The big question on Wall Street in 2021 has been: ‘What happens with interest rates and inflation?” There are two competing views as we explained back in July – one that the recent uptick in inflation is transitory with temporary supply-chain disruptions and the competing view that inflation pressures are here to stay with long-term labor shortages, government budget deficits, and a stockpile of household savings.
There is no shortage of forecasts or predictions on this topic but the historic truth is that no one forecasts inflation well. The economy is incredibly complex and, as a result, both economic activity and inflation are highly unpredictable. The consensus market forecast for inflation is baked into stock prices and interest rates and that is probably the best predictor of the future. Taking a different view than the market consensus is simply a speculative gamble.
Our investment approach is NOT one of taking a binary view of what will happen in the future and then betting portfolios on that scenario happening. Instead, our approach is to consider all the things that can happen in the market and in the economy and in your life and to diversify assets such that whatever scenario plays out, you will be OK. That said, one of the long-term investment tilts we employ in Golden Bell Financial portfolios is one toward value stocks. Many of the underlying equity funds we employ have a strong value bias meaning that the funds are allocated more towards cheap, out-of-favor stocks and less towards expensive, sexy stocks. Historically, there has been a persistent, robust, and economically intuitive advantage to value investing across time periods, geographies, and markets. That is the advantage we seek to capture over the long term.
One interesting biproduct of this value bias is that it may provide a hedge against inflation and rising interest rates. While that is not the reason we employ this bias, it could provide useful insurance in the event that higher inflation is more than transitory.
First, it is important to understand that higher inflation expectations results in higher interest rates, all else equal. If an investor perceives that $100 is going to be eroded by higher inflation over the next 5-10 years, she will require a higher rate of return to compensate for this inflation erosion. It is a simple supply/demand equation. If investors expect 10-year inflation to run at 3%, then there will be less demand for a 10-year bond yielding 1.5%. The bond price will decline resulting in a higher yield (higher interest rate) until supply and demand are back in equilibrium.
But what does this have to do with value stocks and growth stocks? Generally, growth stocks are exciting companies with lofty future expectations. Unprofitable growth companies like Snapchat or Uber are not expensive because of current profits (they don’t have any). They are expensive because of an expectation that they will eventually post large profits in future years. And the fundamental way that stocks are valued is based on something called a discounted cash flow model where future profits are estimated and then a discount rate is applied to these future profits to assess the present value. The lower the interest rate, the more valuable these future profits.
If Snapchat is expected to finally earn a profit in 2025, the profit is going to be less valuable to shareholders if interest rates today are 5% rather than 1%. This is how discounting works. When interest rates are effectively zero, there is little opportunity cost to waiting for future profits. But when interest rates are higher, those future profits are less valuable because the alternative of getting 5% per year for the next five years in a low-risk bond presents a more attractive alternative.
Value stocks, alternatively, tend to be less dependent on future profits because they have current profits and current cash flows. Stocks like Procter & Gamble, Walmart, or ExxonMobil are not relying exclusively on future profits – they have profits today. As a result, investors do not have to depend on cash flows in the future and the price of these stocks is less dependent on discount rates (interest rates).
The net result is that growth stocks, in aggregate, tend to be more tied to interest rates than value stocks. When interest rates decline, it tends to be favorable for growth stocks relative to value stocks. When interest rates increase, the opposite is true – value stocks tend to outperform growth stocks.
The two charts below demonstrate this phenomenon. The first chart reflects the days in 2021 with the largest increase in 10-year Treasury yields and the resulting performance spread between the Russell 1000 Value Index less the Russell 1000 Growth Index. On February 25th, for example, the 10-year Treasury yield increased from 1.38% to 1.54% (a change of 0.16%) and value stocks outperformed growth stocks by 1.1%. On every one of these days, value stocks experienced a sharp return advantage over growth stocks.
Alternatively, we see the reverse when interest rates experience a sharp decline: value stocks underperform growth stocks.
The objective here is not to encourage a value bias because interest rates might rise. That said, there may be an advantage to value stocks within a portfolio context if inflation is persistent and interest rates resultantly rise. Although this interest rate hedge of value stocks is by no means guaranteed, it can be a valuable biproduct. We definitely do not own value stocks for this reason but this interest rate relationship is something we consider when thinking about the interest rate sensitivity within a portfolio framework.
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