Disinflation and Falling Rates Favor Growth Stocks Next Year
When to bet on value stocks versus growth stocks has been a topic of interest for investors over the decades.
Our portfolio currently favors growth sectors like technology (XLK) and consumer discretionary (XLY), bets on disinflation and falling rates.
Value’s outperformance this year (i.e., MSCI USA Value relative to MSCI USA), shown below, represents a threat to our thesis. But we believe that will reverse next year.
We believe that disinflation will lead rates lower next year, benefiting growth stocks. In the next few Macro Notes we’ll be providing evidence supporting our thesis.
In this first Macro Note we’ll look at what’s driven the secular performance of value and growth stocks. A lot of it has to do with the economic regime that’s prevailed in the last few decades.
Value Stocks Have Been Secular Losers
Value stocks have underperformed for decades. However, value stocks have been staging a rebound this year.
The market has seen value stocks as less vulnerable to the big rise in interest rates this year resulting from record-high inflation.
On the other hand, growth stocks (i.e., MSCI USA Growth) have outperformed over the last few decades, but have seen a reversal in their good fortune this year.
Rising interest rates have proven a headwind for growth stocks, given their frothy valuations.
Let’s now take a look at what’s driven value and growth stocks’ secular performance.
Falling Inflation and Rates Have Favored Growth Stocks
The secular performance of value and growth stocks has much to do with the economic environment.
Following the Great Inflation of the 1970s and early-1980s, investors sought out growth stocks because they delivered faster earnings growth than what could be found elsewhere.
Waning economic growth over the years was reflected in falling interest rates over time.
The fall in interest rates of the last few decades was driven by falling inflation expectations. A slowing economy leads to waning price pressures.
Nominal interest rates, like those of the 10-year Treasury bond, incorporate expected inflation in their pricing.
Growth Stocks are the Real Story Here
As the economy slowed over the decades, it became more difficult to find profit growth. That’s where growth stocks came in with an attractive proposition.
Growth stocks generate high nominal returns (i.e., absolute returns) when they outperform the market, as shown below.
At some point, however, investors get overly optimistic about growth stocks, driving valuations to extremes. That’s when value stocks come in.
On average, value stocks outperform when the market is falling. They’ve acted as a hedge as their low valuations make them less vulnerable to the worries that make growth stocks falter.
Growth stocks generally trade at premium valuations, given their growth advantage.
Early next week we’ll follow-up with a Macro Note on how we define value and growth, and why that’s important.
We found that the performance of value stocks depends on how it’s defined. We’ll also take a look at what sectors screen as value and growth today.
 Here we’re using the MSCI USA Value Index, which captures a cohort of U.S. stocks with low valuations as measured by a composite of various valuation metrics like book value-to-price, 12-month earnings-to-price and dividend yield. The composite valuation metric is ranked across the U.S. large- and mid-cap market.
 Here we’re using the MSCI USA Growth Index, which captures a cohort of U.S. stocks with growth characteristics as measured by a composite of various growth metrics like long-term forward earnings-per-share growth rates, short-term forward earnings-per-share growth rates, current internal growth rates, long-term historical earnings-per-share growth trends and long-term historical sales per share growth trend. The composite growth metric is ranked across the U.S. large- and mid-cap market.
 Highly-valued stocks are vulnerable to rising interest rates because their free cash flows go out further into the future than for the average stock (i.e., high duration). Discounting these higher-duration free cash flows at higher interest rates reduces their present value to a greater extent than for the average stock.
On a side note, we’re trying the Macro Notes as shorter and more frequent updates of our strategic research. In the comments below, let us know if you find them a good addition to the service!