(Bloomberg) — A global bond rout. The biggest win for the value strategy since March. A bloodbath in expensive tech companies.
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The new year kicked off with a wild stock rotation akin to the one that gripped markets a year ago — only this time with a Federal Reserve bent on squashing the fastest inflation in four decades.
With the central bank signaling its plan to quicken monetary tightening this week, inflation-adjusted bond yields surged the most since March 2020. In stocks, that means tech is out and old-school laggards from banks to oil producers are in, handing the Nasdaq 100 a 4.5% rout that was the biggest since February. The Dow Jones Industrial Average lost just 0.3% and a long-short value strategy boasted its biggest rally in 14 months.
These exact market moves played out in early 2021, only to fade as the pandemic revival drove down bond yields and boosted Big Tech anew. And historically low inflation-adjusted yields, the spreading omicron variant and the allure of tech visions from electric cars to robots could all yet disappoint proponents of cheap shares.
But this time, confidence is growing that the rotation is here to stay. Stock hedge funds have upped their value exposure to the highest in at least four years, while the likes of Pictet Asset Management and 22V Research are joining Morgan Stanley, Wells Fargo and more in touting equities that outperform when rates rise.
“It’s not a one day rotation, this is the beginning of potentially a six- to 12-month rotation from growth into value,” said Luca Paolini, chief strategist at Pictet Asset Management. “The market has made a reassessment of the risk of monetary tightening and I think the market now is right.”
Rising rates — an upshot of strong economic growth — drive investors toward value stocks, which tend to be more cyclical and offer near-term cash flows. That leaves growth shares wanting for buyers. The long-term earnings potential of names like Tesla Inc. and Peloton Interactive Inc. becomes less appealing as inflation starts to bite.
Last year real yields remained stubbornly low even as the Fed started signaling its tightening plans, but they rose every day this week. The move extended Friday after data showed U.S. average hourly pay jumped more than expected in December — adding to concerns over inflation.
That’s why hedge funds have been loading up on cheap shares and dumping growth. They remain short on value overall, but the net exposure of long-short stock funds to the factor is the highest in at least four years, data from JPMorgan Chase & Co.’s prime brokerage showed on Thursday. Quants have raised their value bet to the highest in months.
“The Fed wants higher real yields and has the tools to make that happen, so investors should position for that outcome,” wrote a team led by Dennis Debusschere at 22V Research, adding that value, quality and small size are among factors that should benefit.
Just a month ago, global value shares were the cheapest versus growth since 2000, and the spread has only narrowed slightly since then. The widening valuation gap between the two in recent years has made the internal swings of the stock market ever more sensitive to bond moves.
Last year’s reversal offers a cautionary tale, however. A value strategy slumped into the doldrums for around five months when bonds rallied again amid persistent virus concerns. In much of the post-crisis era, investors also debated whether value was structurally impaired by technological transformations that inherently favor the growth style.
Away from the value and growth factors, the picture is more mixed. A momentum strategy had its worst week since March. Volatile shares lost out. A Goldman Sachs basket of stocks with weak balance sheets beat those with strong ones by the most on record in data going back to 2006.
All told, confidence is gradually growing that value stocks may finally break through after a moribund few years that has seen only short-lived rebounds. While growth shares can recover once bonds stabilize, the love for the investing style may remain more subdued given the Fed’s tightening path and fading pandemic fears, analysts led by John Schlegel at JPMorgan’s prime brokerage wrote.
“Last year value just narrowly beat growth, but it was not really a rotation last year because real bond yields were at an all-time low,” said Pictet’s Paolini. “Now with the Fed tightening and potentially inflation peaking we are going to see maybe on a smaller scale what we have seen in the previous cycle when bond yields went up.”
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