Growth vs value equities: the key to what happens next?

It's official; everyone is now musing about the risk of a Fed "policy mistake" in light of the steadily flattening yield curve in the U.S. I have mused incessantly about this topic in recent weeks, so I will spare you the gory details of my view. It seems clear, though, that if markets were willing to offer the FOMC a rate hike in June for free, they are not going to roll over in September, let alone play along with a potentially fourth hike in December. In other words; the Fed is now on the spot. A swoon in risk assets over the summer—it has been known to happen—coupled with a further decline in long term bond yields would set up an interesting end of the year for the Federales. I am sympathetic to idea of one last deep dive in long-term bond yields to cement the fate of the late-comers to this rally. After all, we can't really talk about a policy mistake at the Fed before we are staring down the barrel of an inversion. 

Another sinister turn of events would be a government shutdown in the U.S. as the White House straps in to play chicken with Congress—and more specifically its Republican majority—over tax reform. Last time we had a debt ceiling scare in the U.S. was in the summer of 2011, and that ended with a proper blood bath in equities. The particularly nasty prospect of this scenario is that it could well be associated with both higher bond yields and a dive in risk assets.  

Meanwhile in the real world, those who sniffed out this bond market rally before the peanut gallery caught up to up it [1] have the luxury of looking ahead to what comes next. Over at Macro Man—which has been expertly marshalled by Shawn in recent weeks—trusty commenter Leftback is thinking about a switch in position; 

LB is close to terminating what has been a long term trade in US fixed income, specifically long duration govies. TLT is showing signs of exhaustion, the chart shows TLT near to closing the gap from the Trump election as it crawls higher on lower and lower volume. Positioning shows that shorts in TY and US have mainly capitulated, so we are running out of buyers for the time being.

At the same time we see all kinds of negativity surrounding crude oil and the energy stock ETF, XLE, is lagging the market. A squeeze could be imminent in crude as the conditions for one have been building for a few weeks now. We're not catching the falling knife yet but we do have the Kevlar vestments close at hand, waiting for signs of capitulation among the few remaining bulls.

Experience tells me that thick kevlar gloves are needed to follow LB in the early stages of a trade, but he usually gets its right. Additionally, the pivot towards oil and energy is a natural one at the moment for the contrarian punter. I am price taker of oil prices, which is a euphemism for "not having a clue."  It seems to me, though, that the fundamental story is relatively simple. U.S. shale is now the marginal producer in the global market, and their break-even point is much lower than analysts previously thought.

In the rebound from the collapse in 2014-to-2016, the bullish price action maxed out just under $60. Holding demand given, we can probably assume that this is the ceiling in light of the production bonanza such 'lofty' price levels lead to in the latter part of last year. But where is the floor, or more specifically; where is the shale breakeven point? Most of the eggheads I have been talking too assure me that the pain will set in at $40. This suggests only slightly more downside, although of course these things have a tendency to overshoot. My hunch tells me that we have to see a 3-handle before babies are thrown out with the bathwater in earnest. Interestingly, the deluge in energy equity and credit markets hasn't been as severe this time around. This makes sense. A crash from 90-100 to high 20s is different than a decline from 55 to low 40s. If weak price levels persist though, default and liquidity risks will start to bite for the weakest credit players. But as a credit geek pointed this on Bloomberg TV this week; energy is now a much smaller part of U.S. high yield. 

Trailing three-month inflows to HYG US equity have certainly rolled over, but the index itself has barely moved, which is evidence that its sensitivity to a swoon in oil prices has diminished. 

 

Growth vs Value: An equity strategist's version of the world in 2017

With all the action in oil and bonds, you might think that equity strategists would be struggling for attention, but they are not easily deterred. The industry's myriad of sector and strategy definitions means that they always have something to talk about. At the moment, the outperformance of "growth" stocks—as oppose to "value" stocks—is the topic du jour. I have to admit that I am no fan of these definitions. They are often described in a way which means that you can put just about anything you want into them. It's a bit like a horoscope; any good astronomer knows that the key to a good prediction is to make it so general that it will always be right.  My suspicion was initially confirmed by pulling the 15 largest constituencies—by market cap—of the S&P 500 value and growth indices. What is it you say about never visiting the factory to see how sausages are made?

The overlap is striking in light of the fact that these are supposed to represent separate strategies. Heavy weights such as General Electric, Pfizer, Coca-Cola, Phillip Morris and Johnson & Johnson feature in both indices, which makes you wonder just how much "diversification" is offered by positioning yourself along these categories. That said, I have also included the 15 largest members of the iShares S&P 500 growth and value ETFs and to the credit of Blackrock's portfolio builders, they appear to have constructed these things with more divergence than their underlying benchmarks.

The traditional split between the S&P 500 growth and value indices, somewhat paradoxically, offers a perspective on the current trend in equity markets where tech has been running away from just about everything else. Technology stocks—in case you haven't caught on by now—are the quintessential "growth" stocks based on the definitions the industry use to classify them. By contrast, this year's underperforming sectors such as financial and energy are big constituencies in traditional "value" indices. In other words; if you strip out the overlapping names in the tables above, the difference between growth and value is pretty much technology vs financials, energy and Warren Buffet. 

As it turns out, this opens the door for equity strategists to take part in the discussion about the flattening U.S. yield curve. The first chart below shows that the relative underperformance of the S&P 500 value index is closely correlated to the recent flattening the yield curve. The second chart tells the same story in levels. Both are plotted since the financial crisis.  

I concede that a flattening yield curve and outperformance of growth stocks are strange bedfellows. This is especially the case if U.S. yield curve flattening occurs in the context of a hawkish Fed and a U.S. growth scare as short-term rates are rising. On the other hand, in a world where excess global liquidity has become the norm rather than the exception, lower long-term rates—assuming the curve does not invert—means a lower discount rate. That in turn means a higher terminal value of those lofty future revenue and earnings that growth stocks are supposed to generate at some point in the future. In short; low rates makes lofty valuations of growth stocks more likely to persist. 

If you're not convinced by this argument—I am still not sure—the flip side of the link between poor performance of value stocks and a flatter yield curve is more reasonable. A flat yield curve is a drag on financials' ability to earn the classic "maturity transformation" spread. For energy stocks, a flatter yield curve is a bad sign because it often goes hand in hand with lower headline inflation, which is often driven by lower nominal global GDP growth and sluggish price action in commodities and oil.  

Last week, I mused about the return of the reflation trade in the second half of the year. Whatever we think about the characterisation above, it is easy to see how a sector rotation story along this axis could emerge at some point in the latter part of the year. The first chart above hints at a short-term inflection point in the trend of U.S. flattening and outperformance of technology stocks. If true, a U.S. curve steepener and some exposure to global energy and financials—you would assume mainly in the U.S—could be winning punts on a six-to-12 month basis. This brings us full circle to the start of this week's missive. Donning the kevlar gloves to catch some energy and financial, equity exposure, while reducing exposure to duration seems like the obvious contrarian bet. More often than not, the distinction between growth and value stocks—and the associated promise of diversification—is a misnomer, but on this occasion it could hold the key to what happens next. 

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[1] I have made many mistakes this year, but I think I got that one reasonably right.