In this week’s narrative, we review the breakout in 10-year bond yields. We also discuss the Build Back Better legislation and the big returns recently earned on energy stocks. We then assess the recent outperformance of small cap value relative to small cap growth and look at how this dynamic appears to now be unfolding for large caps as well. Lastly, we highlight how value’s outperformance has been beneficial for developed international equities.
- Ten-Year Yields at a two-year high – The first laboratory confirmed case of COVID-19 in the United States was on January 20, 2020. While the bond market was closed on that date, the 10-year Treasury ended the prior trading day yielding 1.84%. After about two years well below this level, the benchmark bond finally punched through to two-year highs, trading to 1.88% last week. Yields have been trending higher over the past few months as investors process higher inflation, along with a Fed which is tapering its bond purchases and now seems likely to raise rates as soon as March. To date, the move in the bond market has been in keeping with our belief that rates would drift higher this year. At the same time, we believe that inflationary pressures will moderate over the coming months. As such, we do not see interest rates spiking from these levels and remain of the mind that peak inflation is near.
- Build Back Better 2.0 – Build Back Better (BBB) was formally derailed late last year when Senator Manchin came out on Sunday, December 19, 2021, and indicated that he could not support the legislation. This pronouncement was made after he previously stated that he would not vote for a bill that relied on budget gimmicks to make the numbers work. While this seemingly halted progress on the bill, it certainly does not mean that Build Back Better, in some form, has no chance of passing. In fact, Dan Clifton, from Strategas Research Partners, believes that this legislation is likely to be resurrected later this month or in early February1. He argues that the goal could be something in the area of $1.8 trillion of revenue, to be matched by a like amount of new spending. If this estimated timeline holds, the legislation, which has largely drifted out of the news of late, will once again be a focus for investors. At the industry level, owners of pharma stocks will be particularly attuned to the revised legislation, as the original bill tagged those companies as a significant source of revenue to be realized from lower negotiated drug prices.
- Big Returns from a Tiny Sector – The energy sector has seen its significance within the S&P 500 dwindle over the past decade, to the point where it now accounts for well under 3% of the Index. While the weight is tiny, it would be even lower were it not for the outsized performance that energy stocks registered in calendar 2021, as the sector proved to be the best performer, advancing over 54%. So far in 2022, energy stocks have picked up where they left off, with the sector now up 16.1% through last Wednesday’s close, versus a decline of -4.8% for the S&P 500. Supporting the performance of energy stocks has been a surge in oil prices, which hit a seven-year high last week. This sector, which tends to be well represented in the value camp, has been helpful to our performance as we continue to have a value bias in our portfolios.
|Russell 1000 Value||(2.9)||(1.4)||19.5||14.60||10.83||1.82|
|Russell 1000 Growth||(5.5)||(8.8)||16.4||27.09||22.42||0.68|
|MSCI EM (Emerging Markets)||(2.2)||0.7||(8.0)||9.62||9.60||2.38*|
|Fixed Income||Week||YTD||1-Year||3-Year||5-Year||Div Yield|
|Bloomberg Barclays US Aggregate||(0.7)||(2.2)||(3.1)||4.03||3.11||2.10|
|Bloomberg Barclays US High Yield – Corporate||(0.6)||(1.2)||3.6||7.06||5.81||4.68|
|Bloomberg Barclays Municipal Bond||(0.3)||(1.2)||0.2||4.18||3.74||1.38|
|Bloomberg Barclays Global Aggregate x US (Country)||(0.6)||(0.9)||(6.5)||2.45||2.99||1.19|
|Crude Oil WTI (NYM $/bbl) Continuous||3.8||14.1||61.9||16.7||10.5||85.8|
|Natural Gas (NYM $/mmbtu) Continuous||(11.1)||8.1||52.0||5.9||2.7||3.8|
|Gold NYMEX Near Term ($/ozt)||0.9||0.9||0.2||12.9||8.9||1,843.1|
|Copper Cash Official LME ($/mt)||1.4||1.1||22.7||17.6||11.4||9,801.0|
|Currencies||1 Week Ago||YTD||1-Year Ago||3-Years Ago||5-Years Ago||Current Level|
|U.S. Dollar per Euro||1.14||1.14||1.21||1.14||1.06||1.13|
|Japanese Yen per U.S. Dollar||114.85||115.16||103.91||109.67||115.30||114.34|
|U.S. Dollar per British Pounds||1.37||1.35||1.36||1.29||1.23||1.36|
Value vs. Growth, Small Cap turned, now Large Cap too
Growth stocks had significantly outperformed value over the recent past, a trend which had mostly continued until the latter part of 2020.
For small cap issues, this dynamic changed in 2021, as small cap value decidedly outperformed small cap growth. The actual results for 2021 show the Russell 2000 Value Index having gained 28.2%, vs. just 2.8% for the Russell 2000 Growth Index.
While the same dynamic looked to be unfolding with respect to large cap issues during the first quarter of 2021, the relative performance of large cap value rolled over and then trended sideways into year-end. The net result being comparable returns for the two cohorts.
More recently large cap value has again started to reassert itself, with the Russell 1000 Value Index down just -1.4% through last Wednesday’s close, vs. a loss of -8.8% for the Russell 1000 Growth Index.
The value camp has recently been the beneficiary of strong performances turned in by sectors which tend to be overrepresented within that style, including energy and financials.
We believe that large cap value can outperform large cap growth for a bit longer. However, as noted in our Outlook, our base case is that economic growth is poised to soften later this year. Broadly speaking, a decelerating economy will be a better environment for growth companies, as they should be better positioned to generate decent earnings growth without a strong tailwind from the economy.
Europe Better Positioned for Current Sector Outperformance
We have often addressed the fact that the developed international markets are meaningfully underexposed to the tech sector when compared to the S&P 500.
This dynamic has been a headwind to the performance of European stocks over the past few years, as technology issues have rather consistently outperformed.
With the recent shift toward value outperforming, the relative underweight to tech and overweight to more value-oriented sectors (energy, financials, and materials) has proved beneficial for European stocks when compared to the United States.
This is evident in returns for 2022 through last Wednesday’s close, which show the EAFE Index lower by -1.5%, the Europe ETF (ticker IEV) down -0.8%, with the S&P 500 off -4.8%.
Similar to how we see the U.S. market performing over the next few months, we think the value trade within Europe can continue a bit longer. However, the slowing economic growth that we foresee later this year will not be limited to the United States, as it is also likely to take place in Europe, which should once again result in headwinds for EAFE equities (given their value orientation).