Real rates and factor performance
Rising real rates
US 10-year Treasury yields have risen by more than 0.70% so far in 2021. Until recently, this increase was primarily driven by rising inflation expectations as investors anticipated economies reopening and stronger growth. This was evident in the widening spread between nominal and real (inflation-adjusted) interest rates until February (figure 1).
However, since mid-February real rates (as measured by the yield on US Treasury Inflation-Protected Securities, or ‘TIPS’) have also started to rise, indicating that the latest increase has been driven by sentiment to US monetary policy, with investors starting to contemplate less easing and even the prospect, albeit distant and uncertain, of policy tightening.
Rising real rates have broadened the value rally
In December 2020, we highlighted a more positive outlook for value investing, driven by expectations of a gradual worldwide economic re-opening in 2021. As shown by the grey line in figure 2, the initial value recovery was led by stocks trading at low multiples of their book value, as companies that had been most impacted by lockdowns (banks, energy, travel, hospitality and retail) rebounded.
While other value metrics, such as low price-to-earnings (PE) ratios, also stopped underperforming late last year, they have only recently started to strongly outperform. As shown in figure 2, there has been a clear correlation between the strength of low-PE stocks and the rise in real interest rates. This relationship makes sense, as higher real rates drive investor interest in shorter-duration equities while simultaneously placing more emphasis on high-quality value – lowly priced companies that are underpinned by solid earnings and therefore are better equipped to cope with a post-Covid-19, post-stimulus world.
Rising real rates have created a hostile environment for growth factors
Longer-duration factors such as 5-year earnings and sales growth initially proved resilient to higher bond yields as rising nominal rates were offset by stronger inflation and growth expectations. However, as figure 3 shows, growth factors have experienced significant weakness since real rates started to increase.
We maintain a positive view on value for three reasons:
- Gradual economic re-opening should continue to support Covid-19 impacted consumer cyclical sectors, which we believe, despite recent outperformance, remain relatively undervalued;
- Barring a major setback on the path to recovery, we expect real rates to move modestly higher, further supporting value by broadening the recovery into higher quality stocks; and
- Value remains relatively cheap compared to its long-term average.
With regard to longer-duration growth factors, while monetary policy may not be as supportive as last year, we do not expect rates to rise substantially this year as the Federal Reserve seeks to carefully manage the recovery and avoid another ‘taper tantrum’. This may cause the recent headwinds to growth styles to abate. In this context, an active approach focused on structural trends like health care, digitisation and the green economy may continue to find opportunities, even if the broader factor backdrop proves to be more challenging.
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