Rate tightening by the Federal Reserve plus a recovery in commodities will most likely boost underpriced value stocks, especially in the United States.
The road towards normalisation of US interest rate policy should deliver support for the value style, which historically has benefitted from a rising and steepening yield curve. Analysis* by NN IP shows that the correlation between the performance of US value-style stocks and the long term interest rates have increased over the last decade and is now at a 30-year high.
NN IP also believes the Fed will likely need to raise rates faster than markets expect because of the strengthening labour market, which is approaching full employment and is set to generate wage-push inflation that will need to be “controlled”.
Market expectations are lagging reality. They may be putting insufficient weight on the possibility that the economy could outperform expectations, that financial conditions could ease or that the risks to growth from Brexit and other international developments could fade away. If such events were to occur, this might necessitate a faster pace of adjustment.”
Core inflation in the US has been broadly stable over recent months despite declines in energy and non-energy import prices, suggesting that overall inflation will return to the 2% inflation objective over the medium term provided economic growth remains moderate but stable.
If the Fed raises rates for a good reason – because of strong economic growth – then the long end of the yield curve will also rise and given the high correlation of value with long-term rates then that will be a positive catalyst for the style. It would kick in via financials and other cyclical sectors.
Another element is the trend in earnings momentum. With the exception of the energy sector, earnings momentum for cyclical sectors has improved.
The rebound in oil and commodity prices should also bode well for value style stocks, NN IP says. This recovery, while apparently hesitant, is helping to increase risk sentiment and could bring some relief to stressed segments of the market. Further stabilization might lead to a sustained tailwind for value investments.
The upturn in commodity prices is one of the encouraging signs that the macro outlook is improving. Elsewhere we see that financial conditions are easing and bank lending growth has picked up. Most importantly however is the support from valuation and low expectations.
Admittedly, there have been several false dawns in the past two years, when cyclical optimism was drowned out by macroeconomic disappointment. Roads hardly go in straight lines. Today there are some encouraging signs in the US, where core inflation is slightly rising.That could signal a regime change where valuation will start to play a bigger role.
NN IP has gradually increased its exposure towards more economically sensitive companies such as banks and certain energy companies. It continues to underweight ‘expensive defensives’, whose valuations it sees as too high from a fundamental perspective.
Moudy El Khodr, senior portfolio manager, US High Dividend and Nicolas Simar, head of Team, European High Dividends at NN IP