor.

In this infographic from New York Life Investments, we illustrate why value stocks offer opportunities in rising rate periods.

Recent Performance

In a matter of two years, the Ukraine war, supply chain shocks, and COVID-19 have led inflation to multi-decade highs.

Amid these complex struggles, value stocks have outperformed significantly.

  • Russell 1000 Value Index: -1.1%
  • Russell 1000 Growth Index: -14.1%
  • S&P 500: -8.4%

As of April 14, 2022

With higher inflation predicted for the medium term, value stocks may be staging a comeback.

As investors look to de-risk their portfolios, many are turning to value stocks, thanks in part to their historical outperformance during inflationary and rising rate periods.

Value vs. Growth: Key Characteristics

As a quick refresher, here are the key distinctions between value stocks and growth stocks.

CharacteristicValue InvestingGrowth Investing
Defining FeaturesCompanies with stronger cash flows, steady income, priced below intrinsic value.Companies with lower cash flows, low (if any) income, strong earnings growth potential.
ValuationUndervalued (low P/E ratios)Overvalued (high P/E ratios)
DividendsMore commonLess common
VolatilityLowerHigher
SectorsFinancials, Energy, Healthcare, IndustrialsTech, Communications, Consumer Discretionary

Cyclical sectors such as financials and energy often benefit when prices increase after an economic contraction.

Since companies earn money in different ways, it is often useful to compare price-to-earning (P/E) ratios within a sector. A P/E ratio is a metric for valuing a company, where a company’s stock price is divided by its earnings per share.

An overvalued company in the tech sector may have a P/E ratio of 100, while the S&P sector average is 24. By contrast, an undervalued healthcare company may have a P/E ratio of 14, lower than the S&P sector average of 16.

When a company is undervalued it means that it’s trading below its intrinsic value.

Value vs. Growth: Performance

Looking back, the previous decade saw the worst performance for value in the last 90 years.

On average, growth outperformed value by 7.8% annually since 2010. However, looking at 10-year periods, value has outperformed growth over every decade since the 1940s.

DecadeValue Outperformance
1930s-0.5%
1940s10.8%
1950s5.6%
1960s4.2%
1970s8.1%
1980s7.4%
1990s0.7%
2000s8.0%
2010s-2.6%

Average annual performance of Fama and French (“HML”) value factor by decade.
Source: Fama & French via Mercer (Mar 2021)

Now, against economic uncertainty and other structural shifts, the growth and value divergence is beginning to change for the first time in over a decade.

What is Driving Value Stocks?

On a broader level, the following forces have driven outperformance in value stocks and growth stocks.

 Value InvestingGrowth Investing

Broad Market Factors
  • Rising interest rates
  • Market recovery
  • Inflationary environment
  • Long-term earnings track record
  • Low interest rates
  • Bull market
  • Disinflationary environment
  • Rising corporate earnings

So how do these apply today?

In an inflationary (and rising rate) period, current earnings become more valuable and future earnings become less valuable. Typically, “value stocks” are assessed based on their current earnings while “growth stocks” are valued on their future earnings.

Consequently, inflationary periods have tended to favor value stocks and deflationary periods have tended to favor growth stocks. When prices are climbing, companies with actual earnings are potentially better positioned to increase prices and retain profit margins.

At the same time, it is important for investors to avoid value-traps, which are companies trading below value that are in financial duress. To help mitigate this challenge, active investment managers can help identify the appropriate companies.

Sign of the Times

It’s worth noting that this isn’t about value vs. growth. Instead, different styles have performed better at different times. Of course, it’s important for investors to consider a number of variables for their portfolios:

With these in mind, investors can implement the best strategies to help achieve their goals.

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Infographics

Europe’s Energy Crisis and the Global Economy

Europe’s energy crisis could last well into 2023. Here’s how the energy shock is causing ripple effects across the broader economy.

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Europe’s Energy Crisis and the Global Economy

Volatile energy prices are squeezing household costs and business productivity in Europe.

While energy prices have fallen in recent months, several factors could influence price volatility looking ahead:

  • Russia slashing energy supplies
  • Rising winter heating demand
  • Shrinking European storage facilities

In the above infographic from New York Life Investments, we show the potential impacts of Europe’s energy crisis on consumers, businesses, and the wider global economy.

