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Portfolio Update

From Growth to Value

By Elliott H. Gue, on Sep. 27, 2017

On Sept. 20, the Federal Reserve announced plans to unwind the extraordinary quantitative easing policies implemented in response to the Great Recession and Financial Crisis starting next month.

Under the central bank’s normalization plan, first announced following their June meeting, the Fed will reinvest principal repayments received on the Treasury bonds above a certain level. The initial cap will be $6 billion per month, rising by $6 billion every quarter until the cap reaches a level of $30 billion per month.

For the mortgage- and agency-backed securities on the balance sheet, the Fed will establish an initial cap of $4 billion, raising it to $20 billion per month over the next year.

Based on that schedule, the Fed will stop reinvesting about $50 billion worth of principal repayments on Treasury and mortgage-backed securities each month by October next year, resulting in a gradual-yet-predictable reduction in the size of its balance sheet over time.

However, the bank left the door wide open to using quantitative easing as a policy tool in coming cycles.

Moreover, the Fed’s currently holds assets of $4.459 trillion, up from $891 billion at the end of 2007 just as the Great Recession began. The central bank has no formal target for balance sheet size and it’s unclear what it considers a “normal” amount to hold.

We’ve been puzzled by the action in federal funds futures markets over the summer months.

For much of the past three months, expectations for the Fed to hike interest rates by 25 basis points at its Dec. 13, 2017, meeting have steadily fallen from north of 55 percent at the end of June to a low of under 22 percent just prior to the Fed’s Sept. 20 meeting.

The main pushback for raising rates again this year appears to be that inflation continues to run under the central bank’s 2 percent target rate with the core personal consumption expenditures (PCE) index rising just 1.4 percent year-over-year in July.

However, we believe below-target US inflation is partly the result of secular factors including technological advancements and an aging US workforce.

In addition, in the latest Fed meeting minutes released in mid-August, there was considerable discussion about “elevated” asset prices–including an extended stock market and low volatility priced into most financial markets. There’s well-placed concern that the prolonged era of near-zero interest rates and several rounds of quantitative easing have contributed to stretched valuations in financial markets.

Concerns about asset prices suggest the Fed will continue to raise rates even if inflation remains below target near-term.

And, perhaps most importantly, US economic data continues to support our view that the economy is picking up steam or, at the very least, continuing to grow at a healthy pace.

Many investors and the financial media tend to get bogged down by volatility and “noise” in economic data releases. We prefer to look at a handful of big-picture indicators that have stood the test of time. Two of our favorites are the US Leading Economic Index and the Purchasing Managers’ Index (PMI).

These indicators point to continued strength in the economy.

Historically, the LEI logs six or more negative month-over-month readings in the 12 months before the US enters recession. That pattern is clearly visible in the LEI data in late 2006 and through 2007. That was just before the S&P 500 topped out in Oct. 2007 and the economy entered recession in December of the same year.

However, over the past 12 months, the month-over-month change in LEI has never been less than +0.2 percent. And in seven of the past 12 months, the reading has been +0.3 percent or better, typically consistent with an economy that’s doing well.

Meanwhile the Purchasing Managers’ Index for manufacturing stands at 58.8, a six-year high. That’s a strong sign of ongoing strength in manufacturing activity from a lull at the beginning of last year.

Even better, and unlike much of the post-crisis era, the US economy’s strength is part of a concerted global cyclical upturn that includes Europe, Japan, China and other emerging markets.

The eurozone PMI, for example, stands at 58.2, a level indicating strong economic expansion. Likewise, China’s PMI is doing well and stands at a five-year high.

We believe the market is just starting to come to grips with this reality and the fact that the Fed is likely to continue hiking interest rates, albeit at the historically glacial pace of three to four times per year.

The bond market also reflects the shift–the yield on 10-year US government bonds recently jumped from an early September low of 2.04 percent to north of 2.20 percent. We see more upside for yields ahead.

The most important implication of this economic and interest rate outlook: The US stock market is in the early stages of a historic rotation that will power significant upside for value-oriented groups and act a as headwind for some classic growth stocks.

Our chart shows the price-to-book ratio for the S&P 500 Value Index divided by the price-to-book ratio on the S&P 500 Growth Index. When this ratio is relatively low, value stocks are cheap relative to their growth counterparts and vice-versa.

The key takeaway: With the exception of the height of the technology bubble in late 1999 and early 2000, value stocks have rarely been this cheap relative to growth stocks in the S&P.

In the last value cycle, a period that stretched from 2001 through 2006, the S&P 500 Value Index returned 54.1 percent compared to a gain of just 17.7 percent for the S&P 500 Growth Index. The current stretched valuation of growth stocks relative to other sectors will lead to a similar-sized period of outperformance over the next two to three years.

Growth stocks can generate upside to earnings without help from US and global economic expansion. While value groups tend to be more cyclical and economy-dependent. Therefore, growth has historically outpaced value in periods when the economy is sluggish (such as last year) while more cyclical value groups assume leadership in periods of stronger economic growth.

Interest rates also play a role. Banks are one of the few industry groups to benefit directly from rising interest rates. The reason is that most commercial and industrial loans carry floating interest rates tied to an index of short-term rates, such as LIBOR or short-term Treasury rates. Therefore, every time the Fed hikes rates, banks automatically charge higher interest rates on their loan balances and enjoy rising net interest margins.

Since financials are a leading group within the S&P Value Index and only a minor component of the Growth Index, rising interest rates tend to drive outperformance for value indexes.

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