Rebuilding the reflation wall of worry
Over the last decade, value has had brief bursts of outperformance, only for the outperformance to be given back over subsequent months. Since Q3 2020 European value has outperformed growth by 10%, but over recent weeks value has cooled and post the latest Fed commentary, underperformed. Investors are wondering if value’s recent outperformance was just a blip – and whether expensive growth is about to reassert itself.
For a number of reasons we view this recent relative pull-back as an important buying opportunity for value and a window to reduce allocations to expensive growth.
What has led to this pull back in value? Are these forces durable?
1. Growth concerns
Markets tend to de-risk when economic momentum peaks. Given the Covid low in economic momentum in Q2 2020, the year-on-year GDP growth peak will be this quarter – Q2 2021. For base effect reasons, as we move into the second half of 2021, the year-on-year growth rate will decline. Whilst this is not a big problem for earnings, the second derivative matters, and it is logical that cyclicals moderate somewhat vs defensives as the second derivative declines. Importantly however, history suggests this effect should be fleeting, provided growth remains at an acceptable level.
The Chinese economy has also cooled. Of the major economies, China accelerated first last year, with the economy growing sharply in the second quarter of 2020. As the rest of the world began to recover in Q3-Q4, Chinese policy makers started to apply the brakes. Over the last eight months China has initiated some regulatory tightening in shadow banking activities and has imposed some restraints to slow the pace of lending growth. Government initiatives were also announced recently with the aim of reducing commodity prices.
The combination of a cooling China with a peak in US economic growth momentum has been enough to reduce investor expectations about economic growth. However, this is at the margin and the effect should be short lived. China is not incentivised to cool their economy much more. China is simply trying to steer their economy toward an optimal growth rate, not slow it down unnecessarily. In October 2022 China holds its 20th National Party Congress, a critical political event that occurs once every five years. A robust economy is a pre-requisite, diminishing economic downside risk. The US is also not heading for a meaningful slowdown. Yes fiscal stimulus wanes in 2022 but continued employment gains, a robust housing market and high corporate and consumer savings provide powerful tailwinds.
2. Policy Communication Error
In recent months the Fed has painstakingly articulated its desire for an overshoot in inflation and its major focus to reduce unemployment. As we have frequently stated, this is an enormous turning point in policy and merits investors owning more inflation hedges and not overpaying for deflation hedges. Yet, Fed commentary this week appeared hawkish and deflationary. The key was the movement of the dots in the Fed plot, with the median now expecting two rate hikes in 2023. This is a hawkish move relative to expectations, and given the softening of growth expectations discussed above, it came at a bad time for cyclicals and bond yields.
The problem with this conclusion is that movement in the dot plot does not itself drive Fed policy. Yes they reflect FOMC members but Powell has repeatedly asked investors not to extrapolate the dots as expected policy. This week some FOMC members have indicated a move earlier in hikes, but this does not reflect FOMC leadership thinking, based on recent speeches. Powell has already talked down the importance of the dots and more of this commentary is likely. After many months of articulating the Fed’s new approach, it is unlikely that the Fed is embarking on such a sudden U-turn. This week has revealed a communication problem that Fed leadership will likely rectify in the coming weeks. As they do this, economic growth expectations will likely rise. There is also a self-correcting element here for markets. As the yield curve flattens and inflation expectations cool, rate hikes start to get pushed out, causing the yield curve to steepen again.
The somewhat counterintuitive message from the above is that dovish commentary pushes treasury yields up, whilst hawkish commentary pushes treasury yields down. Having experienced this hawkish shock this week, as the Fed starts to pushes out rake hike expectations, yields should rise.
By late Q1 this year, the short Treasury trade became crowded. Consensus Inc data showed one of the lowest number of bulls in Treasuries in a decade. The weak dollar had also became consensus and crowded. Higher yields and a weaker dollar are broadly supportive of value and a headwind to growth. As these positions unwound, the decline in yields and rally in the dollar acted as a headwind to value.
Within equity sectors the picture is more mixed, but ETF flows showed strong flows into reflation sectors. The Fed statement and the softening of economic momentum has triggered a big reassessment in positioning. Extended positioning in such extremely liquid instruments like Treasuries and the USD can adjust remarkably quickly, and we anticipate readings will normalise in the coming week.
Why is the opportunity compelling for European value now?
1. Strong earnings growth
The underlying reflationary dynamics of the last 12 months likely remain in place. Yes the pace of reopening is patchy, but economic momentum is solid, consumers and corporates have significant excess cash balances to deploy and cyclical earnings ought to be strong.
Whilst Chinese growth has moderated and US growth is settling down, Europe is accelerating. The Next Generation European Union (NGEU) programme of 750 billion euros in grants and loans is finally beginning. Funding will be spread over 5 years with the bulk of spending due in 2022, 2023 and 2024. EU GDP growth is expected to be boosted by the programme by 0.1% this year, 0.5% in ’22 and 0.6% in ’23 and ’24. This supports the outlook for above trend GDP growth persisting in the Euro area at least through 2023.
The clean energy transition is another important reflationary impulse. Not only is this energy transition resource and material intensive – supporting aggregate demand, but environmental considerations are also constraining the supply of certain materials. Strong demand and constrained supply ought to be inflationary for a number of commodities.
Many value sectors are set to experience sustained high earnings growth in the coming years. Many companies in the Materials, Energy, Autos and Industrials sectors have a solid demand profile for the foreseeable future, often underwritten by government policy, supporting robust earnings growth.
2. Low valuations
European value sectors remain extremely cheap relative to their growth counterparts. When looking at valuations relative to earnings or cashflow, many value sectors have not re-rated at all, their share price appreciation has been fully underwritten by their earnings.
If we assess value sectors on a price to sales or price to book basis, we are also close to record discounts today.
Through 2021, investors had built a large short Treasury position that was extended. A re-set was due, but similar to Fed policy, this does not mean a 180 degree turn. The Fed intervention has given the markets a wall of worry to climb on reflation. Valuations and fundamentals suggest this is a good time to add to value. In most market conditions high price has meant high risk. Adding to value can reduce overall portfolio risk. This reset is also likely a good time to cut exposure to expensive securities.
Sources: Lightman – June 2021
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