Investors have been gravitating toward stocks with price momentum, but higher interest rates should foster more diversity -- with value getting greater consideration as a driver of equity selection.
The return of market volatility in 2018 is an odd kind of familiar. In some ways, it is a healthy return, as the correction helped some security prices reflect a more appropriate level of risk.
But no two periods of volatility are alike. Traditionally, investors have measured the merit of a given investment through some combination of value, fundamentals and price. With the increasing dominance of passive investing today, however, market prices are assumed to be broadly correct, and the underlying realities of fundamentals and value have been forgotten or ignored.
This makes recent volatility unique. The rise of quantitative investing has helped to restore some balance by assigning various factors to stocks; this cycle’s winning and dominant factor so far has been price momentum. As a result, the more price has won, the more it has continued to win, as the dynamic of market feedback loops has flooded the winners with new capital and starved the losers. But a higher rate environment under current conditions should restore some market diversity, reasserting value as a driver of equities at the expense of price momentum.
To be clear, price is always a dominant factor in markets, but in most cycles it has been balanced by capital flows, which are driven by diversifying considerations, primarily longer-term value opportunities. Recent investor herding around price momentum, however, has greatly reduced market diversity, and the resulting commoditization of stocks around one factor has made markets very vulnerable to any wobble in valuation multiples. In the first quarter valuation multiples did indeed start to wobble.
The chart below shows that the S&P 500 Index’s forward price-earnings multiple declined over two multiple points during the first quarter to roughly 16x forward earnings. The decline in multiple was driven partly by a record quarterly increase in earnings estimates from the tax cut. This increase was not fully reflected in market prices likely because the market believes the tax cut benefits will be competed away. This will certainly be the reality for the most competitive businesses and industry sectors. But we think the bigger culprit in the valuation compression is rising interest rates.
P/E Ratio and EPS Estimates for the S&P 500 Index
As of March 31, 2018, using forward 12-month P/E ratio and EPS estimates. Source: ClearBridge Investments, Bloomberg.
The challenge for the markets is that we believe the path of least resistance for interest rates is higher, and the path of least resistance for most asset prices and valuations will accordingly be lower. If so, this shift to higher rates will challenge the hegemony of price. Let’s walk through a benign scenario for higher rates, and a much less benign one.
Fortunately, the most likely context for higher rates is better economic growth, as business investment has finally turned the corner. Capital spending plans dramatically increased in 2017, as enough confidence returned to businesses to make real investments in the future. Unlike share buyback programs, which can be turned off easily, capital spending programs, once they get underway, tend to be sticky.
Capital spending momentum will also benefit from the corporate tax cut, which directly incentivizes U.S. business investment. The tax cut is expected to lead to a 5%–6% increase in investment spending in 2018, which will have a decent multiplier effect across the economy. As economic growth proves to be more sustainable, this should spur further investment, and the economy may finally shake off its deflationary shackles as robustness returns to Main Street.
If this benign scenario plays out, interest rates should continue to climb, eventually weighing on growth. However, we will make a counterintuitive argument that higher rates may actually increase growth over the intermediate term. Why? One of the possible side effects of record low interest rates and cost of capital is that financial engineering through share buybacks has worked too well. As equities continued to climb, executives enjoyed higher stock-based compensation, and investors got to enjoy high asset returns while being subjected to low levels of actual business investment risk. Now, however, with higher stock prices and a rising cost of capital, share buybacks will be much less beneficial, and generating sufficient returns will require taking more real risk through capital spending. If this framework proves to be correct, then higher interest rates will be welcomed by Main Street in the form of job growth and higher wages as capital projects drive real economic activity, while creating a shift among winners and losers on Wall Street.
Forecasting anything as complex as interest rates always comes with peril, and this is especially true today. As the monetary policy experiment of quantitative easing is reversed, and as tax cuts increase the deficit, the market will have to absorb around $1.7 trillion of Treasury debt in 2019, or roughly 8% of the expected GDP. We have not seen this level of U.S. government borrowing since 1945. If this major policy change is combined with more wage growth and inflation than markets expect, Jamie Dimon’s concern in his latest annual report, that “markets will get more volatile as all asset prices adjust to a new and maybe not-so-positive environment,” will be quite legitimate.
Value Factor Returns Versus Inflation
As of March 31, 2018. Source: ClearBridge Investments, Bloomberg LP
Whether we get the benign scenario of gradually rising rates, or a more violent scenario, a higher rate environment should restore some market diversity as price momentum starts to give some ground to value as a driver of equities. This is not just a hopeful statement, as the performance of value has historically been closely linked with inflation expectations. However, as the chart above shows, despite higher inflation expectations, value underperformed in the first quarter, as it did through most of 2017. Investor behavior typically takes time and real pain from lower prices to change. Such a lag may be especially true now, given the rising dominance of passive flows and how well price momentum has done throughout this cycle at the expense of value. Thus — though timing is always very difficult to gauge, and barring another tax-cut boost to earnings — further multiple compression from higher rates could change the game.