Many people have been waiting for value stocks to begin to outperform growth after a long period of lagging, and some are making predictions based on what bonds and interest rates are doing.
Are value stocks destined to suffer in low interest rates regimes and will they rise again when rates creep up? If that’s the conclusion you’ve jumped to, GMO says not so fast.
In a recent white paper, the famed value asset management shop founded by Jeremy Grantham says that value stocks are increasingly thought to correlate with 10-year Treasurys—and thus they share reputations as suffering in low-interest-rate environments. And that’s a bad rap, says the firm.
The story goes like this: Growth stocks are winners when interest rates are low because they represent more distant cash flows, while value represents shorter-duration cash in hand. When rates rise, the authors say, bonds and value stocks should do better.
“The pattern of market movements since the start of the pandemic has tended to reinforce the narrative that value stocks are a ‘short duration’ version of equities that outperform when bond yields rise and underperform when they fall,” writes Ben Inker, head of asset allocation at GMO, in a paper called “The Duration of Value and Growth.”
“A more comprehensive analysis of the drivers of return for the value and growth styles of investing shows that their durations are much closer than most investors realize,” the paper says.
Inker suggests that value stocks are currently trading at too wide a discount to the market. “Should that discount contract, as we have seen in past episodes of growth bubbles, value should outperform by a large amount over the next several years,” Inker writes. A changing interest rate environment might help, but it’s not necessary, he says.
“Given the wide discount at which value stocks are currently trading globally, we expect value to continue to outperform the market over the next few years, but that belief neither assumes nor requires any particular moves in interest rates.”
GMO argues that there are plenty of reasons to throw out the notions of value being locked to bond yields and interest rates. First, value is not as correlated to 10-year Treasurys as is commonly supposed. GMO puts that correlation since 1983 at about minus 0.003. Despite bonds and value stocks pulling closer together since 2007, “as history shows,” says the paper, “value stocks have not had a notably different sensitivity to interest rates than growth stocks in the longer run, and economically there isn’t a compelling reason why they should.”
Duration is such a crucial point because income is a larger part of value stocks’ total return than it is for growth stocks. “If the stock market valuation were to double relative to its historical average, the loss of income for value stocks would be much larger than for growth.”