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So far this year, value stocks have benefited from their sensitivity to the improving economy. REUTERS/Brendan McDermid/File PhotoBrendan McDermid/Reuters

Approaching the midpoint of the year tends to spark a degree of reflection about what has transpired thus far and what future challenges will be.

Judging by the slew of half-time investment outlooks being released at the moment, many investors and strategists are asking how far equity markets can run given their impressive gains over the past 16 months from pandemic lows.

There are some obvious overhanging uncertainties. First, there is the prospect of less monetary and fiscal support. This could blunt the vigour of the current economic recovery and weigh on corporate earnings growth. The likelihood of higher taxes is another potential dampener.

Investors are also fixated about whether current inflation rises are transitory and if so, for how long? If upward pressure on prices persists and, as a consequence, expectations of rising interest rates increase, we could be in for a bumpy ride.

All of these perils complicate the task of assessing what the current early to mid-cycle economic cycle entails for the popular equity investing styles of value and growth.

So far this year, value stocks – shares considered to be undervalued by some metric – have benefited from their sensitivity to the improving economy. They have been running ahead of growth stocks, which deliver more consistent increases in earnings.

However, their lead began shrinking from mid-May. Arguably the pace of gains until that point warranted a period of consolidation. And a subsequent drop in bond market interest rates did signal doubts about how strong the U.S. economic recovery would be.

The current market debate is therefore focused on whether cyclicals and value stocks can run further, or whether investors should look more at growth.

Jason Pride, chief investment officer for private wealth at Glenmede Trust Co. in Wayne, Penn., argues that “value is in the process of resetting” from prior underperformance.

“It will benefit from the fact that we are still in a fundamental recovery where economic growth and earnings come in higher,” he says. “Our base case is that inflation eventually settles between 2 per cent and 3 per cent and that will help value do better than growth.”

Signs of cyclical and value shares finding buyers flashed anew last week. Bargain hunters emerged after a bout of heavy selling triggered by the U.S. Federal Reserve Board policy meeting in the middle of the month, which signalled that the central bank expects interest rates to rise sooner than it had previously thought.

A flurry of speeches from Fed officials in recent days helped defuse market anxiety over the central bank’s policy statement, which was initially interpreted as representing a hawkish pivot. Buying momentum was also boosted by agreement in Washington over a US$1-trillion infrastructure deal encompassing the next eight years on Thursday.

While fiscal stimulus will slow markedly next year, advocates of owning economically sensitive companies expect that consumers and businesses will spend their lockdown savings and boost growth.

“In a hotter economy, you want to own inflation-sensitive stocks and we may be underestimating the duration of the cycle,” says Andrew Slimmon, senior portfolio manager at Morgan Stanley Asset Management in Chicago. “Value is still cheap relative to the [broader] market and I think we are moving into a more extended phase of outperformance.”

One sector Mr. Slimmon highlights is energy. Despite all of the large gains seen for energy shares this year, the sector has lagged the rise in crude oil prices, suggesting there is room for further appreciation.

Other strategists are looking at the merits of shifting toward “quality” companies that are well managed with strong balance sheets and steadily increasing dividends. After the stirring rebound of lower-quality companies that populate the value stock universe, these are looking more attractive on a relative basis.

BlackRock Inc.’s benchmark of high-quality companies is currently trading at its largest discount to the Russell 1000 Index in more than two decades. That reflects how investors have sought recovery stories in companies that were hit hard by lockdowns in the leisure, travel and retail industries.

“We are still very value tilted, but we are starting to dial that back and look at the quality trade,” says Tony DeSpirito, chief investment officer of U.S. fundamental active equity at BlackRock in New York. While he expects that value and cyclical shares have not fully exhausted their run, the clock is ticking.

Once the economy shifts into a mid-cycle phase, history shows that quality shares start outperforming. Mr. DeSpirito argues a more normal pace of economic growth should prompt a more cautious approach from investors as the risks around “taxes, inflation and the timing of a Fed policy shift” become clearer.

He identifies health care and financial companies with strong balance sheets as having the ability to compound their earnings over time.

“As a long-term investor, owning quality will pay off,” he says.

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