MEDIA RELEASE: “Higher inflation and interest rates will be a key factor in market performance in the near term. But they differ in how these conditions will affect individual sectors and companies.
An environment in which global economic activity is recovering strongly and interest rates are rising is going to favour value indices at the expense of growth indices. Value indices relative to growth tend to be more pro-cyclical. The financial, industrial and commodity-oriented sectors, such as energy and materials, are overrepresented in value indices relative to growth indices – and that goes some way in explaining the outperformance in those sectors of late.
However, if you deconstruct relative weights value versus growth, the two biggest differences are the weight of the financial sector in value and the growth indices. Basically, the financial sector is about five times larger in value. At the opposite end of the spectrum, however - the technology space - tends to be dominated by longer-duration growth stocks, and has 3.5 times or so the representation in growth indices than value indices.
If higher rates continue, that has the potential to materially improve the revenue and earnings backdrop for this sector, which has been under persistent pressure for a long time.
As rates have continued to move lower, every loan and every bond that matures is reinvested at lower rates. That’s been a very consistent pressure damaging the earnings power of the. So, in an environment in which rates spiked, financials, which are a much more significant part of value indices, outperformed.
What’s happened more recently is the spread of the delta variant disrupted the recovery to some extent, or at least slowed the trajectory. Interest rates have moderated the sector, and not surprisingly, we’ve seen growth stocks regain some of the ground they lost in the fourth quarter and first quarter.
The earnings backdrop in the second quarter was very good, both in the US and outside the US. Results were substantially better than expected. Some of the surprises have been the velocity of the recovery in corporate profits. If you look at the S&P 500, right around 80 per cent of companies reported second-quarter 2021 revenues that were above second-quarter 2019 levels, meaning they fully recovered from the COVID disruption. The other thing that’s just been hard to ignore is earnings expectations have moved up substantially from where they started the year. The year started with S&P 500 earnings expected to be up 20 per cent year over year against an obviously depressed 2020.
Earnings expectations have more or less doubled. Consensus estimates are now assuming a near-40 per cent recovery in profits year over year. The outlook continues to be favourable despite some disruption created by the delta variant, supply chain challenges and rising costs.
Companies have been able to offset cost pressures through to their customers. Thus, the forward earnings outlook has not taken a material dent from some of these challenges that companies are wrestling with today.”
