A value rotation with legs

In fixed income, US, German and Italian 10-year government bonds remained under pressure, with the yield on the US 10-year treasury hovering around 1.7% at the end of March. The US dollar strengthened against a basket of currencies.

In commodities, Brent crude finished the month down as rising coronavirus cases in a number of European countries, and further lockdowns, sparked fears of a delay to the global reopening. However, it is still among the strongest performers year to date, up around 23% through the end of March. Gold remains a casualty of the market volatility this year, losing ground in March and down around 10% since the beginning of the year. 

All sectors gained ground over the month, with more traditionally defensive areas such utilities and consumer staples leading markets higher. Alongside rising bond yields, we also saw a continued rotation into cyclicals and value stocks, which supported industrials, materials and financials, but weighed on more richly-valued growth names. The MSCI AC World Growth Index just managed to secure positive gains in March. 

Technology, telecom and consumer discretionary also lagged the wider market over the month. A number of US and Chinese tech and media stocks were caught up in large block trades at the end of March after family office Archegos Capital was forced to unwind equity derivative positions amounting to more than US$20 billion. Investment banks including Nomura and Credit Suisse were also left nursing large losses in their prime brokerage divisions.  

Last month marked one year since the COVID-induced market lows on 23 March 2020. Since then, global equities have risen by over 80%.

While there remains some nervousness around the risk of ‘runaway inflation’, amid rising bond yields, many investors are shifting their focus to take advantage of the reflation trade and attractive value opportunities. 

The value rotation in equity markets is also reflected in recent asset flows – with predominantly global and developed market value funds receiving net inflows in March, following four consecutive years of net outflows.

In our view, the combined tailwinds of ongoing loose monetary policy, large-scale fiscal stimulus, higher bond yields and rising inflation expectations, and a sooner-than-expected return to growth, all provide a supportive backdrop for value stocks. 

We started to see the green shoots of the value rotation back in September last year, and a more pronounced rotation from early November following developments in effective COVID-19 vaccines. This year, we’ve started to see a broadening of market performance with accelerated regional vaccine rollouts changing expectations of the speed of reopening, and subsequent demand growth and earnings recovery.

Despite recent strong performance, value still remains at depressed levels when compared with growth. In both the US and Europe, the spread between the cheapest and most expensive stocks on a price-to-book basis remains at historical highs. The most richly-valued stocks are trading at the largest valuation premium to the least expensive names since the ‘tech’ bubble over two decades ago  – which suggests to us that the market rotation has further to run from here.

With signs of the market dynamics we’ve witnessed since the Global Financial Crisis beginning to unravel, we think there are emerging opportunities for value investors across a broad range of sectors. Value typically outperforms in the early stage of an economic recovery, but we believe the extreme valuation gap between growth and value stocks, along with indications of a reversal of the ‘lower for longer’ rate environment, provide additional tailwinds for a more sustained value recovery. 

However, there is still the potential for negative surprises and an ‘uneven’ lifting of lockdowns, so the route back to growth may not follow a linear path. We could see investors’ convictions waver and risk appetite fluctuate in response to near-term newsflow. In addition, with the adoption of new technologies and behaviours, the shape of the post-COVID global economy may differ from the pre-lockdown ‘business as usual’. 

In seeking value opportunities, it will be vital for investors to identify which companies are best positioned to take advantage of emerging themes and structural opportunities, and be able to distinguish ‘misunderstood’ value stocks from ‘cheap for a reason’ companies. This is where active management can come to the fore, and we have seen active equity funds globally attracting $80 billion of net inflows year to date – the last time this happened was in 2013¹.

Being nimble and adopting a selective, fundamentals-driven approach to value investing allows the flexibility to take advantage of new opportunities, but also the scrutiny to avoid the pitfalls and to mitigate the risk of permanent loss of capital. Strong stock selection will be increasingly important as we move through 2021 to sort the wheat from the chaff.

¹Citi Research, EPFR, 22 March 2021