The past few months have seen volatility in the equity markets, yet a prominent trend has emerged.
The outlook for US equities has undergone a significant shift since the beginning of the year. Growth stocks are decisively outperforming value stocks.
This development has taken center stage as the primary narrative of the US equities market in 2023 thus far.
Considerable gains in US growth stocks this year
In 2023, the performance of big-cap growth stocks in the US has been robust, while value stocks have lagged.
For instance, Amazon’s year-to-date gains are around +22%, Tesla is up approximately +50%, and Meta Platforms has surged by roughly +81%. These figures are indicative of a broader trend in which growth stocks have significantly outperformed value stocks.
The contrast is considerable, with value stocks delivering a lackluster performance. Procter & Gamble is flat, Johnson & Johnson is down by about -9%, and Pfizer has declined by approximately -21%. The underperformance of value stocks is not limited to our narrow sample base but is a key theme that pervades the broader market.
To illustrate this, let’s consider the iShares Russell 1000 Growth ETF and the iShares Russell 1000 Value ETF. The contrast in the overall performance between the two ETFs is laid out starkly in the chart below. For reference, we include the performance of the S&P 500 futures, which comprise both growth and value components, as a benchmark.
US interest rates remain important
The outperformance of growth stocks over value stocks can be attributed, in large part, to interest rates and bond yields.
Throughout 2023, the markets have been grappling with the possibility of peak rates by the Federal Reserve. This boils down to two key questions for investors: when will the Fed stop hiking, and when will rate cuts resume?
The recent months have seen some considerable fluctuation in the pricing for US interest rate futures. After pricing for peak rates of maybe almost 5.70% in early March (some had even suggested 6% could be seen), expectations have been significantly scaled back.
At the height of the banking crisis, a peak of under 5.00% was possible. However, now as the actions of the Federal Reserve’s Bank Term Funding Program and the discount window have been lapped up by banks around the world, markets have settled down.
Rate futures have been creeping back higher and now stand above 5.00%. According to the CME Group FedWatch tool, the probability of a hike in May is around 84%. Furthermore, the pricing for rate cuts suggests that there may only be room for only one cut toward the end of the year.
Long-run inflation expectations have fluctuated between 2.1% and 2.5%, but have generally remained range-bound in recent months. However, bond yields have been on a downward trajectory, which has resulted in lower real bond yields (i.e., yields minus inflation). In turn, this has allowed the strong performance of US growth stocks.
A move higher in yields would be bad for US stocks
Although the prevailing market sentiment is that the Fed is nearing the end of its hiking cycle, as yields have rebounded in the past couple of weeks, this could begin to drag on US equity futures.
The E-Mini S&P futures and the US 10-year Treasury Inflation Protected Securities (which is viewed as the 10-year real yield) exhibit a strong negative correlation. In essence, as real yields fall, US growth stocks fare well. This is because growth stocks tend not to pay dividends and their high valuations are less eye-watering in a low-interest-rate environment.
However, as real yields have moved higher recently, the pace of the gains on the E-Mini S&P futures has eased off. If yields continue to move higher, then US futures will likely be pulled lower.
The negative correlation averages around -0.50 over the past 12 months. Subsequently, higher yields will ultimately weigh on US equities.
The warning signs are there
So, what about the performance of growth over value? There are a few factors to consider.
In recent weeks, volatility has seen a marked decline as market fears have receded, thanks in part to the alleviation of the US banking crisis (at least for the time being), which has bolstered growth stocks once more. However, the VIX Index, which measures S&P 500 options volatility, has dropped to its lowest level since January 2022, hovering around 17, which raises concerns about market complacency.
Moreover, there is a worrying signal as the Advance/Decline line on the NASDAQ is trailing. This indicates that the market is being driven by a small number of big hitters. This could make this upward trend unsustainable.
For growth stocks to remain buoyant, in the least, US real bond yields would need to remain stable, without experiencing a significant increase. While the market is largely anticipating a rate hike by the Federal Reserve in May, any hint of hawkishness during its delivery could lead to a surge in yields, which would negatively impact US equities.
Furthermore, this would likely hit US growth stocks the hardest, given their recent robust performance. But also, the performance goes both ways. Rising yields would likely be a catalyst for the underperformance of the US growth stocks.
Steve Miley
Co-Founder of TradeDay.
Steve is the former head of Technical Analaysis research at Merrill Lynch and Credit Suisse, and owner of the award winning research boutique Market Chartist.
