Value and quality are critical for global stocks in today’s high-rate regime
With a new regime of higher interest rates potentially weighing on equity multiples and U.S. technology stocks in particular, the appeal of the value equity style appears to have grown. Explore a market segment that’s been underappreciated in recent years: global value stocks with quality characteristics offering the potential to enhance portfolio performance going forward.
How did global equities get here?
I believe that the global economy and equity market are at an inflection point, as the surge in inflation and resulting speed of the increase in interest rates since early 2022 suggest a transition out of the era of low and generally declining rates that stretches back to the 1980s. In March 2022, the U.S. Federal Reserve (Fed) began a rapid process that’s lifted the federal funds rate from a near-zero level to the current target range of 5.25% to 5.50%—a level reached when the Fed approved its most recent increase on July 26, 2023. And while U.S. inflation has eased from its roughly 9% peak level of mid-2022, it hasn’t yet sunk below a 3% annual rate, and I’m skeptical that it will descend over the long term to the Fed’s 2% long-run target—a goal that many other central banks also embrace.
During this policy transition of the past year and a half, equity markets have undergone changes that I believe are likely to endure. Elevated multiples that were fueled largely by central banks’ rate cuts and other accommodative monetary policies may begin to erode, most likely in a small group of large-cap U.S. technology stocks that drove a huge share of market gains through the first half of 2023. In fixed income, there’s recently been a sharp decline in bond prices (which move in the opposite direction of bond yields). Some U.S. indicators showed only a relatively modest cooldown of the economy, suggesting that a recession wasn’t necessarily imminent. That revised outlook increased the likelihood that the Fed wouldn’t abandon its policy of elevated rates anytime soon—for fear that a swift reversion back to rate-cutting mode could reignite inflation—providing a catalyst that pushed yields higher.
The current situation poses global challenges for monetary and fiscal policymakers alike: With sovereign debt burdens at currently high levels in the wake of the pandemic, can interest rates be kept high enough to blunt inflationary pressures without bankrupting governments by increasing costs to service their own debts?
Implications for equity investing in a high-rate environment: lower multiples and a structural value market
While it appears that the Fed has recently embraced a higher-for-longer approach to rates, any significant setback for the U.S. economy could lead to an abandonment of tighter monetary policy and a reversion to easing and stimulus measures to get growth back on track. Whether or not that scenario plays out, the likely outcome is that recessions and inflation will continue to be related concerns. In my view, inflation and an elevated rate regime are likely to persist, and stocks are likely to be priced at structurally lower multiples going forward, especially among some notable technology stocks that I believe reached excessively high valuations a few months ago. Over the medium term, I expect that markets will shift to an environment that’s more supportive of the value equity style—those stocks that trade at multiples that are low relative to their earnings or returns on capital—than of growth stocks with higher relative prices.
An edge for value equities in high-rate environments
My belief that value equities currently offer relatively attractive opportunities is rooted partly in my expectation that higher rates will endure, contributing to a slow grind-down in multiples and placing higher-priced growth equities at greater risk of underperformance. Indeed, historical results dating to the early 1990s have shown a performance advantage for value over growth during periods in which rates have risen or remained elevated.
A strong correlation—value typically outperformed when rates rose or stayed high
Relative performance of the MSCI World Value Index less the MSCI World Growth Index and U.S. 10-year Treasury bond yields, 1/1/1993−12/31/2022
Furthermore, across global equities, growth stocks’ price-to-earnings (P/E) multiples have expanded since 2009, while the value style’s P/E multiples have remained relatively stable, potentially leaving the growth style more vulnerable to multiple compression.
The growth style's elevated valuations could be vulnerable to multiple compression
Relative forward price-to-earnings (P/E) ratio of the MSCI ACWI Large Cap Value Index vs. the MSCI ACWI Large Cap Growth Index, 7/1/1994−6/30/2023
In addition, the gap separating global growth stocks’ valuations from those of the value style has widened to the largest amount since 2000. This suggests to me the strong potential for a reversion to an extended period of value stock outperformance.
The value style's relative valuations have recently been at their most attractive levels in two decades
MSCI ACWI Large Cap Value Index forward price-to-earnings (P/E) ratio relative to the MSCI ACWI Large Cap Growth Index, 7/1/1994−6/30/2023
Global investing: opportunities in non-U.S. stocks
In addition to seeing more attractive prospects in the value equity style relative to growth, I currently see greater potential in ex-U.S. stocks generally than in U.S. equities. U.S. stocks’ P/E multiples have expanded since 2009—particularly during the market recovery that followed the initial 2020 stage of the pandemic—while ex-U.S. developed markets have seen relatively little change, as measured by the MSCI EAFE Index.
Valuations of U.S. equities have become less attractive since 2009 relative to ex-U.S. developed-market equities
Relative forward price-to-earnings (P/E) ratio of the MSCI EAFE Index versus the MSCI USA Index, 7/1/03−6/30/23
In addition, the gap between U.S. stock valuations and those of their lower-priced ex-U.S. developed-market peers has widened to the largest amount in two decades, making ex-U.S. markets more attractively priced, in my view.
Ex-U.S. developed-market equiy valuations have recently fallen to historically attractive levels
Ex-U.S. developed-market equiy valuations have recently fallen to historically attractive levels MSCI EAFE Index forward price-to-earnings (P/E) ratio relative to the MSCI ACWI Large Cap Growth Index, 7/1/03−6/30/23
While both Europe and Japan have many well-recognized economic problems—many of them similar to those in the United States—I generally view them more favorably than U.S. equities because of equity style differences. Europe and Japan have traditionally been home to a larger proportion of value stocks than the more growth-oriented U.S. market. This difference that has become more pronounced in recent years owing to the outperformance of many of the largest U.S. tech companies, resulting in increased U.S. index exposure to the growth style. Given the currently more attractive valuations that I see for the value style, Europe and Japan appear to offer more fertile environments than the United States for bottom-up equity investing on the whole.
A new era underscores the importance of price-conscious quality and a global opportunity set
As an equity investor, I emphasize a long-term orientation and a focus on fundamentals, quality characteristics, and valuation as a foundation to seek strong risk-adjusted performance and downside market protection. Given the market risks I currently see amid slow economic growth and high rates, some measure of elevated volatility is likely, with periodic sell-offs. In such an environment, I believe that high-quality companies possess strengths that enable them to distinguish themselves from their peers and offer a potential margin of relative safety for investors. I define a quality company as one that can generate a return on capital that exceeds its cost of capital; in other words, it’s a company that can create value, and that value manifests itself in the form of cash flow.
Over the long term, I view investing in quality stocks with an intrinsic valuation focus as a generally solid investment choice—not only for potential capital appreciation but for providing potential capital protection, particularly in down markets. This belief is borne out by the long-term outperformance of the quality factor as measured by the MSCI World Quality Index versus the MSCI World Index broadly.
Global stocks displaying high-quality characteristics have outperformed over the long term
Cumulative returns of the MSCI World Index vs. the MSCI World Quality Index, 1/01/1993−12/31/2022 (%)
However, it’s important to note that quality alone doesn’t offer the potential to protect total returns; rather, paying the right price for that quality can be key to potentially generate strong long-term risk-adjusted returns. That’s why it can be beneficial to invest in a global portfolio that has the flexibility to seek the best valuation opportunities across geographies. That’s why I’m leaning in currently to value equities—especially those from Europe and Japan—with a strong bias toward the quality factor in a market environment that I believe is likely to remain challenging for an extended period.
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