Investment sentiment is increasingly cautious and even fearful of a potential recession amid shifting monetary policies, the US Federal Reserve’s first rate cut in 11 years, and heightened US-China trade war tensions. These fears have resulted in large flows into ‘safe haven’ assets such as bond funds, which have been some of the best-selling sectors in recent months, according to the Investment Association, while riskier equity funds have experienced record net outflows.
Within equities, however, investors have shown a clear preference for equity funds with a growth bias. Such funds look to invest in companies that can deliver strong growth in earnings, regardless of the economic cycle and, as a result, typically have more defensive return profiles, which are particularly attractive when recessionary fears abound.
Conversely, investors have been avoiding value funds which look to invest in companies that appear relatively undervalued, but which retain sound fundamentals. These stocks have often fallen out of favour due to stock specifics or because they operate within a specific sector, and thus can be more sensitive to economic cycles.
These trends have resulted in the price of growth stocks being continually bid up relative to their value peers reaching historic levels as investors seem willing to pay increasingly higher prices for certainty and predictability, both of which are currently in short supply.
Chart one shows the monthly ratio of growth versus value stocks across three major equity markets (US, UK and Europe) over the past 24 years, where a ratio greater than one indicates that growth outperformed value and a ratio below one highlights when value outperformed growth. It shows that growth has not only outperformed value in developed markets for some time, but that the extent of divergence between growth and value in these markets has recently reached the record levels last seen in the late 1990s at the very peak of the dotcom boom.
In the case of the UK, Brexit uncertainty has compounded investor fears, resulting in one of the biggest growth-value differentials in developed markets.
Tech bubble burst?
Given that growth indices in the US particularly are now dominated by tech companies such as the Faangs (Facebook, Amazon, Apple, Netflix and Google’s parent company, Alphabet), some have claimed that we are on the cusp of another tech bubble burst. This does not seem to be the case, however.
First, some of the leading growth stocks in the UK and Europe are admittedly tech-heavy companies, such as the London Stock Exchange, which re-rated significantly this year on the prospects of becoming the world’s leading financial markets infrastructure provider after acquiring Reuter’s data and analytics company, Refinitiv.
However, the UK and EU are still predominantly defensive markets with healthcare and consumer-related companies such as the UK’s Unilever and GlaxoSmithKline buoying growth indices recently.
Second, when looking to Asia, one of the most tech-dominant markets, value continues to outperform growth (evident by a ratio of less than one) as chart two highlights.
Asian and emerging markets were, and still are to an extent, largely dominated by value-related sectors such as commodities, with tech more recently forming a large component of these indices.
Additionally, tech is one of the primary growth sectors in Asia and some EMs, and comprises some of the world’s IT giants, such as Baidu, Alibaba and Tencent. These companies are sensitive to exchange rates, global trade and government regulation, and have come under pressure amid the US-China trade war, while value sectors such as utilities have performed better.
The ‘bubble’ that is emerging thus appears to be formed broadly of growth stocks as opposed to any specific sector, and is more of a developed market phenomenon.
While it is understandable why people investing in developed markets feel more comfortable holding growth assets given the prevailing economic climate, it is concerning that most of the recent performance of growth stocks has been attributed to multiples expansion, while earnings growth has been more muted. This means the price of these stocks is growing at a faster rate than earnings, suggesting their earnings abilities may not justify their current prices.
Of additional concern is that the only time growth has outperformed value to the same extent was just prior to one of the biggest market crashes in the past 30 years.
Amy Kennedy is a fund analyst at FE