We believe value stocks can resume their climb as major central banks keep interest rates higher for longer. Higher rates reduce the value of future cash flows, weighing more on growth stocks and reinforcing our developed market equities underweight. Underneath that, our sector and region preferences tilt to value with quality attributes and growth at a reasonable price.
Value vs. growth
Russell 1000 Value index relative to Growth, 2013-2023
Source: BlackRock Investment Institute, with data from Refinitiv Datastream, February 2023. Notes: The chart shows the U.S. Russell 1000 Value total return index pided by the U.S. Russell 1000 Growth total return index.
The new regime is not a typical business cycle and requires a new playbook. That applies to equity style factors, too, in our view. Value stocks – or those seen as undervalued relative to fundamentals – lagged growth stocks for much of the past decade (left chart). That switched abruptly in 2022 when central banks started rapidly tightening policy – only to be followed by a value dip early this year on hopes for policy easing (right chart). We think value can regain the lead. Why? Higher interest rates and inflation, and a steeper yield curve. That all favours value over growth, in our view. It’s not about choosing one factor over another: Factors mean different things to different people, and the composition of factors also changes over time. Case in point: The healthcare sector is now a modest overweight in the MSCI USA Value index compared with an underweight in 2008.
Our macro view supports a case for value over growth. Higher interest rates feed into higher discount rates, making future cash flows of growth stocks less attractive. We also think persistent inflation is likely to lead investors to demand more compensation for holding long-term government bonds, driving yields higher. Value tends to outperform when the yield curve steepens, we find. While value historically underperforms heading into recession because capital-intensive companies can’t respond quickly to changing cycles, we think that could be different in this atypical economic cycle. Value is still attractive after being beaten down for so long. Companies in the value bucket have also had time to prepare for a well-telegraphed downturn. Case in point: Many banks have already provisioned for losses in advance of a recession. Lastly, we expect a mild recession, so we think the performance impact is likely to be softer on value companies than in past cycles.
Getting granular
Our current asset allocations across regions and sectors have a value tilt with quality characteristics. We find that emerging markets (EM) and Europe have a consistent value bias when looking at the composition of indexes and key company metrics. For sectors, we see energy as a fusion of value and quality. We find value in the sector after being unloved and undisciplined with capital in the past. We think its stronger balance sheets, better investor payouts and improved return on equity give it more of a quality tilt. We find value in financials as well, but not the same quality. We see the sector capitalizing on higher rates with improved net interest margins after years of ultra-low or negative rates in some cases.
Healthcare has become more of a value sector but also has characteristics of growth. This speaks again to how factors can have different meanings and evolve over time. We like healthcare for its growth prospects but at the right price – valuations look reasonable to us relative to other growth sectors. We also see quality in healthcare’s defensive characteristics during a recession and think aging populations bolster structural growth in demand.
Bottom line
We prefer to be selective within our cautious view of developed market equities. We like sectors and regions with a value bent while we stay nimble in this new regime of heightened macro and market volatility. We think structurally higher inflation, higher-for-longer interest rates and our expectation for a steeper yield curve all favour value. We find value in the energy and financial sectors and focus on quality within these sectors. We also like healthcare but at a reasonable price.
Market backdrop
Global stocks retreated further this week, with European equities faring better than U.S. peers. Short-term U.S. yields jumped to a 16-year high, with the yield curve at its most inverted since the early 1980s. The U.S. PCE inflation data showed stubbornly high core inflation. This reinforces our view that sticky inflation likely means major central banks will have to hike rates further and keep them higher for longer to bring it back down to their 2% targets.
Euro area inflation data this week will be key for gauging how much higher the European Central Bank might lift policy rates. We’re also watching unemployment data for signs of further labour market tightness that could stoke persistently high core inflation. China’s services PMI will help assess how rapid the economy’s restart has been.
