The great value rotation – ShareCafe



Europe is the last region affected by supply problems leading to price increases. Eurozone input costs have risen for manufacturers and services at their highest rate since 2000, with input price inflation in the manufacturing sector close to all-time highs, according to the monthly managers survey purchase of IHS Markit. Energy supply problems in the region peaked when Boris Johnson called in the military as panicked buyers flooded UK gas stations. British gilts were sold after the last Bank of England meeting.

The yield on US Treasuries has reached levels not seen since June. This follows the most recent FOMC forecast, which showed that nine of the committee’s 18 members expected a rate hike by the end of next year, up from seven in June. Inflation coupled with low economic growth are hallmarks of stagflation and it was a feature of the revocations of the 1970s and early 1980s.

It is in these environments that value has outperformed growth as it has recently. Value stocks are less sensitive to changes in macroeconomic conditions and have a habit of emerging as the winning “factor” following a recession.

The threat of stagflation

Stagflation is characterized by periods of high inflation and low economic growth. We could be entering a period of stagflation now, with inflation pressures but mild growth. Stagflation was a feature of the economy in the 1970s and early 1980s, which experienced average inflation of eight percent and frequent returns to recessions. Those times were a huge challenge for central banks and governments, as rising interest rates to curb inflation led to increased unemployment and slower economic growth.

Chart 1: US CPI by periods of recession

Source: Bloomberg, National Bureau of Economic Research (NBER), Bureau of Labor Statistics, US CPI Urban Consumers YoY as US CPI.

The threat of stagflation is back

Today, US inflation exceeds 5 percent for the first time since 2008, well above the US Federal Reserve’s long-term target of 2 percent. Markets and the US Federal Reserve have so far ignored this concern, citing that the drivers are “transient” as opposed to persistent, expecting inflation to “calm down”. We call it “inflacence” in our recent views – you can read it here.

The US Federal Reserve has pledged to keep rates low longer, although some form of quantitative easing is expected. The most recent FOMC dot plot forecast showed that nine of the committee’s 18 members expected a rate hike by the end of next year, up from seven in June. The question for the markets is whether the Fed is moving too slowly.

COVID-19 has disrupted supply chains. Firms report significant pressures on input prices, including higher wages, raw material prices and transportation costs. Global shipping container costs have jumped more than 400% in one year. These observations surprised economists on the upside (see graph 2), as shown by the Citi US inflation surprise index.

The delta variant of the coronavirus has also started the global economic recovery. The August non-farm payroll in the United States was lower than expected and this is the first time in two years that economic figures have significantly exceeded expectations (see chart 3).

Chart 2: Citi US Inflation Surprise Chart 3: Citi US Economic Surprise

Charts 2 & 3: Sources: Citi, Bloomberg.

The combination of high inflation and lower economic growth portends stagflation.

The impact of stagflation on equity markets

The 1970s and early 1980s were the era of value investment managers. Value companies outperform when inflation and interest rates rise because they are less sensitive to changes in macroeconomic conditions.

Figure 4 – Performance comparisons over five years per year
Source: Bloomberg. MSCI, creation of the MSCI World Value index on December 31, 1974.

With this in mind, investors looking to exploit current trends should consider investing in a portfolio of valuable international stocks.



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