SustainAbility: No more value versus growth?

The Roaring Twenties

The Roaring Twenties refers to the 1920s, a period of significant economic and societal progress. This decade came straight after a World War and a pandemic, so it is perhaps no surprise some commentators are drawing parallels with the 2020s.

In the original roaring twenties, pessimism was replaced with invention. The 1920s saw the large-scale use and development of cars, telephones, radio, electrical appliances, aviation, and films. Penicillin was discovered in 1928 and went on to become, and remains, a potent antibiotic which changed the path of medicine. From 1920 to 1929, stocks quadrupled in value. However, if you had been alive in 1920, fortunate to have made it through the first World War and the 1918-1920 flu pandemic, you would likely have had a very dim view of the future. Although the decade ended with the Great Depression in 1929, and a decade later the world was again at war, for nine years it was a time of great progression.

Why more optimistic market and economic commentators draw parallels between the 2020s and the 1920s is the existence of this same tension between pessimism and innovation. After coming through a pandemic, witnessing the first land war in Europe for many decades, and a cost-of-living crisis it is no surprise we all may feel a bit downbeat. These undoubtably negative events do however mask a time of incredible social progress.

The digital economy is transforming the way we work, and with artificial intelligence likely moving into the mainstream in the coming years, will only accelerate. The drive to decarbonise economic activity requires unprecedented investment in infrastructure, which has only just begun. Standards of healthcare continue to improve with innovative new cancer and obesity medicines.

All these trends are highly investable, especially for sustainable funds, and are one reason why equity markets are at all-time highs. History doesn’t repeat but it does rhyme, as the saying goes. We could look back in 2030 and say that the roaring twenties now describes the 2020s.

Will central banks cut interest rates?

Perhaps the biggest shift in markets this year has been the change in expectations with respect to interest rates. At the end of 2023, the expectation was the US Federal Reserve would cut interest rates seven times in 2024. As of now, the expectation is they will cut once and maybe not at all.

Central banks describe themselves as data dependent. This means, in theory, they have no philosophical bias towards higher or lower rates; they will be what they need to be. Most central banks also have more than one mandate. Whilst much of the focus is on inflation, they also can have mandates around employment and financial stability.

Currently, the first of these mandates, inflation, does not suggest interest rates should be cut. Inflation is above target with some signs it could increase further. This is what markets seem to be paying attention to, with the recent increase in bond yields. The other two mandates, employment and financial stability, do suggest rate cuts may be appropriate.

If we take the US as an example, there are early signs in the form of falling numbers of job openings that the employment market is weakening. Perhaps more importantly, the scale of deficit spending in the US, and the amount of debt that will need to be issued, means the chances of a dislocation in bond markets and financial markets that could require the Federal Reserve to act. Lower interest rates would reduce the probability of this.

This leads me to think interest rate expectations, particularly in the US, may swing back to somewhere between expectations at the start of the year and today’s expectations. Perhaps three cuts would be the right balance given the variables noted above. In this situation we would see continued progress in equity markets and a ceiling on bond yields. Both would be positive for investors.

A frustrating market for value investors

For those regular readers of this blog, you will know that the division of equity investing into ‘value’ and ‘growth’ is something we are not convinced by. Value is a component of growth investing, and growth is a component of value investing. Individual companies are also badged as value or growth over time, and remarkably some have been badged value and growth by different index providers at the same time! It is a differentiation that needs some caution.

That said, there are two main buckets of stocks in existence: those growing and those not. Those growing tend to trade at higher valuations than those that are not. Because of this, and the way valuing a company works, higher interest rates (all other things being equal) impact the valuation of growth stocks more than value (low growth) stocks. This is the essence of why as interest rates, and expectations of interest rates, rise, growth stocks underperform and value outperforms. We saw this phenomenon strongest in 2022 as interest rates rose. In 2023 growth stocks outperformed especially towards the end of the year as expectations of interest rate cuts grew. In 2024 it has reverted to being more of a value market as those expectations have receded.

At times it can feel like equity markets are simply a consequence of interest rate expectations. They are not. Alongside the significant increase in interest rate expectations, the previously mentioned growth drivers of digitisation, decarbonisation, and healthcare are also influencing markets. This can, and has, acted as a counterbalance to rising interest rates by making growth stocks grow even faster to offset their effect.

This has frustrated value investors, and a market which feels like a value one at its core due to the higher interest rate environment. It seems likely this trend will continue, as markets switch between value and growth as interest rate and corporate growth expectations change. One useful antidote to this is to think about companies, industries, their prospects, and valuations rather than value versus growth. Currently we believe this leads to a portfolio with investments which would be badged in both areas.

This is perhaps the primary lesson for thinking about investing in equity markets today. In my view, the singular value, reversion to the mean style of investing prevalent in the 2000s is unlikely to return, as is the singular growth market of the 2010s. It could be that value and growth areas both perform well. That banks and technology stocks can sit side by side in a portfolio in a way they haven’t been able to in the past 20 years. Two fundamentally different industries, yet both creating value for shareholders and for society.

In this world ‘portfolio’ management will reassert itself. Portfolio managers will be less able to hammer a single nail consistently and deliver performance. Alpha and risk will come from multiple areas rather than just one. We believe this will provide a wider range of investment opportunities to the benefit of stock pickers, as well as sustainable investors.

This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.