Inflation, rising rates, and the return of the value cycle

Support for growth stocks dissipates

Markets over the past several years have been supportive of growth stocks. A broadly disinflationary environment with the Consumer Price Index averaging 2.37% over the decade 2010 to 2020 was coupled with low interest rates around the world—even negative rates in Europe—and growth almost exclusively concentrated in the technology sector. Added to this, COVID-19-related consumer and small business stimulus set the scene for rapid post-lockdown recovery, which has manifested in various forms, including decades-high inflation and an overheated housing market.

Compounding already high inflation is a recent spike in oil and gas prices, which is pushing food and materials higher too. Supply chain backlogs look set to further exacerbate high prices. Altogether an unsustainable picture emerges, which has started to unwind, and which we believe will continue on that trajectory as the U.S. Federal Reserve (Fed) continues monetary tightening.

Many investors are asking, “What will happen to equities in a rising rate, accelerating inflation environment?” Looking back in history, 10-year bond yields have been on a downward trajectory for over 40 years. During the periods 1954 to 1981 and 2002 to 2007, when 10-year yields were moving up, value steadily outperformed growth.

The outperformance of value in a rising yield environment coincided with periods of price-to-earnings (P/E) multiples compression, an effect of both rising rates and higher inflation. Historical indicators show that inflation above 4% can lead to a compression in P/E multiples, often besetting growth stocks most.

The market as a discounting mechanism—compression in P/E multiples

Historically, when inflation accelerates above 4% and interest rates rise, investors demand a higher rate of return to offset both higher inflation and higher interest rates. In our analysis, we’ve also noticed a negative relationship with 10-year bond yields and P/E multiples: As yields have gone up, P/E multiples typically drop. Given the presence of both these factors in today’s markets, we believe it’s reasonable to expect P/E multiples to contract. We’ve already seen some of this, and we believe it will persist.

Longer duration assets are more sensitive to rising rates

Growth stocks are known as longer duration assets, as a significant portion of company cash flows are further into the future. Similar to the bond market, in which 30-year bonds will lose substantially more value than 1-year notes if interest rates rise 1%, growth stocks typically lose more value relative to shorter duration value stocks in a rising interest-rate environment.

Traditional value sectors such as financials, energy, and industrials have been leaders in periods of rising inflation. Banks’ net interest margins benefit from rising interest rates, while strong commodity prices help boost cash flows in the energy sector. Leading industrial companies can often raise prices to offset increased costs. By comparison, high multiple, long duration growth sectors such as technology and communication services have typically lagged as valuations tend to compress more severely for these traditionally high P/E groups.

As growth companies reach the upper end of historically high averages, there’s a risk of rerating spreading from outlier high-growth stocks to capitalizations across the growth spectrum. Large-, small-, and mid-cap growth stocks are trading at multiples far above historical averages. Value stocks, meanwhile, are at more reasonable levels and, as such, we believe they’re ideally poised to reward investors in 2022 and beyond.