Inflationary pressure is giving investors another reason to shift their dollars into better-performing value stocks and move away from tech-heavy growth stocks.
Value stocks — much-maligned after a decade of underperformance relative to growth stocks — have enjoyed a turnaround . The S&P 500 Value index — which tracks the top 100 S&P 500 stocks deemed to be cheapest as per their price-to-book value, earnings-to-price and sales-to-price ratios — has returned 17% year-to-date as of May 27.
Shares of Berkshire Hathaway Inc. and JPMorgan Chase & Co., the two largest stocks by weight in the value index, have gained 24.4% and 27.4%, respectively, in 2021. During the same period, share prices of oil major Exxon Mobil Corp. and America's second-largest bank, Bank of America Corp., which are among the 10 largest value stocks by weight, have risen 43% and 38.7%, respectively.
The broader gain in value stocks outpaced the 12.4% year-to-date rise for the full S&P 500 index and an 8.3% rise in the S&P 500 growth index, which includes tech giants Apple Inc., Microsoft Corp. and Amazon.com Inc.
Consumer price inflation is providing a further tailwind for the gains in value stocks. Prices rose 4.2% in April, up from 2.6% in March, according to government data.
"During higher inflation environments, investors tend to rotate away from growth into value as present income and strong cash flows become more important," Sherifa Issifu, associate, index investment strategy at S&P Dow Jones Indices, said in an email.
That shift into value-heavy sectors such as financials and energy, which tend to perform well in a growing economy, has also benefited from higher oil prices and U.S. Treasury yields as the COVID-19 vaccine rollout that began in November 2020 set the economy on the road to recovery.
Both commodity prices and Treasury yields leveled off in the last month. Yields on 10-year U.S. government debt dipped to 1.58% as of May 26 from 1.65% at the start of the month, while the price of West Texas Intermediate crude oil futures, a key benchmark for oil prices, has been trading around the $65 mark in May.
But the progress of the vaccine rollout and support from government spending has greased the wheels of economic recovery, further boosting the cyclical equities trade into value-driven strategies. The rise in inflation could eventually push the Federal Reserve into raising interest rates, making longer-term investments such as growth stocks less attractive than value stocks, which produce more immediate profits.
"We believe the rotation into value stocks can continue into the second half of 2021 as growing inflation concerns put more upward pressure on bond yields, resulting in a steeper yield curve," Jonathan White, head of investment strategy at AXA Investment Managers, said in an email.
The S&P 500 energy sector has returned 39% year-to-date as of May 26, while financials has delivered 27.9% for investors. By contrast, the information technology sector, which had driven returns for the last decade and performed strongly during the pandemic, has returned just 6.6% in 2021.
The consumer discretionary sector has also seen a decline in performance as the economic effects of the pandemic eased. The share price of e-commerce giant Amazon.com Inc. has grown just 0.3% in 2021 as the reopening of shops suggests online shopping sales may not repeat a gangbuster 2020 total. Amazon has a weighting of 32.7% in the S&P 500 consumer discretionary index.
"We suspect that much of the pattern this month can be explained by optimism about the 'big tech' firms, and the IT sector more generally, falling back from a high level," Oliver Allen, markets economist at Capital Economics, said in an email.
Capital Economics expects the rotation in stock markets to continue over the next few years as the rise in bond yields supports financials, while IT and communications services companies may miss earnings expectations after outperforming during the pandemic.
Valuations still stretched for growth stocks
Despite the price of value stocks picking up, valuations of growth stocks are still far more stretched.
The forward price-to-earnings ratio — a closely watched measurement of valuation — for the S&P 500 Value index is down to 18.2 as of May 26, from 19 at the start of the year as earnings expectations improved. The forward P/E ratio of the S&P 500 growth index has eased back from its historically inflated level of 30.9 at the start of the year but is still high at 28. The ratio was below 25 when the pandemic reached U.S. shores in February 2020.
The difference in valuations means value stocks are still a cheap buy for investors relative to growth stocks after years of underperformance, Solita Marcelli, chief investment officer Americas at UBS Global Wealth Management, said in the bank's June investment outlook.
"The prospect of higher rates, especially if inflation stays high, also favors value," Marcelli said.
The Fed has repeatedly denied it plans to raise interest rates or pull back on its $120 billion a month asset purchase program any time soon, but doubts in the market remain, particularly if inflation persists.