Do you remember the 1970s? The era of stagflation – low growth and high inflation? Well, if you are as old as we are, you remember. The Feds pumped increasing amounts of cash into the economy and kept interest rates low in the face of ever rising inflation, which peaked at 12 per cent by the end of the decade. Looks like we are back to the future these days.
Consumer prices in the United States rose 5.4 per cent this past July, the same as in June, the highest year-over-year increase since 2008. The S&P GSCI Commodity Index traded 28 per cent higher the first half of this year, the biggest gain since 2009. If we exclude price increases caused by supply shortages as the economy reopens, the underlying inflation has steadily exceeded the Fed’s target of 2 per cent.
Companies all over the U.S. are raising prices or plan to do so soon, not only because materials and shipping costs have gone up, but also because they have to raise wages to attract workers. In fact, wages are rising sharply despite an unemployment rate that is remaining stubbornly high.
Yet Treasury bond yields had actually been falling since April, until a recent uptick. Has the traditional relationship between inflation and bond yields changed? For example, given traditional relationships, when inflation is 5 per cent, 10-year U.S. Treasury bond yields should be around 7 per cent. But they are only about 1.50 per cent. True, more than 50 per cent of bonds are currently bought by the Fed and U.S. government, neither of which is very price sensitive. And maybe, as some market commentators argue, “buyers are as important as fundamentals.” But for how long?
Of course, it is not actual inflation that drives interest rates, but expected inflation. So, either the bond market does not believe that inflation will be a problem in the long run, or that the economy is not as strong as it appears to be. Or, maybe the world has changed since the 70s. For instance, there’s less dependence on oil, weaker union power and so on. Excessive money creation is perhaps not so inflationary as it once was.
But, long term, there are other worrisome signs offsetting some of the positives of the 2020s.
For example, as a recent Bloomberg Businessweek article explained, the trend of using low-cost global suppliers – a source of price deflation over the past two decades – may now be under threat as governments around the world erect barriers to trade.
As supply chain disruptions become a big cause of concern for companies, the deglobalization wave of the past few years is bound to continue. If global trade suffers, this may lead to higher and more permanent inflation and expectations about inflation. And then there’s the harmful effect that increasing taxation (needed to finance humongous pandemic-induced deficits) and reduced productivity (because of the retirement of boomers) will be having on long-term inflation.
In light of this, what is an investor to do? For starters, investing in long-term bonds will not be a good idea. When it comes to equities, investing in stocks that can pass cost increases to customers via higher prices would seem to make the most sense.
How about value versus growth stocks? Let us look at the theory first. Valuation metrics such as price-to-earnings and price-to-book are a function of the growth rate of earnings going forward. Companies have low multiples because markets expect low earnings growth, or high multiples because of high earnings growth expectations.
Moreover, P/Es and P/Bs are also a function of interest rates. Growth rate assumptions interact with interest rates. When rates are low, growth stocks benefit the most, as their future growth opportunities look very high in present value terms. As a result, in a low interest rate environment, investors tend to overvalue (and overpay for) high multiple firms and undervalue low multiple firms. Since, historically, interest rates are low when expected inflation is low and vice versa, this denotes one of the ways in which inflation affects valuations.
Let us now look at the evidence regarding the historical performance of value and growth stocks in different inflationary periods.
Given the many outliers, we decided to focus on median “value premiums” of U.S. stocks for nine non-overlapping 10-year periods between 1930 and 2020.
The value premium is defined as the difference in annual returns between value and growth stocks, where value stocks are those in the lowest tercile of stocks sorted based on P/Bs, and growth stocks those in the highest tercile. Simply put, the value premium is positive when value beats growth, and negative when the opposite occurs. Stock return calculations are courtesy of Kenneth French of Dartmouth College and include stocks from the main U.S. stock exchanges.
According to Federal Reserve Economic Data, the 10-year periods with the highest inflation were: 1940-50, 1970-80 and 1980-90. The median value premiums were 7.56 per cent, 9.96 per cent and 13.93 per cent, respectively. The 10-year periods with the lowest inflation were: 1930-40, 1950-60 and 2010-20. The median value premiums were minus 2.1 per cent, 1.98 per cent and minus 2.7 per cent, respectively.
We also examined the annual inflation rate above which the value premium became decidedly positive. This inflation rate was approximately 2.5 per cent. Once inflation started to exceed 2.5 per cent, value stocks started to outperform, while growth stocks, in general, did better when inflation was below 2.5 per cent. Between 1930 and 2020, there were 50 years when annual inflation was at or above 2.5 per cent and 40 years when it was below 2.5 per cent. The median value premium in the first period was 11.04 per cent and in the second 2.34 per cent. It’s worth noting that it is primarily small-cap value stocks that drive these relationships.
Should high inflation persist, value stocks should perform relatively well versus growth stocks, providing a stark contrast to what has been recently the worst decade for value in the past 90 years. The bond market is assuming “this time is different,” but history suggests interest rates should follow inflation. If this is the case, the future should bode very well for value stocks.
George Athanassakos is a professor of finance and holds the Ben Graham chair in value investing at the Ivey Business School, University of Western Ontario. Reyer Barel is the chief investment officer at Oak Bay Capital and an advisory board member at the Ivey Value Fund.
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