The Value-Growth Dichotomy

January 27, 2022

Source: Bloomberg Source: Bloomberg

Federal Reserve (Fed) Chairman Jerome Powell’s statement that he expects a series of interest rate hikes was received with mixed views. With inflation reaching a 39-year high of 7% in December 2021, some welcomed this announcement. The economy is expanding and the unemployment rate is falling,  so it was anticipated that interest rates would go up in response to inflation.

On the other hand, some viewed the higher prices as “transitory” due to supply chain disruptions, bottlenecks and shortages. So they worry that increasing interest rates is not the right tool, arguing that higher rates will hurt corporate profits, overly cool recovery from the pandemic and risk starting an economic recession with global spillover effects, negatively affecting emerging and developing markets.

It may take months for rate changes to have a widespread economic impact. However, the stock market tends to respond immediately, even though interest rates do not directly affect it. The Dow Jones Industrial Average declined 1.1% and the S&P 500 Index fell 1.9% after the Fed’s December meeting minutes were released.

Some sectors, such as financials, tend to perform well in higher-interest-rate environments. U.S. bank stocks started the year strongly, with Bank of America and Wells Fargo both hitting their 52-week highs in the first week of January. Following the conventional adage that higher rates are not good for growth, tech stocks fell and continue to slide as investors reposition in response to the potential hikes. The Nasdaq Composite Index fell for a third straight week, and is down 11% so far in 2022.

Interest rate increases tend to affect growth stocks, such as technology companies, more negatively than value stocks because net present value (NPV) stock valuation would discount their future profits at the new higher rates. The further out the expected earnings are in the future, the less they are worth today. Additionally, it may be harder or more costly to borrow to invest in growth projects in higher-interest-rate environments, which affects the ability to meet or outperform earnings expectations.

Conversely, higher interest rates tend to favor value stocks. Value companies may produce profits more quickly than growth companies. Also, a frequent characteristic of value companies is maturity, and being more established increases their ability to weather changes. Additionally, if higher interest rates are a result of inflation, companies with current earnings are able to increase prices to improve margins. Growth companies with expected future earnings are less able to adjust current prices.

If we look back at the last decade or so, we see that growth has substantially outperformed value overall. From 2010 to 2022, growth average monthly returns have outperformed value average monthly returns by 0.44%, 0.17%, 0.26% and 0.25% for large-cap stocks, small-cap stocks, the developed world excluding the U.S. and emerging markets, respectively. However, when we look at the periods of rapid U.S. interest rate increases between 2010 to 2022, value has outperformed growth.

This week’s chart depicts periods where interest rates changed by 1, 5, 10, 20 or 30 basis points in one month, and compares the average monthly returns for comparative value stocks and growth stocks from 2010 to 2022. We see that while growth outperformed value overall, value consistently outperformed growth in periods where interest rates increased by 5 basis points or more in one month.

In periods of more rapid U.S. interest rate increases, value stocks outperformed their comparative growth stocks. We see this performance reversal in periods with an interest rate increase of 5 basis points within one month, and it is even more pronounced in periods with an interest rate increase of 20 or more basis points within one month.


Key Takeaway

With traders in interest futures already pricing in hikes, it will be interesting to see how much interest rates increase, how many times and whether this dichotomous value-growth pattern continues to hold in upcoming periods.


Index definitions:

Russell 1000 Value Index measures the performance of those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth values.

Russell 1000 Growth Index measures the performance of those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values.

Russell 2000 Value Index measures the performance of those Russell 2000 companies with lower price-to-book ratios and lower forecasted growth values.      

Russell 2000 Growth Index measures the performance of those Russell 2000 companies with higher price-to-book ratios and higher forecasted growth values.        

The MSCI World ex USA Value Index captures large and mid-cap securities exhibiting overall value style characteristics across 22 of 23 Developed Markets countries. The value investment style characteristics for index construction are defined using three variables: book value to price, 12-month forward earnings to price and dividend yield.

The MSCI World ex USA Growth Target Index is based on MSCI World ex USA, its parent index, which includes large and mid-cap stocks across 22 Developed Market (DM) countries excluding the US. The index is designed to represent the performance of a strategy that seeks to capture increased exposure to the Growth factor while exhibiting lower or equal ex-ante total risk to the underlying parent index.

The MSCI Emerging Market Value Index is a free-float weighted index.

The MSCI Emerging Market Growth Index is a free-float weighted index.

Tags: Inflation | interest rates | growth stocks | value stocks | Federal Reserve

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