Over the course of the end of 2020 and early 2021, investors rotated their portfolios strongly towards “value” stocks, which outperformed “growth” companies. All this is set to change this year as investors are going again after growth companies, especially innovative businesses with accelerating revenues and profits. However, valuations in some of these better quality growth areas now appear to look somewhat stretched.
Key Definitions
Growth stocks are typically characterised by higher profit growth, generally sell at higher valuations. The MSCI© Europe Growth index, designed to represent 50% of the market capitalisation of MSCI© Europe, is defined through the factorial analysis of short- and long-term growth in earnings per share (EPS), current growth and historical long-term growth in EPS and sales.
Value stocks are generally defined as having a lower price relative to profits or assets. For the MSCI© Europe Value index, they are defined using a factorial model of book value relative to price, long-term P/E and dividend yields.
Where are we at?
Interest rates are in flux. We are expect to see the end of the upward cycle on long-term rates. In the short term, 10-year US and German rates have been rising and we expect them to stabilise at the new level sometime in the early part of 2022.
After a period of uncertainty around inflationary risks, which lasted until Spring 2021, market sentiment completely reversed by the end of the Summer 2021. Central bank statements had a calming effect on market participants, who are now appraising the current situation. Inflation remains strong on both sides of the Atlantic and is expected to stay that way for much of 2022. While fewer barriers to international trade look to be in store, we expect higher food inflation featuring among the key indicators for a number of subsequent quarterly updates.
Meanwhile, central banks have resumed tapering their support, which should also help the normalisation of long-term interest rates both in the US and Europe.
Economic growth. Budget deficits, which had led to substantial increases in the level of debt in the US and Europe, highlighted the need for the countries concerned to apply greater financial discipline.
Government assistance is expected to be terminated at an increasingly brisk rate, with regard to both the stimulus measures to boost consumption and subsidies for small and medium size businesses.
Economic growth in the US and Europe is expected to slow at varying rates in 2022 and beyond, as it will continue to be impacted substantially by the COVID-19 crisis, which sent national deficits and debt skyrocketing globally.
Markets are likely to continue to be characterised by low economic growth. In addition, the growth potential of China, which has been the main global growth driver for over a decade, is expected to lose some of its muscle as the country seeks to reduce the financial leverage of its economy.
Given the weak growth potential, we expect long-term interest rates to peak in the first half of 2022. In stock market terms, this will correspond to a pick-up in the performance of quality/growth companies which are able to deliver profitable structural growth amid a slowing market environment.
Contrary to our observations six months ago, when the market was thoroughly relaxed – and hanging religiously on every word of central banks – the focus of attention now is firmly on inflation.
Central banks agree that inflation could be less temporary than expected. Based on our inhouse style management and valuations model, the valuation premium of growth stocks had disappeared completely around March 2021, following value rotation taking place in the preceding months.
THE MSCI EUROPE VALUE (BLUE) VS GROWTH (ORANGE) INDEX SINCE THE START OF THE PANDEMIC
Source: Bloomberg, performance of the MSCI© Europe Value and MSCI© Europe Growth indices from 28/02/2020 to 29/10/2021.
All change for 2022?
With bond yields rising higher, we expect to see a final upward surge in value stocks over the same period. The trend is likely to last until the first quarter of 2022. However, we think it appropriate to capitalise on this less favourable period for growth stocks to “buy low” into businesses set to generate profitable and structural growth over the coming years.
For the value style to demonstrate strong long-term performance, economic growth will need to accelerate considerably, which is not our core scenario for the short to medium term.
Our challenge this year will be to select the companies that are likely to benefit from stronger economic growth owing to their high-potential market segment or to their use of innovation. In Europe, we see a broad range of companies that can offer solutions to numerous accelerating megatrends, such as energy transition, new health technologies, digitalisation, and the automation of the economy.