Rising Rates and the Absence of Equity Duration | Lord Abbett
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Market View

Concerns that equity returns may be hurt by rising U.S. Treasury yields run counter to the historical record.

Read time: 4 minutes

Value is finally having its day.  After a nearly three and one-half year run of growth beating value in every quarter and a 13-year secular run of growth dominance, the Russell 1000® Value Index has outpaced the Russell 1000® Growth Index by over twenty percentage points (25.3% to 5.2%) since the end of August 2020 (through March 19, 2021). 

In our view, the primary reason for this shift in investor preference has been expectations of a strong reopening for the U.S. economy as the result of highly effective vaccines ending most pandemic-related restrictions at some point this year.  This development, which became apparent in November of last year with the extraordinary clinical trial results from the Pfizer/BioNTech and Moderna COVID-19 vaccines, effectively lowered investor perceptions of the default risk of many struggling businesses that were hurt by social distancing and lockdown orders during the crisis. As the vaccine-aided “grand reopening” of the U.S. economy draws nearer, it has fueled expectations for growth that benefit many types of Value companies with high economic sensitivity.

A by-product of this rebound in economic activity is the expectation for higher inflation and higher rates, while the U.S. Federal Reserve (Fed) may be eventually forced to combat a meaningful rise in consumer and producer prices. And while we can debate whether this expectation for higher rates and inflation is warranted, the impact of these hypothetical higher rates on equity valuations, a concept being called “equity duration”, is one we believe needs to be addressed.

Discount Rates, Duration, and Data

Basic bond math shows us that rising inflation is a negative factor for longer-dated bonds as it erodes the present value of future cash flows, typically more so the further out those cash flows (coupons and principal) are into the future.  As inflation rises, so do interest rates, making the discount rate on those future payments less valuable to bondholders today; under these conditions, it would be increasingly preferable to hold investments with cash flows that are paid sooner.  This is central to the concept of duration, a measure of a bond’s sensitivity to a one percent rise in interest rates, and under normal market conditions it is closely related to the bond’s maturity date.  

So, what about equities? Does “equity math” suggest that prices of growth stocks, whose big expected earnings are much further out into the future, will fall like long duration bonds in a rising-rate environment? Is that the time when Value, by contrast, might shine?  In looking at the data in Figure 1, the intuitive narrative of equity duration does not pan out. We see that over the last 20 years there has been a very mixed bag of relative and absolute performance from growth and value during environments where the 10-year U.S. Treasury yield increased by at least 100 basis points (bps). In fact, on average and in frequency, growth edged out value. 

 

Figure 1. Over the Last 20 Years, Growth Stocks Have Outperformed in Rising-Rate Environments
Data for the most recent periods of greater than 100 basis points increases in the 10-year U.S. Treasury yield

Source: Morningstar and Bloomberg. Data compiled March 15, 2021. Returns for periods of greater than one year have been annualized. One basis point equals one one-hundredth of a percentage point.
Performance data quoted reflect past performance and are no guarantee of future results. Performance during other time periods may have been different or negative. Other indexes may not have performed in the same manner under similar conditions. For illustrative purposes only. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

We have a few key observations based on the data in Figure 1:

  1. History shows that stocks can do well—quite well, in fact—in a rising-rate environment, and small caps may be even bigger beneficiaries.
  2. Growth has done a bit better than value, though the variance has not been that big.
  3. In thinking about these periods (especially the most recent one), what is likely most important is why rates are going up. Is it a response to rapidly accelerating inflation or a healthy boost to economic growth that’s accompanied by modest inflation starting from a low base level?

Big Earnings Growth Overwhelms Rate Changes

Are we to believe that changes in interest rates have no impact on future cash flows? Hardly. Discounted cash flow math still holds, and a big rise in rates likely would be a natural depressant to intrinsic stock values.  However, what is often lost in the discussion around simple equity duration is the growth component of equity math versus bond math.  For investors, Treasuries have two basic ingredients: coupons and principal.  There is no hope of any growth or return beyond that.  When it comes to a stock—and a potentially fast-growing company underlying that stock—the rate of growth both today and years from now may indeed dwarf a modest rise in the discount rate placed on those cash flows.

