Regime Change

How a Republican-Led Revolution Could Accelerate the Recovery in Value Strategies

By Richard Wong and Jonathan Norwood, Co-Heads and Portfolio Managers of the Mackenzie Cundill Team and Mary Mathers, Senior Investment Director, Equities

Jonathan Norwood
Portfolio Manager

Richard Wong
Portfolio Manager

Mary Mathers
Senior Investment Director – Equities

The value investment style began its recovery in the spring of 2016, coinciding with an acceleration in global economic activity, outperforming growth and momentum strategies. Despite a brief interruption in the immediate aftermath of the UK referendum vote to leave the EU, the style reasserted its dominance in the third and fourth quarters of 2016. A few quarters do not always constitute a trend, but we believe we are in the very early days of a multi-year reversion from bond proxy stocks and high growth stocks to value.

In this paper, we expand on our rationale by providing:

  1. Stretched valuations in bond proxies
  2. Research on the correlation between rising bond yields and value style equities, and
  3. Evidence of the cyclical nature of value and growth styles.

Business conditions have a mean reverting tendency, as do investment styles such as value and growth. Corrective forces are inevitably set in motion, which tend to restore profits and valuations where they have shrunk, or to reduce excesses.  No one knows what form they will take, or exactly when they will occur. Benjamin Graham acknowledged this as “one of the mysteries of the market.” In hindsight, it is apparent what triggers the shift; however, we are confident that the fiscal stimulus and pro-business policies of the new U.S. administration will be the trigger that accelerates the trends that were already underway in 2016. Rising protectionism remains a risk and could temper to some extent the benefits of fiscal stimulus.

Sometimes these corrective forces arrive in the form of political events, such as the UK referendum, or the recent electoral outcome in the U.S. Regardless of your views on Donald Trump, we believe the recent Republican sweep of the U.S. Congress and White House represents a paradigm shift for the U.S. economy and asset markets in general. The bond proxy trade ran its course from 2009 to 2016 on the back of monetary stimulus and fear. We are convinced that fiscal austerity in the U.S. is over and there will be substantial stimulus in the form of tax cuts,  less onerous regulation and increased infrastructure spending. We expect that this will be reflationary and force the U.S. Federal Reserve to continue to hike rates, perhaps faster than expected. Of note is that fiscal stimulus will arrive at a time when unemployment rates are low, wage growth is accelerating and households have largely completed their deleveraging phase. Further, the ECB, BoJ and BoE continue to expand their balance sheets via their QE programs. Higher GDP growth and interest rates provide a superb environment for U.S. banks and insurance companies to drive profits. Therefore, we expect a continued rotation into cyclicals and value stocks as U.S. growth improves and the reflation trades that have supported market gains since the summer continue to dominate.

In the search for yield, investors have poured into bond proxy stocks in the Utilities, Consumer Staples, and Telecommunications sectors. Bond proxies are securities that act similarly to bonds, as they have relatively high dividend yields and their returns are inversely correlated to interest rates. It is our view that the bond proxy trade is still extremely crowded, particularly by quants.  On the other hand, many value stocks are considerably under- owned by fund managers, especially U.S. banks. This is the result of essentially seven to eight years of near-zero interest rates in the U.S., so the rotation/unwinding of related positions should have substantial legs.

We believe that the UK referendum vote marked the peak of the bond bubble and the dawn of a new era for value investing. Similarly, a Republican sweep could mark the official bursting of said bubble.

Republican-Led Fiscal Stimulus to Take over from Monetary Stimulus

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The new Republican-led administration promises to usher in an era of “pro-growth” fiscal policies that could potentially drive continued acceleration in the U.S. economy, which would put a tailwind behind higher inflation and interest rates on the back of infrastructure spending, tax cuts and less onerous regulation. Monetary stimulus, which began in earnest in 2009, provided life support for a weakened economy. In turn, it lifted asset prices in bonds, growth stocks, bond proxies such as utilities and consumer staples, as well as telecommunication stocks. Monetary stimulus has inflated asset values with debatable impact on the real economy, but we believe fiscal stimulus has the ability to drive investments, increase employment and lift consumer confidence, which all translate into real impact on the underlying economy and accelerate earnings growth in value stocks.

