Three Key Drivers of Growth-Value Rotations

Stefan Rondorf | 24/01/2017
sprouting growth

Summary

While major market returns seemed fairly normal last year, one of the most forceful sector rotations since the 1980s lurked just under the surface, resulting in previously unloved sectors outperforming former investor darlings by a wide margin. Here are three top-down drivers that can move stocks so suddenly.

Key takeaways

  • Global GDP dynamics should help value stocks slightly in the near future, but the overall trend favours defensive growth
  • Since spring 2016, rising inflation expectations have favoured a shift toward value stocks; this should be sustained in 2017
  • US bond yields are expected to move higher this year, which should aid value names – particularly banks
  • While the value rotation trade is too strong to ignore, we believe this is still only a trade – not a complete change in climate

Equity markets were shaken more thoroughly in 2016 than any of James Bond’s martinis. At first glance, index returns for major markets stayed in normal ranges, but just under the surface was one of the most forceful sector rotations since the 1980s. This resulted in previously unloved sectors like mining, energy and – in the US – banks outperforming by a wide margin, while former investor darlings like consumer staples found themselves left behind.

Three top-down drivers of growth-value rotations

So how can investors get a grip on movements like these? Setting aside for a moment certain bottom-up (ie, company-specific) drivers and valuation factors, we have identified three key top-down (ie, macroeconomic) drivers that can move stocks along the spectrum from defensive growth to cyclical value.

1. GDP growth

The level and direction of gross domestic product growth plays a major role in sector rotation. Periods of low or decelerating economic activity help companies exhibiting superior growth rates precisely because growth is scarce in such an environment. This has been the case since 2011, when low absolute and less dynamic GDP growth began pushing investors toward growth stocks. We believe global growth dynamics will turn around and move slightly upward in the near future – partly driven by easing fiscal strains in Japan, the UK and the US – which should help value stocks slightly. However, this situation should not last past 2018 or 2019, because the ongoing recovery still lacks the resilience and self-sustaining qualities it needs to achieve “escape velocity”.

2. Inflation expectations

Projections of increasing prices generally support recovery rallies in cyclical value names, while persistent disinflation typically helps defensive growth stocks. This explains why rising inflation expectations – which are often seen in conjunction with rising commodity prices and some pick-up in economic growth – tend to drive up earnings estimates in traditional cyclical value sectors like mining, energy and banks. Since the spring of 2016, many developments have contributed to rising inflation expectations, and we believe some of these will be sustained in 2017: Overly depressed market expectations have begun to correct themselves, commodity prices have recovered and we have seen some initial adjustment to overcapacity in China. Moreover, output gaps have begun gradually closing around the globe – particularly in the US labour market. This should lead to increasing wage inflation, especially if the Trump administration starts to fiscally stimulate the US economy, which has a labour market that is already close to full employment.

3. The direction of bond yields

Bond yields reflect both growth and inflation expectations, but they also tell us about investor positioning and monetary-policy expectations. Lower bond yields are better for the defensive growth end of the spectrum, and we have seen this situation manifest itself in recent years. During this time, bond markets priced in a secular stagnation scenario, which allowed for the discounting of distant future cash flows at ever-lower discount rates, driving up earnings multiples for growth stocks considerably. With risk/return perspectives deteriorating in sovereign fixed-income securities, this shift also made defensive equities a serious investment alternative for multi-asset allocation funds. Today, however, the leading global bond market (the US) is slowly waking up to a tough rate-hike path, unusual late-cycle fiscal stimulus, stronger inflation and too-ambitious valuations – which mean US bond yields are expected to move higher during 2017. This should favour value names – particularly banks, especially when higher bond yields come with steeper yield curves.

A closer look at valuations

Beyond these macro drivers, valuation of course plays a role in sector rotation, and there is still some room to move in today’s market. For example, banks are still at above-average discounts relative to markets, and consumer staples look pricey despite a recent correction. However, the huge valuation gap between pricey growth and cheap value has already closed quickly, especially with value areas like materials and energy appreciating markedly.

