- Growth stocks tend to outperform in a slow economic growth environment; value stocks have historically outperformed as the economy is expanding.
- Financials and energy are the two largest sectors in the large-cap value universe relative to large-cap growth.
- From an economic perspective, faster GDP growth historically benefits financials and cyclical value sectors like energy.
In a June post, I discussed the reasons why growth stocks outperform in periods of slow economic growth or when the economy is decelerating. As a reminder, growth stocks tend to outperform in such environments because investors are looking for companies with more predictability of earnings growth in an uncertain environment. Conversely, value outperforms when the economy is accelerating. What may be more counterintuitive to some investors is the characteristic of growth stocks outperforming in periods of weaker growth, but these are the periods when highly regarded growth stocks have typically escalated in price.
Value thrives in a positive cycle
Value stocks can be divided into cyclical and defensives sectors. From an economic perspective, faster GDP growth historically benefits cyclical sectors, which include financials and energy, while the defensive sectors like utilities have historically underperformed in a faster growth environment due to rising interest rates.
What is today’s economic environment?
In the ISM June report, the ISM Manufacturing Index and the Non-Manufacturing ISM Index both accelerated to levels historically associated with higher real GDP growth going forward. In fact, the latest Q2 GDP growth forecast from the Atlanta Fed’s GDPNow model is for a growth rate more than double the Q1 GDP rate.
How financials could lift value stocks in general
For value stocks to do well in relation to growth, financials need to outperform. One way to monitor this possibility is to use the yield curve as an indicator in the growth-versus-value allocation decision. As interest rates move higher and the yield curve steepens, profits in the financials sector are likely to increase and earnings estimates may be raised higher. In the current environment, we would add that financials appear to have the fastest earnings growth of all sectors and the cheapest price-to-earnings-growth valuation of all the S&P 500 sectors. In addition, they are also positioned to benefit disproportionately more than other sectors from deregulation initiatives by the Trump administration.
Potential for active strategies to outperform
In an accelerating economic environment with the prospect of higher rates, active large-cap value managers have an opportunity to outperform. Large-cap value stocks in different sectors react to different factor influences, and several of these influences are in place currently. For example, the potential for an expanding economy can drive up cyclicals like energy and basic materials. At the same time, financials are primarily driven by interest rates and policy decisions. On the other hand, while rising rates benefit financial stocks, they have historically hindered interest-rate-sensitive sectors like utilities and REITs. An active large-cap value manager has the ability to tilt a portfolio in favor of stocks and sectors that perform best given the specific cyclical conditions.
Value stocks may be poised to outperform
If the economy continues to expand, interest rates rise, and the yield curve steepens, history would suggest that the value outperformance investors experienced in 2016 would reassert itself.
Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Russell® is a trademark of Frank Russell Company. Russell 1000 Growth Index is an unmanaged index of those companies in the large-cap Russell 1000 Index chosen for their growth orientation. Russell 1000 Value Index is an unmanaged index of those companies in the large-cap Russell 1000 Index chosen for their value orientation. You cannot invest directly in an index.