After steadily declining for most of the year, the interest rate pendulum has reversed, pushing rates higher and investment style leadership upside down. The rate rise was predicated on a growing belief that global growth won’t slip into imminent recession. Since sliding as low as 1.4 per cent a little more than a month ago, the benchmark 10-year Treasury yield spiked to 1.9 per cent and is now flirting with the psychologically important 2 per cent threshold. This shift was supported by better-than-expected 3Q earnings, beating analysts’ downbeat 3.5 per cent year-over-year retreat scenario.
Recent economic metrics confirmed the optimism. The National Association of Homebuilders survey recently reached its highest level since February 2018, reflecting renewed confidence in the housing market. Personal income expanded 4.9 per cent year over year, according to the Bureau of Economic Analysis. European manufacturing, while tepid, is showing signs of stabilization. Coincident economic data in Japan is improving as well.
While the economic uptick is good news, the interest rate reversal threw a curveball at investors who were accustomed to the largest, most expensive stocks getting ever larger and more expensive, while relatively cheaper stocks got hopelessly cheaper. US large-cap growth stocks, dominant through August, were outperformed by just about every other investing style from September through today. The Russell 1000 Growth Index gained nearly 24 per cent through August, outpacing its value counterpart by nearly 10 percentage points. Since then, however, it has fallen behind the Russell 1000 Value Index by more than 3 percentage points. Foreign markets are following a similar pattern: large-cap growth stocks have trailed both international large caps and emerging market equities by near 4 percentage points since the pendulum swing.
A similar trend is occurring beneath the surface of the S&P 500. For most of the year, the largest, most expensive stocks have led the index to the upside. More recently – and consistent with the reversal in interest rates – cheaper stocks have prevailed. Over the last month, constituent stocks in the lowest price-earnings quintile of the S&P gained an average 8.4 per cent, besting the highest price-earnings quintile constituents by more than 7 percentage points.
Have markets regained their senses? Will investors now be rewarded for owning cheaper stocks? Possibly. One dominant factor in large-cap growth’s corner has been massive capital flows into passive, low-cost index funds. Perhaps the rate reversal stemmed that flow, which tends to favor the largest, most expensive names. We expect cheaper stocks and markets to outpace US large-cap growth once the tidal wave of capital flowing into passive strategies ebbs, especially if global economic conditions improve.