Investors shift from high-growth equities to value stocks as energy prices rise

Oil & gas prices have surged around the world, boosting the share prices of energy majors such as Exxon Mobil Corp. and ConocoPhillips.
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Rising energy prices and the likely end of the Federal Reserve's pandemic-era monetary policy are pushing investors into value stocks and away from tech-heavy growth stocks.

The energy and financials sectors — traditional value picks defined by measures of book value and earnings — have generated far stronger returns since early September than growth-centric information technology and consumer discretionary groups that include companies such as Apple Inc. and Amazon.com Inc. The broader S&P 500 is down about 3% over the same time.

Value stocks will likely keep drawing investors' attention as rising inflation and an expected jump in borrowing costs connected to changing Fed policy will likely eat into potential future returns of the highly valued growth sector. The central bank is expected to start tapering its $120 billion in monthly bond purchases as soon as November, which will likely contribute to rising Treasury yields, and half of the Fed's rate-setting committee expects at least one interest rate hike in 2022, according to projections released in September.

"At this point, we think value stocks on an absolute basis are more attractive," Dave Sekera, chief U.S. market strategist at Morningstar, said in an interview. "Growth stocks are generally overvalued."

Value versus growth

Energy stocks are performing particularly well for investors. The share prices of oil majors Exxon Mobil Corp., Chevron Corp. and natural gas giant ConocoPhillips have increased by 14.5%, 11.9% and 35.4%, respectively, since the start of September.

Shortages in the supply of natural gas and the resulting increased demand for oil have had dramatic impacts on commodity prices. The benchmark NYMEX Henry Hub U.S. natural gas contract price has climbed to near seven-year highs, while the price of Brent crude oil, a key barometer for oil prices worldwide, is above pre-pandemic levels at close to $83 per barrel. Goldman Sachs revised its forecast for year-end Brent oil prices up to $90 per barrel in late September, up from $80 previously, according to Reuters.

Higher interest rates are also good news for financial companies like Bank of America Corp. and JPMorgan Chase & Co., which stand to generate greater returns from lending.

"The banks represent the cheapest non-commodity inflation hedge while energy is the most inexpensive non-financial that can absorb rises in U.S. Treasury yields," Sean Darby, global equity strategist at Jefferies, said in an email.

Higher rates also tend to attract foreign investment, increasing demand for U.S. dollars and strengthening the currency. While this is bad news for companies with significant overseas business, it plays well for companies focused on the home market, analysts said.

"Regional banks, industrials, smaller domestic-focused U.S. dollar earnings; those parts of the market might do well, rather than international growth names with higher sensitivity to longer-dated interest markets," Tim Edwards, managing director of index investment strategy at S&P Dow Jones Indices, said in an interview.

Rising yields will test valuations

S&P 500 stocks are priced at historically high levels. The index's forward price-to-earnings ratio — a closely watched measurement of value calculated by dividing a company's share price by earnings per share — was 21.5 as of Oct. 8, lower than the peak of over 25 in July 2020, but still higher than the pre-pandemic level of below 20.0.

Even with that high valuation, the S&P 500 is still providing a better return than U.S. Treasurys. Investors weigh whether to put their money into stocks or less-risky government bonds based on a variety of factors, including equity valuations and the potential returns on each investment.

The earnings yield of the S&P 500 — calculated by dividing the last 12-month earnings by the share price — was 3% on Oct. 8, compared to a yield of 1.61% for the 10-year Treasury bond. That yield, which rises as the price of the bond falls, has climbed recently from below 1.3% in early September.

As a result, investors have not dumped more risky assets such as stocks yet.

"Yields have room to rise before they start to meaningfully impact the stock market," Sekera of Morningstar said. "[A yield of] 2.5% would start to meaningfully impact long-term stock."

Inflation is also eating into stock returns, with the Fed-preferred gauge reaching 3.6% in August, excluding volatile food and energy prices. The central bank expects that to fall to 2.3% in 2022, about in line with its long-term target.

Still, the Fed is eager to clamp down on rising prices. The central bank could wind down its monthly bond purchases altogether by mid-2022, which may contribute to rising yields, while Fed policymakers expect as many as seven rate hikes through the end of 2024.

The next quarterly earnings season, which begins in October, will likely also impact stocks. Investors will be looking out for supply chain issues, inflationary pressures on margins and shortages, according to Geraldine Sundstrom, asset allocation portfolio manager at PIMCO.

"Already a number of large multinationals have issued warnings about production cuts and downgraded their third-quarter outlook due to supply chain and labor shortages," Sundstrom said in an email.