DR.CHENJIAZI ZHONG

Value stocks outperformed through mid-February this year as investors repriced expensive growth stocks. Mounting inflation and rising interest rates are creating conditions for broader value recovery, particularly for companies with solid business fundamentals. Style return patterns have been erratic over 2021, where returns of global value stocks and growth stocks flip-flopped, and both cohorts ended the year with similar gains. During the sell-off in January 2022, value stocks outperformed growth stocks by a wide margin, as evidenced by the fact that the MSCI World Value Index fell by 0.6% through February 15, while the MSCI World Growth Index dropped by 10.1%, in US-dollar terms.

Inflation is changing the game. With investors and central banks acknowledging that inflation will stay higher for longer than initially expected, interest rates are poised to continue rising, which should benefit value stocks, even as it raises challenges for equity investors. Rising rates tend to compress valuation multiples of all stocks; growth stocks are particularly vulnerable, while value stocks are generally more resilient.

Despite their recent outperformance, value stocks still trade at a near-record discount to growth peers. As of January 31, 2022, the price-to-forward earnings ratio of the MSCI World Value was 50% lower than that of the MSCI World Growth. Investors might think this discount implies that value stocks are impaired. The three indicators of profitability, earnings expectations, and balance sheet strength, however, show that value-stock fundamentals rank near historic highs relative to growth stocks.

In recent years, multiples of growth stocks have benefited from the falling-rate environment as well as investor demand for high-flying growth companies. Many of these companies have long-term potential but weak current cash flows. This, together with fears of a prolonged economic slump, filed a massive valuation gap between growth stocks and value stocks. However, these trends are ripe for reversal. Since 2009, valuations of growth stocks have been tightly linked to the real yield of the 10-year US Treasury. As real yields fell, growth stocks valuations rose in near lockstep. Over the same period, valuations of global value stocks were relatively stable.