Tilting toward value

We believe bond yields will be the strongest of our three top-down drivers in the next year; GDP growth expectations are only slightly upward-turning, and inflation already moved dynamically during 2016. As the accompanying graphic shows, the outlook for inflation expectations and bond yields favours cyclical value names in the coming months; however, the GDP growth picture is improving only moderately, which is an argument in favour of defensive growth stocks.

As a result, while the value rotation trade is too strong to ignore and should continue for some time, we believe that in the end, this is still only a trade – not a complete change in climate. The big picture for GDP growth has not been altered, and there are still constraints to supply such as low productivity, deteriorating demographics and reform fatigue in many parts of the Western world. Once the markets realize this, rising inflation expectations and bond yields should slow – which would once again argue for an above-average valuation premium for defensive growth stocks.

In between, equity markets will probably continue to be shaken between the two styles – and investors may find themselves in need of a drink from their favourite bar keeper.

Macroeconomic Indicators Slightly Favor Value Investing

Rising inflation expectations and bond yields support a shift to the cyclical value style, but still-low GDP levels favor defensive growth.

Macroeconomic Indicators Slightly Favor Value Investing

Source: AllianzgGI Economics & Strategy. View expressed as of December 2016.

Investing involves risk. The value of an investment and the income from it will fluctuate and investors may not get back the principal invested. Past performance is not indicative of future performance. Investments in commodities may be affected by overall market movements, changes in interest rates, and other factors such as weather, disease, embargoes and international economic and political developments. Investments in smaller companies may be more volatile and less liquid than investments in larger companies. Investments in emerging markets may be more volatile than investments in more developed markets. Dividends are not guaranteed. Bonds are subject to interest rate risk and the credit risk of the issuer. This is a marketing communication. It is for informational purposes only. This document does not constitute investment advice or a recommendation to buy, sell or hold any security and shall not be deemed an offer to sell or a solicitation of an offer to buy any security.

The views and opinions expressed herein, which are subject to change without notice, are those of the issuer or its affiliated companies at the time of publication. Certain data used are derived from various sources believed to be reliable, but the accuracy or completeness of the data is not guaranteed and no liability is assumed for any direct or consequential losses arising from their use. The duplication, publication, extraction or transmission of the contents, irrespective of the form, is not permitted.

This material has not been reviewed by any regulatory authorities. In mainland China, it is used only as supporting material to the offshore investment products offered by commercial banks under the Qualified Domestic Institutional Investors scheme pursuant to applicable rules and regulations.

This document is being distributed by the following Allianz Global Investors companies: Allianz Global Investors U.S. LLC, an investment adviser registered with the U.S. Securities and Exchange Commission; Allianz Global Investors GmbH, an investment company in Germany, authorized by the German Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin); Allianz Global Investors Asia Pacific Ltd., licensed by the Hong Kong Securities and Futures Commission; Allianz Global Investors Singapore Ltd., regulated by the Monetary Authority of Singapore [Company Registration No. 199907169Z]; Allianz Global Investors Japan Co., Ltd., registered in Japan as a Financial Instruments Business Operator [Registered No. The Director of Kanto Local Finance Bureau (Financial Instruments Business Operator), No. 424, Member of Japan Investment Advisers Association]; Allianz Global Investors Korea Ltd., licensed by the Korea Financial Services Commission; and Allianz Global Investors Taiwan Ltd., licensed by Financial Supervisory Commission in Taiwan.

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Expert-Image

Stefan Rondorf

CFA, Senior Investment Strategist

Facing a Tricky Situation, Fed Must Communicate Clearly

Franck Dixmier | 26/01/2017
Federal Reserve Eagle

Summary

While the FOMC isn’t expected to raise rates at its next meeting, the markets may be underestimating the future pace of rate hikes. The Fed should clarify its intentions so the markets can adjust smoothly, particularly given that Trump is getting ready to ramp up his stimulus plans.

