Portfolio Manager Justin Tugman discusses his outlook for value equities and a shifting market environment where investors have once again begun to appreciate fundamentals.
- Inflationary pressures, evolving monetary and fiscal policy, and stretched valuations in select market segments are causing a shift in market dynamics.
- In this environment, we have once again seen investors paying attention to fundamentals like profitability and relative valuation ‒ more in line with historical investment norms.
- Interest rates are likely to rise and market volatility could continue. This type of environment presents opportunities and has typically been favorable for defensive-value investors.
Following the rapid, COVID-driven market correction in March 2020, the government and Federal Reserve (Fed) injected trillions of dollars in both fiscal and monetary stimulus into the economy. This enormous financial support created a risk-on environment in which high-beta, high multiple as well as deeper value and money-losing stocks outperformed by a wide margin. Now, as pandemic-related stimulus cools and markets digest the effects of rising inflation, investors have begun to turn their focus back to profitability, risk and relative valuations ‒ more in line with historical investment norms. Given the market backdrop, we expect this return to fundamentals could continue in 2022, potentially favoring defensive-value stocks.
The Impacts of Inflation and Higher Rates
As the world strives to move beyond the pandemic phase of COVID, we believe that investors are beginning to process some of the consequences of the policies and market environment of the last two years. For one, as we wrote this past summer, inflation is proving to be less transitory than many initially predicted. While the acceleration in inflation may begin to slow, we think that it could remain above the Fed’s target rate of 2% for some time, given that we have seen significant inflation in the form of higher wages, which tend to be more “sticky” than other cost increases.
The Fed is now faced with the unenviable task of slowing its stimulus to rein in inflation without disturbing the economic recovery and market expansion. With low nominal rates and higher inflation pushing real rates into negative territory, it appears the central bank will need to be relatively aggressive to get monetary conditions under control. However, it remains to be seen what the Fed’s tolerance for volatility will be if the market sells off in response to tighter policy.
While we may see higher interest rates in 2022, this could bode well for more moderately valued companies with strong balance sheets. Conversely, we have seen high-growth names with valuations that are very expensive relative to their long-term growth prospects sell off, as even small changes in sentiment can lead to steep stock price declines with valuations based solely on revenue still at extreme levels. Companies with pricing power should also be better positioned to weather this environment as opposed to those whose costs are increasing faster than they can raise prices. Value stocks generally had a strong year in 2021, but we have been in a long period of outperformance for growth. That said, historically, value versus growth outperformance is multiyear in nature. We believe this could be the case again, especially if rates and inflation march higher.
The shifting investment environment is also affecting certain market segments. Driven largely by government stimulus to consumers, many names in the consumer discretionary sector ‒ specifically, in retail ‒ have appreciated significantly and now warrant caution. Strong demand from consumers flush with cash has allowed these companies to keep inventories lower and discount their products far less than in a normal market environment. As fiscal stimulus has waned, we have seen personal savings rates decline, and while wages have risen, due to inflation, real wages have declined. We think these developments could result in consumers less willing to spend, pressuring certain areas of the sector.
On the other hand, companies in the health care sector with stable earnings and strong balance sheets have experienced declining valuations and may perform more defensively if the economy slows, and we see potential for a rebound in demand for elective medical procedures once virus concerns ease.
While we have been wary of certain areas of the energy sector in recent years, we believe there may now be opportunity in higher-quality names ‒ in industries such as oil and gas exploration and production ‒ with management teams that are able to sustain recent capital discipline, produce consistent free cash flow and return capital to shareholders. We also believe we have been through a significant period of underinvestment in many commodities. As demand returns, we have seen supply shortages and rising prices in commodities such as lumber, copper, aluminum and oil, which can bode well for value index performance relative to growth, given the materials and energy sectors relatively larger weightings within value indices.
Why Defensive Value Now?
After witnessing periods of market irrationality over the last couple of years, we have welcomed a renewed investor focus on fundamentals. Given that we have not seen significant inflation since the 1970s and that we have been in a period of generally declining interest rates for nearly the same amount of time, to us it makes sense for investors to now be more defensively positioned.
While the economic expansion appears on track, we could see higher rates and continued bouts of market volatility in 2022. Historically, periods of rising interest rates have favored value and higher-quality stocks over growth equities. We also believe market volatility could provide value opportunities in companies whose potential may not yet be fully appreciated by the market.