All through the pandemic era and its aftermath, Jerome Powell lived rent-free in the heads of Wall Street stock traders.
(Bloomberg) — All through the pandemic era and its aftermath, Jerome Powell lived rent-free in the heads of Wall Street stock traders.
As he cut interest rates to historic lows and then again when he ramped them up to decade highs, money managers sweated over his every word and deed – buying or selling shares in line with their supposed sensitivity to monetary policy. That drove the fortunes of practically all investment strategies — and none more so than two equity trades known as value and growth.
But in a sign that the Powell obsession is now easing, these popular investing styles have defied gyrations in the rates market time and time again this year. This in turn is raising the question of whether something changed in the underbelly of the stock market.
For example all through 2022, cheap-looking shares posted a big rebound while their expensive peers that promise to expand earnings over the long haul plunged – moves largely attributed to rising interest rates. The thinking went that growth names like Tesla Inc. and Nvidia Corp. would perform worse given their valuations look excessive next to a higher discount rate.
Now even as 10-year Treasury yields surge toward 2007 highs, the tech-stuffed Nasdaq 100 has returned more than double than the S&P 500 so far in 2023. Gains from value investing have disappointed compared to what might be expected. The correlation between each investing style and how bonds move on any given day has slumped.
“Value and growth have become substantially less sensitive on the shorter-run, a trend I believe will remain,” said Guido Baltussen, head of factor investing at Robeco. “The high sensitivity of value and growth was more specific to a zero-ish yield environment — temporary and not structural.”
All this is a big deal given the trillions of dollars invested in quant strategies that slice and dice equities by characteristics like their valuation multiples. And it’s an increasingly pressing issue as bond yields climb near a 16-year high on expectations that the Federal Reserve will keep policy tight for a prolonged period to temper a still-expanding US economy.
Market prognosticators have different takeaways. The view favored by the likes of Robeco is that benchmark rates have now risen high enough that moves in yields from here will have a modest impact on both growth and value.
Another perspective, favored by Goldman Sachs Group Inc., is that the 2023 artificial-intelligence boom has boosted expected future profits of growth stocks enough to soften the threat posed by elevated interest rates.
“AI has created this new lease of life for the tech sector,” said Christian Mueller-Glissmann, head of asset allocation research at Goldman Sachs. “With regards to longer-term optimism, that supports equities and it helped the Nasdaq 100 digest higher rates.”
Read more: Nvidia Slips From Record as Wall Street Awaits Key Results
The concept of bonds as an underlying driver of equities is intuitive and logical. Value stocks like Exxon Mobil Corp. and Berkshire Hathaway Inc. tend to be more cyclical and valued based on near-term cash flows, so appear more attractive when rates are rising. On the flipside, growth shares like Nvidia Inc. and other tech darlings are prized for their long-term prospects, which hold less appeal when future profits get discounted at higher rates.
But the broader trend this year is different: The link between 10-year Treasuries and value-growth has slipped. Even with higher benchmark rates, Russell 1000 Value Index has underperformed its growth counterpart by 24%.
All this might signal the return of healthier economic trends, when macro stress eases and fundamentals matter more. Six-month correlations of both global stocks and factors have dropped near the lowest in more than two decades, Sanford C. Bernstein data show.
“Last year factors would have been a bit more correlated because we had such extreme movements in yields and value and growth going in opposite directions,” said Sarah McCarthy, a strategist at Bernstein. “That has calmed down now to some extent.”
Rate Pain
Read investment bank research and you could be forgiven for thinking stock investing remains as simple as betting on where rates will go.
Wells Fargo & Co., for one, says a drop in 10-year yields back to 4% would be strong catalysts for growth outperformance. JPMorgan Chase & Co. also favors the style against value based on its conviction that bond yields have peaked. Barclays Plc has turned overweight on value, saying the factor should catch up with the breakout in yields.
But for quants, all this reignites a contentious debate about the relationship between interest rates and factor returns.
The likes of AQR Capital Management have argued repeatedly that the historic data doesn’t show much of a link between the two. In this view — favored by fans of value investing — any rise or fall in bonds won’t materially impede the timeless rule: Lower valued equities tend to outperform over the long term.
PGIM Quantitative Solutions, which oversees about $97 billion, laid out another theory about what’s going on in a recent note. When rates are high enough like now, the future profits of growth stocks are discounted so much that they are worth little in present value. So even if rates ease but to still-elevated levels, it wouldn’t necessarily boost the cohort in the same way as during the era of low interest rates.
Meanwhile to quants at GMO — which has famously stuck to value through thick and thin — it’s still all about the market’s valuation gaps that have widened anew in this year’s stock rally.
“Value stocks are exceptionally cheap today,” said Ben Inker, co-head of GMO’s asset allocation team. “As long as markets are driven by fundamentals, value stocks today have a substantial built-in advantage.”
–With assistance from Cecile Gutscher.
(Updates with more market context in the top)
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