In brief
- The rapid increase in discount rates year-to-date (YTD) has hurt the growth factor disproportionately, as valuations were much higher to begin with
- As valuations for the growth factor have gotten more reasonable, more questions around the ability of growth stocks to deliver sustained outperformance have started to surface
- Patience is still needed for now as we wait for interest rates to peak and growth risk to dissipate
Growth factor performance year-to-date
Inflation, which has been missing for more than a decade, returned with a vengeance in 2022. Admittedly, it is a bigger problem in developed markets ex-Japan than it is in Asia, but we are also starting to see some inflationary pressures come through to Asian economies, especially those that rely heavily on energy and food imports. Alongside developed market central banks like the Federal Reserve (Fed), the European Central Bank (ECB) and the Bank of England (BOE), Asian central banks have also started to tighten monetary policy, albeit at a much more measured pace.
On the back of hawkish central banks, risk free rates have risen significantly since the beginning of this year. Case in point – the last time U.S. 10-year yields rose from 1.5% to 3%, it took two years from 2016-2018. However, it has since more than doubled from 1.5% to ~3.5% in the first half of 2022, which speaks volumes to the unprecedented pace of tightening.
The rapid increase in discount rates has hurt the growth factor disproportionately, as valuations were much higher to begin with. The underperformance of the growth factor is a testament to the higher discount rate dynamic, with MSCI World Growth underperforming MSCI World Value and MSCI World YTD by ~15.6% and ~7.8% respectively. The MSCI Growth factor now trades at a next twelve months (NTM) Price-to-Earnings (PE) ratio of 23.4x compared with 33.9x at the beginning of this year. While still not cheap versus its 15-year historical average levels, today’s NTM PE is just 0.6 standard deviations expensive compared to 2.7 standard deviations expensive on 12/31/2021.
As valuations for the growth factor have gotten more reasonable, more questions around the ability of growth stocks to deliver sustained outperformance have started to surface in client conversations.
For now, we still think investors can be patient while looking out for catalysts to fuel growth stocks’ comeback.
Exhibit 1: Rolling 24-month correlations between MSCI Growth and U.S. 10-Year Yield changes across inflation regimes
Source: Bloomberg, J.P. Morgan Asset Management. Data reflect most recently available as of 09/16/22.
Necessary conditions for growth outperformance
1. Core inflation needs to ease meaningfully
- With key commodity prices like oil, wheat, corn down anywhere between 15-30% since peaking in May, we believe that the price action should feed through to lower headline inflation going forward
- However, U.S. core inflation at 6.3% year-over-year (y/y) remains uncomfortably high for the Fed, as larger and stickier components of inflation like shelter and wages remain firm
- As Exhibit 1 shows, the correlation between the growth factor and U.S. 10-year yield changes has largely been positive in the two decades before the pandemic as core Personal Consumption Expenditure (PCE) inflation traversed in a tight range between 1-2% (gray dots). However, prior to the 2000s, correlation between the two were mostly negative as core PCE inflation was higher and more variable. It is likely that the negative correlation between yield changes and the growth factor will persist with the latest core PCE reading at 4.6%. This means that growth factor returns will continue to come under pressure should core PCE prove to be stickier than expected and drive the rate trajectory higher
2. Continued deceleration in economic activity
- While Purchasing Managers’ Index (PMI) New Orders, a forward-looking indicator of the growth of economic output, has been on a declining trend, a study of historical bottoms outside of the Global Financial Crisis and the Pandemic suggests that we can see more downside from here. The 3-month moving average of the PMI New Orders currently sits at 49.5, while history suggest it could decline to ~43
- Typically, growth does outperform value as PMI New Orders fall but we have not seen this play out this time so far as central banks remain hawkish amidst high inflation. As economic activity continues to decelerate, investors will eventually return to search for growth again
3. When conditions (1) and (2) are met, yields should peak and start to fall
- The market currently expects the end policy rate for 2022/2023 to be 4.2% and 3.8% respectively. While there is hawkishness baked into the price, it also shows an expectation that rates may continue to stay high through 2023. In our opinion, this reflects the markets acknowledging that core inflation can remain sticky and keep rates elevated. It is only when we see a meaningful deceleration in both inflation and economic activity that the Fed will be able to deliver a believable dovish pivot
Investment implications
While we bear in mind the philosophy of renting value and owning growth, we think there are still near-term headwinds and volatility that comes with the uncertainty of the path of core inflation.
While there are stock-specific opportunities that look attractive, we think investor portfolios will be better positioned by maintaining a more neutral factor tilt today.
Over the longer term, growth exposures have shown the ability to consistently generate superior earnings growth over time so it is not a question of if investors should have exposure to growth stocks but when.
