Multi Asset: It’s a question of style

On the Mark – Multi Asset Strategy - February 2022

Summary:

Growth vs value
Style dynamics
Possible outcomes

The Ukrainian conflict is rightly uppermost in investors’ current considerations for a whole host of matters and amongst those are asset prices.

We would like to look at the style rotations that have occurred in equity markets over the last few years. Prior to the Ukrainian conflict we have argued that, unsurprisingly, the inflation outlook has been core to investors’ considerations for all assets in 2022.

Figure 1: Polar Cap Global Tech vs Global Equity Index Information Ratio.

Source: EPIC Investment Partners, Bloomberg L.P.

Readers may recall that in October 2020 we highlighted rapid acceleration of outperformance of growth stocks, and our concerns that this would peak and leave investors with disappointing returns. To quote “The reward from holding growth style funds has been nothing short of spectacular this year”.

We cited one of our holdings, Polar Global Technology Fund, as it had a very long-term track record spanning several market cycles and it exhibited one of the most extreme out performance readings.

The chart (Figure 1) is copied from our prior piece shows the rolling one-year information ratio (IR) – a measure of excess risk and reward for the fund vs. a recognised major global equity index. By end September 2020 the IR had expanded to an amazing +5.0, clearly breaking out to the upside from the previous near 19 year historical -2.0 to +4.0 range.

In the second half of 2020 US 10 year government bond yields started to move up from their lows around 0.6% to 0.9% before transitioning to a violent repricing from late January 2021, peaking around 1.75% in March. This was mainly driven by the successful vaccination breakthrough and growing concern over the oultook for inflation given the reopening of economies around the globe.

Figure 2:  US 10-year Government Bond yield 

Source: Bloomberg

This was coincident, and most likely responsible for a massive rotation out of growth stocks into value stocks. Similar observations were seen in most, if not all, developed market equities. However, US yields once again resumed their downwards trend before returning to their lows in the summer. In this period US growth stocks once again outperformed their US value counterparts, almost reversing the entirety of the short term underperformance.  The little blip up towards the end of the chart below (Figure 3) and its subsequent reversal.  

Figure 3: S&P Value vs Growth relative returns

Source: Doubleline

From the start of 2022 yields broke violently higher moving from 1.5% to a peak of 2% in mid February. As the Ukranian situation has worsened, oil has rallied to over $100 per barrel and natural gas prices have pushed up about 200%. The US CPI inflation moved up to a 40 year high at 7.5% and with it expectations for more aggressive interest rate increases.   

Obviously the energy sector had become a very unloved area of the market  due to environemental concerns amongst other issues. Valuations had become completely washed out, but  cashflow generation for oil and gas stocks has dramatically improved. Consequently, investors have dramatically increased exposure to energy, along with financials which are large consituent parts of the value index. The flip side of this move is that the recent BofA Global Fund Manager survey shows (Figure 4.) the underweight to Technology stocks is the greatest since August 2006.

Figure 4: BofA Global Fund Manager Survey, January 2022.

Source: B of A Securities    

Many of you will be aware that this has led to a major setback in the prices of many technology stocks, but especially those in the higher growth segments. Jeffries research shows that “tighter monetary policy expectations has led to Global Value stocks outperforming Growth stocks by circa 16% since mid-November”.

They add that “looking at each quintile of (DM Europe) growth and value stocks on an equal weighted basis, Growth stocks on average were attracting a 2 s.d. premium to Value stocks. Now that premium has almost returned to its LT average. Timing this inflexion is difficult but we seem to be fast approaching a more benign scenario in the context of relative valuation.” (Figure 5.)

Figure 5: MSCI DM Europe Q1 growth vs Q1 value

Source: Jeffries

Aubrey Capital Management recently commented that “the relative performance of European growth vs value stocks in January as measured by MSCI has now been worse than any time since 1970s”. If that doesn’t illustrate the scale of the rotation then please look at the following from the manager of Prusik Asian Equity Income fund, which is a value orientated strategy, “January saw the fund’s highest monthly outperformance since inception...”

We can see in the chart below (Figure 6) an update of the Polar Capital Technology Fund’s information ratio vs global equities. The peak of 5.7 occurred in October 2020, the month after our warning. Since that date the information ratio has collapsed to -1.63 in January 2021. This is amongst the worst levels in the fund’s history and, just like the rise, the collapse is nothing short of extraordinary.

Figure 6. Polar Cap Global Tech vs Global Equity Index Information Ratio.

Source: EPIC Investment Partners

We did forecast a deterioration in the risk reward of growth stocks vs value and for the Polar Capital Technology Fund. However, we did not forecast an outcome where growth stocks would witness two massive and violent rotations, the size of which we have not seen in decades. We simply underappreciated the speed with which things would play through.

Where does that leave us now?

Short term, growth style equities, and for that matter technology stocks, are deeply oversold and have the potential for another bounce. Equally many of these companies face into the structural changes that are evident in underlying economies. They have the tailwind of growth, but investors must decide how much they are willing to pay for that growth. Value stocks are cheap by definition and if you believe in long term mean reversion, they could continue to outstrip their growth counterparts for many years to come.

It is evident that both camps of investors ardently feel that their approach will reward in the future. As we highlighted from UBS asset management last month “The sluggish growth, below trend economic environment of the past decade kept the range of realized macroeconomic outcomes fairly narrow. One consequence of operating in a higher-pressure economy is that the volatility of macroeconomic outcomes is also likely to increase – and this should feed into higher market volatility”.

The potential for a wider range of outcomes has increased and we can see both sides of the argument. We are open to the idea that we enter a new regime where the relative levels of each styles’ out and underperformance are lower. However, the weight of our conviction lies with the high-quality growth sectors including technology.

As the Polar Capital Technology team state: “It is also worth noting from a long term structural perspective that many of the most acute pressures in the economy and society today can be best alleviated, if not totally solved, by the application of more technology rather than less; labour shortages call for a higher degree of automation, online skills training, the ability to work from anywhere and deeper online labour markets; climate change requires creative and ambitious technological solutions, products and services delivered with greater energy efficiency and ever more data to understand the world we wish to preserve; an ageing population requires remote health provision, personalised medicine and greater connectivity”.

Indeed, the following graphic chart from McKinsey Global institute strongly resonates with us and we believe that many investors underappreciate intangibles. We believe that they are a foundational element of any investment strategy. Whilst we appreciate that they are hard to value, we must point out that they are inextricably linked to future growth and innovation.

Figure 7: Intangibles drive productivity and growth

Source McKinsey Global institute

We remain of the view that longer-term, the structural themes surrounding technology, the greening of the economy and medical advancements will provide many of the winners.

Mark Harris
Fund Manager, Multi Asset