- Extraordinarily loose monetary policy has been favorable to growth investors.
- Inflationary pressures are problematic for longer duration assets.
- The opportunity for value investors to add alpha is rarely better than it is today.
INTRODUCTION
In December of 2008, the Federal Reserve (Fed) adopted its zero-interest-rate policy (ZIRP) and fired up the printing presses to revive frozen credit markets and promote the resumption of economic growth. After a brief attempt at policy normalization several years later, COVID-19 forced the Fed to take action to avert a total collapse of the financial system. In both cases, the combination of monetary policy and fiscal stimulus measures that were instrumental in stabilizing markets and rejuvenating the U.S. economy also resulted in investors piling into longer-dated assets as the risk for doing so decreased. The result was a period of prolonged and unsustainably wide performance dispersion between value and growth.
Chart 1: Monetary Policy Impact on Performance of Value vs. Growth
Without question, extraordinary government intervention has so far delivered the intended results of improving employment and economic expansion following COVID-induced lockdowns. However, with an improving employment situation, interest rates pegged to the zero-bound, and over $8 trillion accrued on the Fed’s balance sheet driving a surge in inflationary pressures, it is reasonable to believe another shift in policy may be on the horizon.
INFLATION
Business owners and consumers are currently experiencing inflationary pressures unlike any in recent memory. But when it comes to official inflation figures the story is less clear. For instance, the Consumer Price Index (CPI) is the most widely publicized measure of inflation, focusing on the average price changes urban consumers pay for housing, transportation, food, and clothing. However, the lens through which the Fed views inflation is the Personal Consumption Expenditure Price Index (PCE), which measures inflation via business surveys as opposed to consumer surveys that feed into the CPI.
Although the Fed and economists are largely aligned on the future direction of inflation, it is the magnitude of the rate of change that is being vociferously debated. The Fed is currently forecasting a rise of 3.4% in the PCE for 2021 and 2.1% in 20221. Furthermore, the Federal Reserve Bank of St. Louis developed an index called the Price Pressures Measure (PPM) to gauge the probability of inflation exceeding 2.5% over the next 12 months. The June PPM reading is 83%, which puts the measure at the highest level since June 2006. While not perfectly correlated, pricing pressures have recently become disconnected from the Effective Federal Funds Rate as evidenced in Chart 2.
Chart 2: Pricing Pressure Expectations Far Exceed Interest Rates
It is true that the merits of each of these inflation measures will be endlessly debated. It is also true that the Fed’s rather dovish stance on inflation expectations, which appears out of touch with business owners, sets the stage for a potential taper shock sooner rather than later. Chart 3 shows the share of U.S. businesses expecting higher labor and non-labor costs in the coming months.
Chart 3: U.S. Businesses Expecting Higher Labor and Non-Labor Costs
Furthermore, mentions of inflation by companies reporting earnings in the past month climbed to a record high, with labor inflation and supply chain citations more than doubling Year-over-Year (YoY)2.
Inflationary pressures are extending to consumers. Consider that the YoY CPI print in June was 5.4% after posting a 5.0% print in May3. Base effects notwithstanding, U.S. consumers are experiencing the fastest level of inflation since August 2008. Energy alone was up almost 25% YoY. After stripping out the more volatile food and energy segments, the YoY change in Core CPI was 4.5%, the highest level since November 1991 (Chart 4).
Chart 4: U.S. Consumers Experiencing Higher Costs
INFLATION AND VALUE
Expected and realized inflation are on the rise. As a result, evaluating portfolio positioning to help ensure appropriate compensation for a given level of risk assumed is prudent. Longer duration growth stocks thrived in recent years, but as indicated in Chart 5, value stocks outperformed during much of the pre-GFC period when inflation was generally more elevated.
Chart 5: Rolling Long-Term Performance of Value vs. Growth Relative to Inflation
The outperformance of growth over value in recent years reflects changes in price multiples as investors gravitated toward non-cyclicals amid a slow growth and low interest rate environment. With COVID-19 vaccines rolling out at the end of 2020, re-opening optimism began to favor more cyclically exposed value stocks once again. We believe we are still in the early innings of a durable rotation to cyclically sensitive sectors, particularly as the valuation gap between expensive stocks and inexpensive stocks continues to be wide, as shown in Chart 6.
Chart 6: Russell 3000 P/E Gap Near All-Time Wide
Chart 7 further highlights that valuation discounts continue to look attractive for value across various metrics.
Chart 7: Historical Valuation Dispersion as of June 30, 2021
History tells us that the “tails” matter. Value has outperformed growth following wide valuation gaps, while growth outperforms following narrow/negative valuation gaps. Chart 8 illustrates the difference between the valuation of Russell 3000 Growth stocks and Russell 3000 Value stocks over time. Even after value’s recent run of strong performance, its discount to growth remains wide (7th percentile).
Chart 8: Value Continues to Trade at a Wide Discount
The importance of valuation in the current environment is also demonstrated in Chart 9. Empirical Research Partners developed their Failure Candidate Model that identifies stocks poised to underperform the market over the next 9-12 months. The share of stocks with forward P/E Ratios of 50 times or more, or stocks generating losses4, is near an all-time high, matched only by the environment coming out of the tech bubble. Perhaps not coincidentally, the Russell 3000 Value Index outperformed the Russell 3000 Growth Index by 1,580 basis points annually after the model peaked at 83% in August 20005. The model posted a reading of 82% at the end of May.
Chart 9: Share of Failure Candidates Near All-Time High
Finally, regime shifts create alpha opportunities. After a challenging environment for value managers during an era of unprecedented monetary policy, the tide may be turning (Chart 10). Even if earnings do not improve from current levels, value outperformance could continue through multiple expansion alone.
Chart 10: Regime Shifts and Alpha Generation
CONCLUSION
The timing of policy normalization will continue to be debated in the months ahead, with stocks fluctuating on every data point and Fed member soundbite. Valuations continue to look stretched for the stock cohort with lofty growth rate expectations, and earnings and margin expectations will become increasingly difficult to meet as inflationary pressures mount. However, we believe the cyclical rebound experienced since the end of 2020 has additional room to run and a reversion toward more normal value relationships is likely to continue for some time. As value investors, we look forward to further alpha opportunities as investors refocus on underlying business fundamentals and valuation.
