Is the reflation trade that favoured value stocks and small caps already over? Not according to BNP Paribas.
Daniel Morris, chief market strategist at BNP Paribas Asset Management, believes the factors that recently turned against this trade should revert given the broadly supportive macroeconomic environment; particularly the expectations of further growth and higher inflation, and high valuations of growth stocks.
But he concedes that this scenario is likely rather than inevitable.
“Too much stimulus in the US may cause inflation expectations to become unanchored, forcing the US Federal Reserve to raise policy rates sharply. However, the markets currently do not reflect such a scenario.
“The Fed has continued to stress it is comfortable with the anticipated increase in inflation and that it is in no hurry to raise rates. This helps explain the recent reversal in nominal US bond yields.”
US Government spending
Medium-term inflation expectations have eased slightly, perhaps reflecting the impact of rising taxes on growth after the debt-fuelled stimulus. Morris argues that the details of the Biden administration’s broadly defined ‘infrastructure’ packages will be crucial.
“The size of the spending and the degree to which it is paid for by higher corporate and personal taxes or further debt issuance will determine the extent to which bond yields, that is, market rates, will rise.”
He points out that rising bond yields benefit value stocks such as financials. Other factors support value such as higher crude oil prices and crude prices have returned to pre-pandemic levels. “As the US and Europe loosen the pandemic-related restrictions further and reopen borders, we expect the rebound in demand to drive oil prices higher.”
The view at BNP is that the shift to value stocks reflects the rotation in demand away from lockdown beneficiaries, such as technology companies, to ‘reopening winners’ such as transportation.
As Morris explains, this can also be seen in analysts’ earnings estimates in that they are rising faster for value stocks than for growth.
He adds: “Between strong earnings momentum, attractive valuations, rising energy prices and interest rates, we believe there is still room for value to outperform growth.”
Nicolas Simar, head of equity value at NNIP, takes a similar line to Morris on a favourable environment for ‘value’.
“Recent data and central bank commentary suggest a potential sustained rise in inflation, particularly if governments follow through on their promises to continue delivering hefty fiscal support. In particular, 10-year bond yields – a common market indicator that inflation might be about to increase – have been steadily climbing over the past few months.”
He also believes the value cycle may have some distance left to run.
“The positive vaccine data last November and the recovery hopes since then have already noticeably boosted the performance of value sectors, but this has gone only a small way towards making up for their long period of underperformance. Growth-value cycles historically last for several years. If we are indeed at the beginning of a value cycle, there is a great deal of catching-up still to come.”
Bert Veldman, senior portfolio manager European equities at Actiam, is of a similar mind. “We believe the reflation trade will continue to benefit cyclical stocks as the reopening of economies is benefiting these sectors most, leading to a relative strong upward momentum in earnings revisions. This will also support the value style, which has pulled back recently, to catch up again as we see the strongest revisions among typical value sectors.”
According to Veldman, this will include the banking sector as higher interest rates and more lending support operating income. The energy sector however, while seen as a typical value sector, is less likely to benefit to the same extent.
“The sector needs to make substantial investments into a more sustainable business model, creating uncertainty on future cash returns,” he says.
Veldman echoes Morris’ point that relative earnings momentum of value stocks is currently supported by strong economic performance as fiscal stimulus is applied and rising vaccination rates make a reopening realistic. “The outsized relative outperformance of growth names last year means the current valuation discount of value stocks versus growth is high. This creates additional room for outperformance of value stocks.”
Small cap resurgence?
US small caps have previously suffered under the same large-cap tech ‘curse’ as value stocks, Morris says, meaning that the good returns for large-cap technology stocks dominated the index gains. To the degree that large-cap tech now lags the broader market, as part of the rotation to value, he suggests small caps could resume their outperformance.
However, he suggests the potential gains may be limited. “Given that small caps are now trading at the long-run average premium over large caps. From here on out, we believe it will take superior earnings growth for small caps to outpace large caps.”
Veldman has a slightly different take on things. “When viewed from a European perspective, it is noticeable that ever since the first vaccines were announced in November 2020, small caps in Europe have started to outperform the broader market as the value style. We believe this is the result of a risk-on attitude amongst investors preferring to add to smaller and (perceived) riskier names. Given the strength of the earnings momentum in value stocks and the relative discount to the broader market, we think there is a better return opportunity in the value segment of the (small cap) market”.