As the Federal Open Market Committee prepares to hold its first meeting of 2017, we do not expect any changes to be announced to the Fed’s monetary policy – particularly given Janet Yellen’s recent comments that the trend in wages does not warrant the Fed taking further action at this time. The Fed will also likely want to learn more about President Trump’s stimulus plans before making any adjustments.

We do, however, expect more clarity from the Fed in its prepared statement, given that there will not be a press conference accompanying the meeting. Of particular importance is the difference between the Fed’s “dot plot” and the market’s expectations. The dots show the FOMC’s consensus expectations of three rate hikes this year and three more in 2018. However, the market expects only four rate hikes in total over the next two years – a significant difference.

This ongoing gap between the market’s expectations and the future pace of rate hikes shows that there is a kind of fragility in the US markets, particularly given that the reflation trade is underway and there is mounting pressure from the labor market. It is in the Fed’s interest to be more precise about the future pace of rate hikes to allow the markets to adjust smoothly, given that financial stability is at the core of the Fed’s decision-making process.

We also note that the Trump administration is expected to introduce more fiscal stimulus into a US economy that is already operating at full employment. This should generate more inflation, particularly on wages. As such, we are strongly convinced that the Fed will, at the very least, have to act consistently with the rate-hike path presented in its dot plot. In fact, if there are any surprises, we think they will be to the upside – more hikes, not fewer.

Overall, we believe the core issue is the Fed’s credibility. The market must be convinced that the Fed is voluntarily behind the curve and will let inflation go up before it acts. It will also not be lost on the markets that the Fed stands ready to cool down the US economy while President Trump is promoting new pro-growth stimulus measures, putting the Fed in a very tricky situation.

Investing involves risk. The value of an investment and the income from it will fluctuate and investors may not get back the principal invested. Past performance is not indicative of future performance. Investments in commodities may be affected by overall market movements, changes in interest rates, and other factors such as weather, disease, embargoes and international economic and political developments. Investments in smaller companies may be more volatile and less liquid than investments in larger companies. Investments in emerging markets may be more volatile than investments in more developed markets. Dividends are not guaranteed. Bonds are subject to interest rate risk and the credit risk of the issuer. This is a marketing communication. It is for informational purposes only. This document does not constitute investment advice or a recommendation to buy, sell or hold any security and shall not be deemed an offer to sell or a solicitation of an offer to buy any security.

The views and opinions expressed herein, which are subject to change without notice, are those of the issuer or its affiliated companies at the time of publication. Certain data used are derived from various sources believed to be reliable, but the accuracy or completeness of the data is not guaranteed and no liability is assumed for any direct or consequential losses arising from their use. The duplication, publication, extraction or transmission of the contents, irrespective of the form, is not permitted.

This material has not been reviewed by any regulatory authorities. In mainland China, it is used only as supporting material to the offshore investment products offered by commercial banks under the Qualified Domestic Institutional Investors scheme pursuant to applicable rules and regulations.

This document is being distributed by the following Allianz Global Investors companies: Allianz Global Investors U.S. LLC, an investment adviser registered with the U.S. Securities and Exchange Commission; Allianz Global Investors GmbH, an investment company in Germany, authorized by the German Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin); Allianz Global Investors Asia Pacific Ltd., licensed by the Hong Kong Securities and Futures Commission; Allianz Global Investors Singapore Ltd., regulated by the Monetary Authority of Singapore [Company Registration No. 199907169Z]; Allianz Global Investors Japan Co., Ltd., registered in Japan as a Financial Instruments Business Operator [Registered No. The Director of Kanto Local Finance Bureau (Financial Instruments Business Operator), No. 424, Member of Japan Investment Advisers Association]; Allianz Global Investors Korea Ltd., licensed by the Korea Financial Services Commission; and Allianz Global Investors Taiwan Ltd., licensed by Financial Supervisory Commission in Taiwan.

99064

Expert-Image

Franck Dixmier

Global Head of Fixed Income, CIO Fixed Income Europe
Franck Dixmier is Global Head of Fixed Income and Chief Investment Officer Fixed Income Europe. Franck is a member of the Global Executive Committee at Allianz Global Investors. He joined Allianz Group in 1995.
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