In nearly all the cases from the data above, the absolute returns of growth and value equities demonstrate stronger expectations of future earnings than concerns about the underlying discount rate.  But we could certainly go back to the 1970s and early 1980s and point to the dramatically higher rate environment and far larger intermittent rate increases back then as big negatives for equity returns.  Clearly, the magnitude of rate changes matters.

Back to Today – Growth or Value?

Bringing the discussion back to the current environment, we have seen a big move in Growth versus Value and Large Cap versus Small Cap.  In Figure 1, for instance, we can see that Small Cap Value has trounced Large Cap Growth by 3800 basis points over the past seven months.  Before that, Growth had crushed Value for over three years running, and for the majority of the post-GFC era.  As we have discussed in several recent articles, we increasingly see growth and value as a less-than-ideal framework for thinking about equities today.  In our view, investors should consider innovation, vulnerability, and durability as the key factors influencing the economy and equity markets.

But even through the growth/value lens, the big takeaway for us is to avoid betting on one or the other.  We believe the case for value is based primarily on the reopening of the U.S. economy, which should benefit a large number of companies in sectors that were affected directly due to COVID-19; industries that directly benefit from higher interest rates, namely banks, should also see a lift from their depressed levels. Nonetheless, we think the case for innovation and growth equities remains remarkably strong as we look at many powerful secular growth areas of the economy.  And history would suggest that an increase of a few dozen basis points in interest rate would not likely impede their progress.

 

A Note about Risk: The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. While growth stocks are subject to the daily ups and downs of the stock market, their long-term potential as well as their volatility can be substantial. Value investing involves the risk that the market may not recognize that securities are undervalued, and they may not appreciate as anticipated. Smaller companies tend to be more volatile and less liquid than larger companies. Small cap companies may also have more limited product lines, markets, or financial resources and typically experience a higher risk of failure than large cap companies. The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall.

No investing strategy can overcome all market volatility or guarantee future results. 

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

This Market View may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize, or that actual returns or results will not be materially different from those described here.

Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future.

Glossary and Index Definitions

A basis point is one one-hundredth of a percentage point.

Discounted cash flow (DCF) is a method of valuation used to determine the value of an investment based on its return in the future–called future cash flows. DCF helps to calculate how much an investment is worth today based on the return in the future.

 Growth/Value Investing: Growth stocks may be characterized as equities of companies that have demonstrated better-than-average gains in earnings in recent years, and that are expected to continue delivering high levels of profit growth. Growth equities typically carry higher price-to-earnings multiples than the broader market, high earnings growth records, and greater volatility than broader market. Value stocks may be characterized as equities of companies that have fallen out of favor with investors but still have good fundamentals, or new companies that have yet to be recognized by investors. Value stocks typically feature lower price-to-earnings multiples than the broader market—and often their industry peers—and somewhat lower volatility than the overall equity market.

Intrinsic valuation looks only at the inherent value of a company’s stock. Financial analysts build models to estimate what they consider to be the intrinsic value of a company's stock outside of what its perceived market price may be on any given day, based on the present value of expected future cash flows.

The Russell 1000® Index measures the performance of the 1,000 largest companies in the Russell 3000® Index, which represents approximately 92% of the total market capitalization of the Russell 3000® Index.

The Russell 1000® Growth Index measures the performance of those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values.

The Russell 1000® Value Index measures the performance of those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth values.

The Russell 3000® Index measures the performance of the largest 3000 U.S. companies representing approximately 98% of the investable U.S. equity market.

The Russell 3000® Growth Index measures the performance of those Russell 3000® Index companies with higher price-to-book ratios and higher forecasted growth values.

The Russell 3000® Value Index measures the performance of those Russell 3000® Index companies with lower price-to-book ratios and lower forecasted growth values.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

The information provided herein is not directed at any investor or category of investors and is provided solely as general information about our products and services and to otherwise provide general investment education.  No information contained herein should be regarded as a suggestion to engage in or refrain from any investment-related course of action as Lord, Abbett & Co LLC (and its affiliates, “Lord Abbett”) is not undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity with respect to the materials presented herein.   If you are an individual retirement investor, contact your financial advisor or other non-Lord Abbett fiduciary about whether any given investment idea, strategy, product, or service described herein may be appropriate for your circumstances.

The opinions in this Market View are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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