04 May 2022
Value stocks and sectors have rallied sharply over recent times, driven by shifting expectations for inflation and monetary policy. Our value-focused portfolio managers discuss what lies ahead for investors in the US and UK markets, with a focus on the evolving opportunity set in the financials sector.
The ideas and conclusions here do not necessarily reflect the views of Fidelity’s portfolio managers and are for general interest only. The value of investments can go down as well as up, so your clients may not get back what they invest.
Sotiris Boutsis: The overall global economy is robust, but it is slowing down following the strong rebound we saw in the aftermath of Covid-19. In terms of regions, the US is doing better than expected but Europe has been affected by the war in Ukraine and China is dealing with the aftermath of the Omicron waves and further lockdowns.
The key question is how inflation develops from here and whether efforts to control inflation will damage the economy. The good news is that inflation is moderating. The huge spike in real money supply is behind us and the monetary picture is consistent with inflation returning to target. Also, quantitative tightening, which is expected to commence over the coming months, will remove further stimulus, while financial conditions have tightened, and Covid-19-related supply disruptions are gradually normalising.
However, the downside is that inflation is unlikely to moderate quickly. Monetary policy operates with a 12-18 month lag so it will be a while before we see the effects of recent Fed measures. At the same time, employment remains tight with strong wages and rents rising - all pointing to higher inflation. Additionally, we have also had the war in Ukraine and lockdowns in China in response to Omicron variants that are exacerbating this inflationary outlook.
This is creating a dilemma for the Fed - either be patient for longer or act hastily and risk causing a recession. The Fed would like unemployment to be higher, but this is not easy to achieve. It has to choose between higher prices and causing millions of job losses, so there is a strong likelihood that the Fed will tolerate high inflation for a bit longer.
In summary, while we expect volatility to remain elevated in the near-term due to a range of headwinds from inflation and the Fed tightening to the war in Europe, the outlook for value stocks remains positive.
Rosanna Burcheri: Although value has generally outperformed growth since 1930, value stocks have had a tough time since the global financial crisis, particularly from 2017. The valuation gap has narrowed slightly in the last few months but remains very wide by historical standards.
Some theorise that this gap is explained by value stocks being lower quality - particularly in comparison with high quality, mega cap growth names like the FAAMNG stocks. But analysis of returns on assets for value stocks over the last half century shows a fairly consistent -5% difference versus expensive ‘growth’ portfolios, with no significant deviation over the last decade. So, value stocks have not become much lower quality recently.
Interest rates are offered as another explanation. Growth stock multiples are based on future earnings potential, which are very sensitive to changes in the discount rate. Higher rates mean present cash flows are comparatively more valuable, with declining interest rates in recent years seen as the driver of value underperformance/growth outperformance.
However, while there have been periods such as the last decade when this seemed to be the case, interest rates have been in long-term decline since 1982. But from then until 2007, value actually outperformed, and this was particularly strong from 2000 to 2007. Again, this does not seem an adequate explanation.
Technology cycles may explain some of the value/growth divergence. From the mid to late 1990s, value underperformed due to the emergence of the internet, while the last decade has seen increasing adoption of technology like cloud computing and digital advertising. But now growth in many of these themes is in a more mature stage and no longer justifies the stretched valuations we see in many growth names.
We prefer to focus on good stocks backed by attractive valuations, that are mispriced or out of favour, because their intrinsic value is misunderstood. Just as commonly held theories for recent value underperformance are based on misconceptions, we believe investors are not fully appreciative of the fact that there are a number of very good value stocks, which are not in structural decline, and offer solid growth and excellent long-term return potential.
Moreover, we believe the US market has structural advantages which make it an attractive investment environment and is relatively insulated from some of negative effects of the tragic war in Ukraine.
Alex Wright: UK equities remain significantly undervalued compared to global markets, and reasonably valued in absolute terms. While the UK market has looked cheap over the past five years, the key differentiator compared to prior years is that fundamentals on the ground look very good. Against this backdrop and given that much of the headwinds around Brexit and the pandemic have cleared, it is surprising as to why the UK has continued to derate against major markets.
With the global outlook deteriorating rapidly, the outlook for returns across all asset classes looks more challenging. But the UK is actually quite well placed, mainly due to the composition of the FTSE Index and the low valuation starting point.
In times of high inflation, value and cheaper price stocks tend to outperform, and since the composition of the UK market is biased towards value, we have started to see some of this valuation gap versus Europe close over the last six months. In comparison to the US, we are seeing that the stronger relative earnings of the UK market have meant that the valuation gap has only closed a small amount. The UK market is still cheap - for example, it is currently only around 11 times forward earnings versus the US which is 21 times forward earnings.
Within our portfolios, we have been overweight GDP sensitive sectors such as UK consumer facing stocks, where strong fundamentals have delivered positive earnings surprises in 2021. Given the recent pick-up in the cost of living, we have now cut back on some of these stocks and have added to financials. This is an area that is well placed to benefit from inflation and higher interest rates.
Within financials, we have maintained meaningful exposure to life insurers and banks. Indeed, life insurance is the sector that I am probably the most excited about - given that companies here remain cheaply valued, despite strong balance sheets, positive earnings outlooks (thanks to a healthy demand for protection products, bulk annuities and pension de-risking) and offer attractive dividends.
Overall, we remain comfortable with how the portfolio looks from a valuation, return on capital and risk perspective, and continue to see meaningful upside potential for our holdings.
Important information
This information is for investment professionals only and should not be relied upon by private investors. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. Changes in currency exchange rates may affect the value of investments in overseas markets. Fidelity's range of equity funds can use financial derivative instruments for investment purposes, which may expose them to a higher degree of risk and can cause investments to experience larger than average price fluctuations. The Fidelity American Special Situations, Special Situations and Global Financial Services Funds have the potential of having high volatility either due to their composition or portfolio management techniques. Investments in smaller companies can carry a higher risk because their share prices may be more volatile than those of larger companies. The shares in investment trusts are listed on the London Stock Exchange and their price is affected by supply and demand. Investment trusts can gain additional exposure to the market, known as gearing, potentially increasing volatility. Reference in this document to specific securities should not be interpreted as a recommendation to buy or sell these securities, but is included for the purposes of illustration only.