1. Impact on Consumers

Energy plays a central role in overall inflation. Here’s how it factors into the consumption baskets of various countries:

CountryEnergy %
of Inflation
Total Inflation Rate
(Sep 2022)
EnergyFoodAll Items Less Food
and Energy
Germany46%9.9%4.5%1.8%3.6%
Italy42%8.7%3.7%2.2%2.8%
Japan42%3.0%1.3%1.0%0.8%
France29%5.6%1.6%1.6%2.4%
United Kingdom28%8.8%2.5%1.3%5.0%
U.S.17%8.2%1.4%1.0%5.8%
Canada15%6.8%1.0%1.3%4.5%

Source: OECD (Oct 2022). Annual inflation is measured by the Consumer Price Index.

As the above table shows, energy makes up nearly half of consumer price inflation in Germany. In the U.S., it contributes to about one-fifth of overall inflation.

Amid energy supply disruptions, U.S. winter heating costs are projected to rise to the highest level in a decade. As heating costs rise, it could impact consumer spending on discretionary items across the economy, along with other essential household bills.

2. Impact on Business

Natural gas and petroleum are key components in many industries’ energy consumption. As a result, the recent rise in energy prices is adding significant cost pressures to operations.

Below, we show how four primary sectors use energy, by source:

U.S. SectorPetroleumNatural GasRenewablesCoalElectricity
Transportation90%4%5%0%<1%
Industrial34%40%9%4%13%
Residential8%42%7%0%43%
Commerical10%37%3%<1%50%

Source: EIA (Apr 2022). Figures represent end-use sector energy consumption in 2021.

In Europe, soaring energy prices have led to production declines in energy-sensitive industries over recent months. As a ripple effect, European fertilizer production capacity has decreased as much as 70%, crude steel capacity has fallen 10%, and aluminum and zinc production capacity has sunk 50%.

In response, some companies may move production out of Europe to regions with lower energy prices. This occurred in 2010-2014 amid high European energy prices, where companies relocated to the U.S., the Middle East, and North Africa.

3. Impact on the Economy

While the energy crisis is having devastating effects on many countries, some markets like the U.S. are more sheltered from the impact. As seen in the table below, the U.S. produces virtually all of its natural gas. Figures are shown in trillion cubic feet.

YearU.S. Natural Gas
Production
U.S. Natural Gas
Consumption
Net Imports
20213531-4
20203331-3
20193431-2
20183130-1
201727270
201627271
201527271
201426271
201324261
201224262
201123242
201021243

Source: EIA (Sep 2022).

By contrast, Europe imports 80% of its natural gas, primarily from Russia, North Africa, and Norway. Not only that, natural gas imports have increased over the last decade, up from 65% of total supplies in 2010.

Meanwhile, the energy sector is seeing strong returns supported by higher oil and natural gas prices, along with key fuel shortages as Russia constricts supplies to Europe. In November the S&P 500 Energy Index was up 65% year-to-date compared to the broader index, with -17% returns.

Europe’s Energy Crisis: Looking Ahead

Given the complex geopolitical environment, Europe’s energy crisis could last well into 2023, driven by many factors:

  • Rising demand from China post-COVID-19 lockdowns
  • Lower European fuel reserves
  • Inadequate energy infrastructure in the medium-term

The good news is that European government relief has reached €674 billion ($690 billion) to cushion the effect on households and businesses.

However, this has additional challenges as increasing money supply may be an inflationary force.

Amid market volatility, investors can avoid getting caught up in short-term market movements and stay focused on their long-term strategic allocation.

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Infographics

5 Key Questions Investors Have About Inflationary Environments

This infographic explores questions on today’s inflationary environment as the economy faces persistent price pressures.

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Inflationary Environment

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5 Key Questions on Inflationary Environments

What does a changing inflationary environment mean for financial markets, and how could this impact investors?

While there are no clear answers, the above infographic from New York Life Investments looks at key questions on inflation and the potential implications looking ahead.

1. What Are the Main Factors Driving Inflation?

Often, investors closely watch core inflation since it doesn’t factor in volatile energy and food prices. In September, core inflation rose 0.6% from the previous month while headline inflation, as represented by the Consumer Price Index, increased 0.4%.

DateCore InflationHeadline Inflation
Sep 20220.6%0.4%
Aug 20220.6%0.1%
Jul 20220.3%0.0%
Jun 20220.7%1.3%
May 20220.6%1.0%
Apr 20220.6%0.3%
Mar 20220.3%1.2%

Source: Bureau of Labor Statistics, 10/13/22.

Earlier in the pandemic, surging second-hand car prices and supply-chain distortions were factors driving up inflation. But as dynamics have shifted, rising services costs, including housing, have played a significant role.

Along with these factors, a strong labor market is adding to price pressures. Nominal wages increased 6.3% annually in September, after hitting almost 7% in August, the highest in 20 years.

