With global anticipation that central banks are likely to increase short-term rates and with the specter of inflationary pressure on longer-term rates, can we expect Value to come up top and Growth to lose out? Not necessarily. We examined stock returns during several historical periods of rate increases in the US and UK to see what might happen this time around:
- Rising long term rates will see Value outperform, but only if rates rise fast enough
- Value will beat Growth if long term rates rise more than 5% in a given month in the US and more than 20% in the UK
- If rates don’t reach those thresholds, there will be no clear winner
- So, a long-term rate hike doesn’t mean you can bank on Value’s outperformance, yet…
On any given day over the past 9 months, you could accurately predict whether Value stocks or Growth stocks would perform better by looking at the 10-year bond rate’s movements. On days when bond rates went up, Value beat Growth and vice-versa. This is because long-term interest rates force Growth stocks, which tend to have longer-term cash flow horizons than Value stocks, to be more heavily discounted than Value stocks. As a result, Growth stocks appear less valuable. Rising rates should help Value stocks and hurt Growth stocks.
Recent long-term rates increased from a low of around 50 bps last August to a high of about 160 bps in May in the US and from 20 bps to around 90 bps in the UK. But what can we expect from stocks if inflationary pressure pushes those rates back to historically ‘normal’ values like 3% or 5%, or even higher?
The US Value-Growth spread is about twice as sensitive to rising rates as the UK spread. Our research has found that in the US, Value stocks outperform Growth stocks by about 100 bps for every 10% rise in rates. For example, if rates rise from 1.0% to 1.1% within a month, we can expect to see Value stocks outperform by around 100bps over Growth stock (as shown in Figure 1). In the UK, the Value-Growth spread is about 100bps for every 20% rise in monthly rates (as shown in Figure 2). This means that for Value stocks to see a 100 bps outperformance on Growth stocks, rates would need to increase from 1% to 1.2%.
But Value only consistently wins if rates rise fast enough. In the US, Value only systematically beats Growth once the 10-year rate rises more than 5% in a given month. In the UK, the minimum rate increase is closer to 20%. Below those amounts, there is no clear winner between Growth and Value.
Figure 1: Value stocks outperform Growth stocks in the US by about 100bps for every 10% increase in the 10-year rate, but only when the rates rise by more than 5%. Source: Investment Metrics and FRED.
We found this by looking at stocks’ returns during several historical periods of rate increases to see how they might react this time around. In the US, we looked at Mar 1983- Jun 1984 (10.7% to 13.56% rise in the 10-year rate), Mar 1987 – Aug 1987 (7.25% to 8.76%), Feb 1994 – Nov 1994 (5.75% to 7.96%), Oct 2010 – Dec 2010 (2.65% to 3.29%), and Aug 2020 – Apr 2021 (0.62% to 1.64%). In the UK, we looked at Aug 1989 – May 1990 (9.91% to 12.4%), Jun 1994 – Nov 1994 (8.71% to 8.64%), Oct 2012 – Apr 2014 (1.77% to 2.75%), and Jul 2020 – Apr 2021 (0.21% to 0.85%).
Using our Style Analytics™ factor database, we measured the monthly returns during the periods of interest rate increases for portfolios made of the top quartile of stocks on Value measures like Book-to-Price, Free Cash Flow Yield and Sales-to-Price and on Growth measures like Earnings Growth, Sales Growth and Forecast Growth. We then averaged those returns to determine the overall Value and Growth return in each month.
Figure 2: Value stocks outperform Growth stocks in the UK by about 100bps for every 20% increase in the 10-year rate, but only when the rates rise by more than 20%. Source: Investment Metrics and FRED.
So, will Value beat Growth? Only if long-term rates rise above their local market thresholds. Growth stocks can breathe a sigh of relief, for now.