Rotation and the Great Growth Sell Off

The rapid surge in US yields since late February 2021 unnerved financial markets, triggering a long overdue correction in risk assets.

Since rates went on the move, the biggest laggards have been high growth, high multiple, long duration stocks, many of which were also COVID-economy winners. Meanwhile, value-oriented stocks that are reasonably priced, and levered to the economic recovery, are holding up well, or rising.

As a result, after a strong showing in early 2020 with relative performance peaking in Sep 2020, we have seen Growth vs. Value outperformance (as proxied by the Russell 1000 Growth/Value Index) revert further towards trend (see chart 1).

Will growth underperformance continue?

We think this rotation has more to go. Consensus expectations is for rates to move higher over the course of the year, which means multiple risk for the richest valued stocks remains a concern. At the same time, many of these names have to grapple with receding COVID-economy benefits, as wallet share shifts with reopening and as they move through difficult year on year comparisons. 

Are rising real yields worrying for markets as a whole?

Notwithstanding the internal market rotation that is being played out, we remain constructive on the overall US equity market, as history suggests that an orderly rise in real and nominal yields, as well as inflation expectations tend to be positive for risk assets, as long as the rise is accompanied by strong nominal GDP growth. i.e. yield rises for a good reason.

We are expecting above-trend GDP growth in 2021 which will be supported by the recently approved USD1.9 trillion stimulus package, post-vaccination re-opening, pent-up savings, easy financial conditions, and a very dovish Fed.

Near term momentum will stay with cyclicals

Cyclicals and financials (with still very reasonable PE multiples) have historically shown positive correlation with rising US Treasury 10-year real yields (see chart 2), and we continue to favor them. We hence favour a barbell strategy, riding the near term momentum in cyclicals, while using the correction in growth stocks to bottom fish in structural growth names that we like. 

It's raining cash! -  How to play the recovery in consumer spending?

We expect consumer spending to be robust this year given a strong US consumer setup at a time of economic reopening and aggressive stimulus. This will likely unleash pent-up demand and drive growth.

As a testament to that, Jan 2021 retail sales (ex-auto) beat expectations (6% growth vs 1% consensus) with every category seeing growth.

US households in aggregate saw disposable income rise by 7.2% in 2020 (vs. 3.7% in 2019) even with record unemployment rate. This was largely due to multiple rounds of COVID-relief packages, which authorised economic stimulus spending of ~USD3.5 trillion.  The Biden administration has negotiated another USD1.9 trillion package, where payment to households would be similar in size as the last two packages combined (see chart 3). Importantly, this would come at a time when lockdown restraints are easing and consumer behavior is normalising.

Consumer discretionary sector should benefit, especially consumer services such as leisure, gaming, hotels and offline retail which have been more badly impacted by the pandemic. Given these industries also have significant operating and financial leverage, earnings growth is expected to be multiples of revenue growth and has potential to significantly surprise to the upside.

While there’s still much uncertainty about how the recovery trajectory in spending will play out, if we look to countries that have more effectively controlled the virus like China, services-related activities had normalised quickly. Monthly domestic airline passenger traffic in China was at 81% of peak in Nov 2020 (compared to 36% in US) and down just 6% YoY. It also only took 6 months from its low in February 2020 (and without a vaccine) for China domestic traffic to return to >80% of peak levels.

However, no such V-shaped recovery appears to be anticipated by the consensus. Consensus forecasts for occupancy rates across key US services industries such as airlines, cruises, and hotels are not expected to recover to 2019 levels until 2H2022 at the earliest. We think expectations in general are low and risk/reward are likely skewed to the upside for these services companies.

Payment names, despite falling into the technology basket, is also a good way to play the re-opening/consumption recovery trade, having held up remarkably well through this corrective phase. In fact, momentum seems to be improving on the names most leveraged to the recovery trade e.g. merchant acquirers. Payment networks will also benefit from the resumption of international travel and as cross border payment recovers.

US financials – enjoying a renaissance

The financials sector has been a big beneficiary of recent moves in bond yields, providing market leadership for the reflation narrative. The strong correlation between rising yields and bank stock performance would help underpin broader sector performance (see chart 4).

Looking beyond bond yields

In addition to the bond yield narrative, investors can also point to a supportive results season. 2020 Q4 numbers reinforced the view that the worst of earnings destruction could be behind us, as earnings trends are improving relative to the broader market. The recent results benefited from lower provisioning, continued financial markets-related revenue generation and robust capital positions. At the same time, valuations remain reasonably attractive.

Some risks coming from excess liquidity

Net interest income (NII) remains a key income pillar for banks. Looking ahead, one risk to NII includes the challenge in dealing with the growth in surplus liquidity.

While GDP expectations point to above-trend growth in 2021, underlying loan growth remains sluggish. This is partly a reflection of a system flushed with liquidity from capital markets issuance, government stimulus, and the Paycheck Protection Program. 

This has led to a surge in deposits sitting in low-yielding cash, at the same time as lending sharply declining. A demand pickup is pivotal to improving NII. Still, sizable reserves provide a cushion to an expected increase in debt delinquency.

Summing it up

With yields around the world trending higher, and an evidence pointing to a sustained period of global growth and reflation, a more bullish case can be made for the broader sector.

We like large cap banks, which have been maintaining their dominant market position and gaining market share, especially in capital market related segments. Insurers would be levered to the increase in bond yields, while asset managers and brokerage firms would be positively exposed to increased capital market activity. 

Conclusion

We think the rotation from growth to value has yet to run its course. Rates will likely move higher over the course of the year, which means multiple risk for the richest valued stocks remains a concern. Cyclicals have historically shown positive correlation with rising rates, and we continue to favor them. We hence favour a barbell strategy, riding the near term momentum in cyclicals, while using the correction in growth stocks to bottom fish in structural growth names that we like.