For this trend to reverse, unemployment levels may need to rise and interest rates may need to increase to cool an overheating economy.

2. What is the Effect of Fiscal Stimulus on Inflation?

In response to a historic crisis, the U.S. government allocated over $5 trillion in fiscal stimulus. The Federal Reserve released research that suggests that the fiscal stimulus contributed to 2.5 percentage points in excess U.S. inflation.

Specifically, the fiscal stimulus affected supply and demand dynamics, stimulating the consumption of goods. At the same time, the production of goods didn’t increase, which elevated demand pressures and price tensions.

As the short-term implications begin to unfold, the longer-term structural effects of record stimulus remain far from clear.

3. How Do Interest Rates Impact Inflation?

When inflation is running high, the Fed often hikes interest rates to cool an overheating economy.

Consider how in February 1975 there was a 17% difference between core inflation and real interest rates, an instance when the Fed got “behind the curve”. This shows that the real rate is far below the core inflation rate.

Sometimes, this prompts the Fed to raise rates to combat inflation. After several rate hikes, inflation fell to 4% by 1983, bringing the real rate and core inflation closer together. The table below shows when this gap rose to the double-digits between 1974 and early 2022:

DateCore InflationReal RateDifference
Oct 197410.6%-0.5%11.1%
Nov 197411.0%-1.5%12.5%
Dec 197411.3%-2.8%14.1%
Jan 107511.5%-4.4%15.9%
Feb 197511.9%-5.6%17.5%
Mar 197511.3%-5.8%17.1%
Apr 197511.3%-5.8%17.1%
May 197510.3%-5.1%15.4%
Jun 19759.8%-4.3%14.1%
Jul 19759.1%-3.0%12.1%
Jan 198012.0%1.9%10.2%
May 198013.1%-2.2%15.3%
Jun 198013.6%-4.1%17.7%
Jul 198012.4%-3.4%15.8%
Aug 198011.8%-2.2%14.0%
Sep 198012.0%-1.1%13.1%
Oct 198012.2%0.7%11.6%
Dec 20215.5%-5.4%10.9%
Jan 20226.0%-6.0%12.0%

Source: Peterson Institute for International Economics, Federal Reserve Bank of St. Louis, 03/14/22. The real policy interest rate is the Federal Funds Rate minus Core Inflation over 12 months.

In January 2022, this gap reached 12%, hinting towards further interest rate action from the Fed.

Over the last 11 tightening cycles since 1965, six resulted in soft landings and three resulted in hard landings. Whether or not the recent tightening cycle will result in a hard landing, also known as a significant decline in real GDP, remains an open question.

4. How Long Will Inflation Last?

From the vantage point of 2022, the direction of inflation is as complex as it is uncertain. Below, we show where inflation may be headed in the near future based on analysis from the Federal Reserve.

 2022P2023P2024P
PCE Inflation5.4%2.8%2.3%
Federal Funds Rate4.4%4.6%3.9%

Source: Federal Reserve Board, 09/21/22. Reflects median projections for PCE Inflation and the Federal Funds Rate.

By 2024, inflation is expected to fall closer to the 2.0% target amid higher interest rates. What other key factors could influence inflation going forward?

 2023 Projection
U.S. Real GDP Growth1.2%
Interest Rates4.6%
Housing Price Growth-10.0%
Unemployment Rate4.4%

Source: Federal Reserve Board 09/21/22, Morningstar, 08/07/22. Interest rates represented by the Federal Funds Rate. Housing Price Growth represented by median U.S. home prices.

A combination of slowing GDP growth, higher interest rates, decreasing housing prices, and higher unemployment could potentially dampen inflation leading into 2023.

5. What May Lessen the Impact of Inflation On My Portfolio?

During inflationary periods, value stocks have tended to perform well, based on data from Robert Shiller and Kenneth French. In fact, value stocks saw nearly 8% annualized outperformance over growth during the 1970s and over 5% outperformance during the 1980s.

Similarly, tangible assets like commodities and real estate have tended to weather these periods thanks to their ability to increase portfolio diversification and stability across economic cycles. For instance, between 1973 and 2021, commodities have averaged 19.1% during inflationary periods while real estate assets averaged 5.0%.

The Big Canvas

Generally speaking, periods of high inflation over history are quite rare. Since 1947, the average U.S. inflation rate has been 3.4%.

Inflation (1947-2021)Percentage of Time Spent
Below 0%16%
Between 0 and 5%57%
Between 5 and 10%20%
Above 10%7%

Source: CFA Institute, 07/19/21.

Against a changing environment, investors may consider balancing their portfolios with more defensive strategies that have been historically more resistant to inflation.

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