A value stock comeback, maybe

Good morning. The Magnificent Seven tech stocks rallied yesterday, taking the rest of the market with them, a pattern we find acutely boring at this point. A new paradigm would make our jobs more interesting. If you have one to suggest, email us: robert.armstrong@ft.com and ethan.wu@ft.com.

Whither value stocks

People, like me, who are drawn towards value stocks — stocks that are inexpensive relative to fundamentals such as profit or book value — have had a rough 15 years or so. Since the great financial crisis ended, value stocks have underperformed growth for all but a few transitory periods (the year 2022 being the longest of them). So anytime value shows strength, we get excited. 

And value stocks did well during the Santa Claus rally. They didn’t outperform, exactly, but they kept pace with growth stocks during an exuberant moment in which tech and speculative assets, from Nvidia to bitcoin, rose sharply. This is surprising. The rally was, by common consent, about the realisation that interest rates were set to fall. And it is a cliché, even if not a perfectly accurate one, that growth outperforms value when rates are falling.

Was this just a blip? Or can value win again in ‘24?

Patrick Palfrey of UBS points out that it is economically sensitive stocks — which he defines as stocks whose returns are particularly sensitive to Treasury yields, commodity prices and credit spreads — that have really soared since late October, after a poor performance in 2022 and most of 2023. This makes sense to me, inasmuch as what happened at the end of 2023 is that the market concluded that falling inflation would allow the Federal Reserve to loosen policy soon. This sharply reduced the probability of a policy-driven recession. So cyclical stocks, which would be hurt the most by a recession, rallied. Here is Palfrey’s list of the most economically sensitive S&P 500 components:

Not all of these exactly qualify as value stocks. The highly indebted cruise lines and casino stocks are not a perfect fit with the term, for example. But most of the list — energy, materials, banks, industrials — are classic value. 

What is interesting is that as a general rule, value stocks outperform in the recovery that follows a recession. A rapidly improving economy benefits riskier stocks that depend on a strong economic backdrop most. But while one can debate what kind of economy we are in, it does not seem like a recovery. Growth seems very likely to be slower this year than last year; the labour market, while still strong, is cooling a bit. We’re in a slowdown, though probably a mild one. So the good performance of value looks like a passing phase, a byproduct of a one-time reduction in the probability of recession, rather than any sort of regime shift. If the slowdown continues or deepens, value is probably not going to be the place to be. Yin Luo of Wolfe Research summed up the problem in an email. While value and especially cyclical value has done well recently,  

for 2024, we are generally negative or neutral on value stocks. “Defensive value” stocks (ie, stocks that are cheap on price/earnings or enterprise value/ebitda) typically benefit from a high/rising interest rate/inflation environment. “Cyclical value” (ie, stocks that are cheap on price-to-book) perform well during sharp market rally/bullish investment sentiment. As we head into 2024, neither catalysts are likely to last. Inflation is falling steadily . . . At the same time, economic growth has also moderated.

I put this to one of Unhedged’s favourite value investors, Patrick Kaser of Brandywine Global Investment Management. He said that he had thought we were headed for recession in 2023, and that value would have its moment as we came out of that recession. That didn’t happen, or hasn’t yet. But Kaser says that post-recession is not the only scenario in which value can outperform. When growth stocks have become badly overvalued, you can have a weak market and economic slowdown — and value outperforms anyway. This is what happened in 2000, for example. It may be that we have an analogous situation with the Magnificent Seven tech stocks now (indeed, Kaser points out that most of the outperformance of growth versus value has come from those seven stocks). “Glamour stocks are at a premium to history, and that is a good starting point for value to outperform,” he says. (Armstrong)

Why QT might need to slow down

Quantitative tightening — the Federal Reserve’s balance-sheet-shrinking programme — has been running along at $95bn a month for more than a year. Mostly, the process has been smooth. Yes, QT might have played a role in the regional banking crisis, but that crisis was cut short by targeted bank liquidity injections. We have so far been spared a funding crisis reminiscent of the 2019 repo market meltdown.

For how long, though? In recent months, funding markets have been making ominous (if not loud) noises. We’ve been seeing fleeting jumps in the secured overnight financing rate, which measures the cost of short-term borrowing in the repo market. Normalising Sofr using another short-term interest rate, the Fed’s reverse-repo rate, makes these spikes easier to see:

Each episode of funding-market stress has its own idiosyncratic cause (a Bloomberg report on a late November Sofr leap cites a “perfect storm” of a Treasury rally, banks’ month-end balance sheet window dressing and constrained dealer capacity). But the bigger picture is the declining quantity of reserves (that is, cash) sloshing around the financial system, which results from QT. As long as cash is ebbing, the little storms will continue.

In the Fed’s terminology, QT is meant to move the financial system from a regime of “abundant” reserves to one of “ample” reserves — from an uncontrolled flood of cash to a more modest, but still plentiful, level of liquidity. Crucially, QT must not create “reserve scarcity”, the rigid pre-financial crisis monetary regime. 

The problem, as Robin Wigglesworth notes, is that the lines between abundant, ample and scarce reserves are fuzzy. Since QT has happened only twice in the US, history is not much of a guide. Broadly, the transition from abundant to ample is often marked by the sort of mild funding market pressures we are seeing now. The move from ample to scarce is marked, or perhaps defined, by something blowing up. The level of reserves in the system before the 2019 repo crisis was about 7-8 per cent of nominal GDP, so some use that as a lower bound on how far reserves can decline. If that’s the threshold, we’re some way off:

But maybe that’s not the right threshold. Fed governor Christopher Waller has argued that so long as there is a positive balance in the Fed’s reverse-repo window, a bolt-hole for unused cash, there is likely enough liquidity in the system. The balance at the window now stands at $690bn. Others argue this is uncertain. In any case, the Fed will have to feel its way towards the right level of reserves.

This is the context in which Lorie Logan, Dallas Fed president and formerly the central bank’s top portfolio manager, made these comments over the weekend:

As we did in 2018 and early 2019, we are likely to see modest, temporary rate pressures as our balance sheet shrinks and our liabilities redistribute. These rate pressures can be a price signal that helps market participants redistribute liquidity to the places where it’s needed. Experience shows that these pressures tend to emerge first on dates when liquidity is unusually encumbered . . . indeed, we saw small, temporary rises in [Sofr] over the November-December and year-end turns . . . 

. . . individual banks can approach scarcity before the system as a whole. In this environment, the system needs to redistribute liquidity from the institutions that happen to have it to those that need it most. The faster our balance sheet shrinks, the faster that redistribution needs to happen . . . In my view, we should slow the pace of [balance sheet shrinking] as [reverse-repo facility] balances approach a low level.

Logan’s point is that liquidity isn’t uniform. It matters which players in the financial system have it. This is what the rumbles in Sofr show. If the QT endpoint is uncertain, approach it slowly. (Ethan Wu)

One good read

Believing in America (by a Brit).

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