ADRIAN CLAYTON: Busting myths about growth, value and interest rates

The market has a communal mind. Frequently a narrative, an idea or concept is latched onto by investors, hard coded and accepted as gospel. Examples include:

• The idea that higher interest rates will catalyse equity weakness.
• Growth and quality has been a fad and it is time to pivot into value, which is a better long-term performance metric. 
• Value outperforms growth and quality when interest rates rise. 

Being natural sceptics, we used a data-focused approach to test the following potential myths. 

Stock markets rise as rates fall and fall as rates rise

We analysed 10 hiking and 10 declining dollar rate cycles dating back to the 1950s, and our findings are:

• There is an unexpectedly long lag, and during the initial stages of a rising cycle generally markets continue to head higher for at least a year, before performing poorly. 
• The same lag, up to two years, exists when rates are cut. 
• Economies and markets have natural momentum, be it positive or negative, and this lasts longer than expected when interest rates are changed. Though broadly similar, each cycle differs uniquely based on the relative levels of equity valuations. 

So interest rates are negative for equity prices, but this is not always immediate and in the short term (up to two years) equity prices often move in the opposite direction to what is expected.

Growth and quality is a fad; pivot to value

The chart compares growth against value over the past 45 years. Growth outperforms when the blue line on the chart rises.  We note four distinct periods, showing which style outperformed.

• 1974 to mid-1988 — value 
• Mid-1988 to early 2000 — growth
• Early 2000 to mid-2007 — value 
• Mid-2007 to 2020 — growth

Both styles pretty much returned the same quantum from December 1974 to February 2020. Both styles win when they start off cheap. 

Growth’s well-known outperformance from 2007 to 2020 created a buying opportunity for value. It is impossible to forecast the duration of the current value cycle.

Historically, once a style gains momentum it tends to last for a long time. There is no quantitative evidence to point to one style being superior to the other.

Value outperforms growth during rising interest rates cycles

The theory behind front-loaded cash flow being worth more to investors in a rising interest rate environment makes sense. We intuitively buy the concept that more mature companies that we view as value stocks should offer this. In practice, though, there is no conclusive evidence that value outperforms growth and quality companies during interest rate rising cycles.

The definition of a rate cycle is key and we have focused on the longer, more established US cycles stretching back to the early 1970s. 

With reference to our chart, we note four significant interest rising periods and indicate which style outperformed:

• 1977 to 1981 — massive increasing cycle value.
• 1986 to 1988 — growth.
• 1993 to 2000 – growth.
• 2004 to 2007 — value.
• 2015 to 2019 – Value outperformed for the first 15 months and then growth accelerated and outperformed.

There appears to be no direct correlation between rising interest rate cycles and value outperforming.

Hard-coded narratives are dangerous.

Though rising rates in the long term are not great for markets and declining rates are market friendly, lags exist in the short term once interest rate cycles start to change. 

One style is not necessarily better than the other. Their relative pricing or valuation is key to initiating an outperforming or underperforming cycle. Growth/quality became expensive in late 2020 and value was relatively cheap. 

The view that higher rates always favour value stocks appears unfounded and we struggle to see proof of this in the numbers.

• Clayton is NorthStar CEO.