Stretched Valuations in Bond Proxies

The valuations of the U.S. consumer staples and utilities sectors peaked in June 2016, with forward P/E multiples roughly 30% higher than their 10-year averages. Both sectors have had negative returns since that point – a dramatically different experience than the previous five years when they were among the top performing sectors in the S&P 500. We believe they are likely to continue to deflate as interest rates rise and investors shift out of bond proxy stocks into value stocks. In contrast, U.S. banks have been significantly undervalued. In June 2016, the P/B multiple fell below 1.0. U.S. banks returned 38.6% during the subsequent six months and despite the ramp up, we believe they have ample room to appreciate. Valuations are still compelling especially compared to the previous cycle peak of 2.2 times book value. We also believe that U.S. banks are poised for higher profitability during the coming rate cycle and potentially accelerated GDP growth in the U.S.

Valuation of bond proxies peaked mid-2016 while banks remain undervalued

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Source: Bloomberg, June 30, 2016. S&P 500 Consumer Staples Sector, S&P 500 Utilities Sector, S&P 500 Banks Industry Group.
*Source: FactSet, June 30, 2016 to December 30, 2016, returns in local currency.

Research on the Correlation between Rising Bond Yields and Value Style Equities

Following the U.S. election, the yield curve immediately steepened, reflecting higher inflation expectations due to stimulative fiscal policies. Performance of investment styles tend to diverge during a tightening interest rate cycle benefitting investors in the winning style. The chart below illustrates the correlation of the performance of different investment styles with the U.S. 10-year treasury yield. Independent research has found that the style that is in the lead going into a rate hike cycle tends to continue its lead when yields increase. We can see that the value style (dark blue line) has a higher correlation with yields relative to other styles. As rates increase, the spread between style correlations increases. Style correlations are typically very tight, but the gap in correlations widens in periods of Fed rate hikes. As correlations start to diverge, we expect the value style to outperform until the end of the rate hike cycle.

U.S. yield curve steepened after the election

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Source: Bloomberg

Value’s correlation with yields has increased during current rate tightening cycle

SQoRE U.S. Top 50 - Correlation* with U.S. 10-Year Treasury Yield by Style

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*Rolling 2-year correlation of monthly returns. Source: Scotiabank GBM Portfolio Strategy. The SQoRE model is a quantitative model ranking equities.

Evidence of the Cyclical Nature of Value and Growth Styles

From 2009 to mid-2016, we have witnessed significant underperformance in value-oriented styles. We can essentially chalk this up to three trends: slow economic growth, low bond yields and higher than normal stock market volatility.

Value stocks, by their nature, underlie slow-growing, cyclicallychallenged, out-of-favour or underperforming businesses. During periods of slow economic growth or investor uncertainty, it is expected that these types of businesses underperform. In contrast, growth stocks attract a disproportionate amount of investor capital and garner expensive valuations. Regardless, value underperforms on a relative basis.

Low yields and interest rates have hurt value strategies on two fronts. First, they have held back the banks, where much of the value in the market lies today and second, they have extended the gains in sectors that any authentic value manager would have sold out of long ago. Investors in search of yield have ventured further out along the risk/return spectrum, out of bonds and into bond proxies – almost irrespective of valuation.

Similarly, the market has rewarded low volatility stocks due to the perceived safety of such stocks. In fact, the “low volatility” trade was primarily the result of declining interest rates, which supported the valuation of most bond proxy equities.

The world economy has been mired in low growth and enveloped in a highly uncertain economic environment since the financial crisis. More recently, we have been in the midst of a mid-cycle ‘profit’ recession, which we believe came to an end in Q3/2016.

Earnings rebound – end of the profit recession

S&P 500 Index earnings, year-over-year change

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Source: Bloomberg, December 31, 2016.

Reversion to value investing leadership

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Source: Morningstar, December 31, 2016. 5-year trailing performance MSCI World Value Index relative to MSCI World Growth Index

Value has made a Comeback that We Expect to Continue for Several Years

Value investing works best in a reflationary period accompanied by economic reacceleration, which we started to see post-Brexit. This provides the ideal backdrop for out-of-favour, cyclical and often problematic companies to perform better. We also expect to see more pro-business policies (e.g. less onerous regulatory oversight) from the new U.S. administration, which should drive valuations higher in financials, health care and energy sectors, which are fertile areas for value investors.

We are confident that the reversion back to value strategies has only begun. History demonstrates that these cycles can last for five to seven years. Value has underperformed since 2009, about seven years, so history is on our side.

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