Global MarketsSMSF Strategies
Growth versus value stocks in inflationary times
3 Jun 2022
23 day(s) ago
When inflation surges, it tends to change the emphasis in stock selection.
One of the interesting things about financial markets is how often they are late to the party. For a long time various authorities and pundits were saying that inflation is only temporary – which may still prove to be the case of course – but now they are coming to the opposite conclusion as David Walsh, analyst at Realindex Investments, comments. He says that inflation commentary has moved from ‘transient’ to ‘temporary’ to ‘sticky’ and is now approaching ‘entrenched’ at a fast clip.
These are the cycles of sentiment in the market; the herd rushing from side to side. That does not necessarily mean that it is a good idea to defy the herd, because sentiment is so important in pricing. But it is intriguing to observe.
So far, the spike in inflation and other bearish pressures have hit the US stock market much more than the Australian. Over the last six months the S&P 500 has fallen about 7.9%, while over the same period the S&P 200 is actually up slightly:
There is little doubt that conditions are getting bearish, which typically means shifting towards value stocks: stocks whose share price reflects existing earnings rather than growth stocks, companies that have good prospects yet to be realised.
Walsh outlines the thinking:
“During this period of uncertainty, Value stocks have performed well, which coincides with (but is not entirely driven by) higher inflation. Very expensive Growth stocks, hit both by slowing growth and by inability to source materials, have sold off significantly.
We believe Value will continue to do well for some time (or Growth will do poorly), as the issues driving inflation are unlikely to be resolved any time soon, and the knock-on impacts will take some time to filter through.
How has Value performed?
While there is a fairly well-known, positive relationship between the returns to Value and inflation, the relationship is by no means simple. It was probably greater in the high-inflation period of the 1970s when oil prices were high and inflation was not targeted by central banks, as it is today.
However, two comments on this relationship:
- Inflation is up, is sticky and is expected to stay high for some time
We know that higher inflation means higher nominal interest rates, and higher cost of debt for companies. Companies that rely on longer-dated cash flows for their valuation – so-called ‘long duration’ companies – are much more affected by increases in interest rates than those with shorter duration. These longer duration names are typically the expensive Growth stocks and are devalued and sold off more than shorter duration stocks, which are typically the cheaper Value-style companies.
- Economic growth expectations are muted
When projections of expected growth and future cashflows are positive, the market is willing to pay up for expensive stocks, betting that things will go well. However, if this growth is interrupted, as it has been recently, the expectations are less optimistic and expensive companies are sold off in favour of companies with more certain short-term opportunities, especially those that are cheaper.
Shares may be inflation resistant whereas other types of investments such as term deposits are always eroded by inflation. That is also worth considering.
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